Understanding Balance of Payment Accounts and Exchange Rates

1. AP Macroeconomics Mr. Graham AP Exam Review

2. Unit 7: Open Economy: International Trade and Finance (10-15%) 2

3. Capital Flows and the Balance of Payments 3

4. We learned that economists keep track of the domestic economy using the national income and product accounts (i.e. GDP) Economists keep track of international transactions using a different but related set of numbers—the balance of payment accounts Capital Flows and the Balance of Payments

5. A country’s balance of payment accounts are a summary of the country’s transactions with other countries. Current Account Represents the purchases and sales of goods and services with other countries (i.e. net exports) Also includes factor income and international transfers Financial Account Represents the purchases and sales of assets with other countries Balance of Payment Accounts

6. Current Account • Sales and Purchases of Goods and Services • U.S. wheat exports or U.S. oil imports, for example. • Factor Income: Payments for the use of factors of production owned by residents of other countries. • The profits earned by Disneyland Paris or the profits earned by U.S. operations of Japanese auto companies, for example. • International Transfers: Funds sent by residents of one country to those of another (i.e. foreign aid, gifts). • Remittances that immigrants (i.e. millions of Mexican-born workers employed in U.S.) send to their families, for example.

7. Balance of Payment Accounts

8. Financial Account • Sales and purchases of assets between governments or government agencies, mainly central banks • In 2008, for example, most of the U.S. sales in this category involved the accumulation of foreign exchange reserves by the central banks of China and oil-exporting countries. • Private sales and purchases of assets. • The 2008 purchase of Budweiser by the Belgian corporation InBev or the purchase of European stocks by U.S. investors, for example

9. Balance of Payment Accounts

10. Current account (CA)  Financial account (FA)  0 Balance of Payment Accounts • Any nation experiencing a current account deficit must also be running a financial account surplus. • In Table 41.2, the U.S. current account deficit and financial account surplus almost offset each other—the $167 billion difference was just a statistical error, reflecting the imperfection of official data. • In fact, there is a basic rule of BOP accounting:

11. To explain the equation, we again use a circular-flow model to explain the flow of money between economies. Balance of Payment Accounts

12. Balance of Payment Accounts

13. Why do the accounts balance? • When the current account is negative, it means we have been spending more abroad than foreigners have been spending here. • This excess spending puts dollars in foreign hands… • The financial account will be positive because it accounts for those dollars put in foreign hands. • These dollars are most commonly used to buy assets in the United States. • If foreigners decided to hold onto them, it is still an investment—in U.S. currency, which is also an “asset”.

14. The Foreign Exchange Market 14

15. Understanding Exchange Rates • In general, goods, services, and assets produced in a country must be paid for in that country’s currency. • Foreign Exchange Market • International transactions require a market in which currencies can be exchanged for each other. • Exchange Rates • The prices at which currencies trade, as determined by the foreign exchange market.

16. Understanding Exchange Rates • Exchange rates are expressed in two different ways:

17. The exchange rate for any currency is determined by the supply of that currency and the demand for that currency (in the foreign exchange market model). The Equilibrium Exchange Rate

18. How does a shift in demand for U.S. dollars affect equilibrium? The Equilibrium Exchange Rate • Changes in real interest rates • Changes in productivity • Changes in product preferences • Perceptions of economic stability

19. Appreciation An increase in the exchange value of one nation’s currency in terms of the currency of another nation Depreciation An decrease in the exchange value of one nation’s currency in terms of the currency of another nation The Equilibrium Exchange Rate

20. The Equilibrium Exchange Rate • When the Japanese demand for Dollars increases, the supply of Yen increases in foreign exchange market. • The dollar appreciates, while the yen depreciates.

21. The Role of the Exchange Rate • The capital account reflects the international movement of goods and services. • The financial account reflects the international movement of capital. • So what ensures that the balance of payments really does balance (i.e. offset each other)? • The Exchange Rate!

22. The Role of the Exchange Rate

23. The Role of the Exchange Rate • Increase in real interest rates in the United States causes an increase capital inflow into the U.S. • Appreciation of the dollar makes U.S. exports relatively more expensive.

24. The increased capital inflow to the United States (financial account) must be matched by a decline in the balance of payments on the current account. The Role of the Exchange Rate Caused by the appreciation of the dollar

25. So any change in the U.S. balance of payments on the financial account generates an equal and opposite reaction in the balance of payments on the current account. Movements in the exchange rate ensure that changes in the financial account and in the current account offset each other! The Equilibrium Exchange Rate

26. Real Exchange Rates Exchange rates adjusted for international differences in aggregate price levels As an example, we’ll look at the number of Mexican pesos per U.S. dollar. Let PUS and PMex be indexes of the aggregate price levels in the United States and Mexico, respectively. Then the real exchange rate between the Mexican peso and the U.S. dollar is defined as: Real Exchange Rate = Mexican pesos per U.S. dollar x PUS/PMex Inflation and Real Exchange Rates

27. To understand the significance of the difference between the real and nominal exchange rates, let’s consider: The Mexican peso depreciates against the U.S. dollar, with the exchange rate going from 10 pesos per U.S. dollar to 15 pesos per U.S. dollar. At the same time the price of everything in Mexico, measured in pesos, increases by 50%, so that the Mexican price index rises from 100 to 150. We’ll assume that there is no change in U.S. prices, so that the U.S. price index remains at 100. The initial real exchange rate is: Real Exchange Rate = Mexican pesos per U.S. dollar x PUS/PMex Inflation and Real Exchange Rates

28. The current account responds only to changes in the real exchange rate, not the nominal exchange rate. Inflation and Real Exchange Rates

29. Exchange Rate Policy 29

30. Exchange Rate Regimes

31. Exchange Market Intervention Government purchases or sales of currency in the foreign exchange market to make up the differences above. Stocks of foreign currency (usually U.S. dollars or euros) that they can use to buy their own currency to support its price How Can an Exchange Rate be Fixed?

32. Governments can shift the supply/demand curves in the foreign exchange market Government conducts monetary policy to raise/lower the interest rate to decrease/increase capital flows from abroad How Can an Exchange Rate be Fixed?

33. Foreign Exchange Controls Government-imposed licensing systems that limit the right of individuals to buy foreign currency. Reduces the supply of a currency by limiting the number of licenses to people engaged in government-approved actions How Can an Exchange Rate be Fixed?

34. Fixed Exchange Rate Benefits Certainty about the future value of a currency. Commits a country to not engaging in inflationary policies, which would destabilize the exchange rate Fixed Exchange Rate Costs A country must keep large quantities of foreign-currency on hand for stabilization needs. Monetary policy used to stabilize the exchange rate is diverted from other policy goals. Foreign exchange controls distort incentives for importing and exporting goods and services. Exchange Rate Regimes