Ch. 18: International Finance

1. Ch. 18: International Finance • Financing international trade • Balance of payments accounts • International borrowing and lending • Explanations for U.S. change from lender to borrower. • Exchange rate determination. • Interest rate differentials

2. Financing International Trade • Balance of Payments Accounts • Records international trading, borrowing and lending. • Three accounts: • Current account • Capital account • Official settlements account • + in balance of payments = inflows of currency • - In balance of payments = outflows of currency

3. Financing International Trade Current account: net exports + net investment income + net transfers Capital account (financial account): Foreign investment in U.S. - U.S. investment in foreign co.’s Official settlements: – net change in U.S. official holdings of foreign currency Current + Capital + official settlements = 0 (approx.)

4. Financing International Trade • The balance of payments (as a % of GDP) over the period 1983 to 2003.

5. Borrowers and Lenders, Debtors and Creditors • A country that is borrowing more from the rest of the world than it is lending to it • is a net borrower. • has a current account deficit and a capital account surplus (assume official settlements acc=0) • A country that is lending more to the rest of the world than it is borrowing from it • is a net lender. • has a current account surplus, and capital account deficit (assume official settlements=0) • The U.S. is currently a net borrower (but as late as the 1970s it was a net lender.)

6. Borrowers and Lenders, Debtors and Creditors • Debtor nation • during its entire history has borrowed more from the rest of the world than it has lent to it. • Creditor nation • invested more in the rest of the world than other countries have invested in it over its entire history • Difference between borrower/lender nation & creditor/ debtor • difference between stocks and flows of financial capital.

7. Borrowers and Lenders, Debtors and Creditors • Being a net borrower is not a problem provided the borrowed funds are used to finance capital accumulation that increases income. • Being a net borrower is a problem if the borrowed funds are used to finance consumption.

8. Borrowers and Lenders, Debtors and Creditors • Current Account Balance • NX + Net int. income + Net transfers • NX is largest item in current account. • The other two items are much smaller and don’t fluctuate much. • NX = (T – G) + (S – I ) • (T-G): govt surplus/deficit. • (S-I): private sector saving (surplus/deficit).

9. Financing International Trade • Net exports for the U.S. for 2003 • –$506 billion = +$42 b (priv sector surplus) • - 548 b (govt sector deficit)

10. Borrowers and Lenders, Debtors and Creditors • S-I has moved in the opposite direction of (T-G) • No strong relationship between NX and the other two balances individually.

11. Borrowers and Lenders, Debtors and Creditors • Is U.S. Borrowing for Consumption or Investment? • U.S. borrowing from abroad finances investment. • It is much less than private investment and almost equal to government investment in public infrastructure capital.

12. The Exchange Rate • Foreign exchange market • currency of one country is exchanged for the currency of another. • Foreign exchange rate • The price at which one currency exchanges for another • Currency depreciation/appreciation • fall/rise in the value of the currency in terms of another currency.

13. The Exchange Rate More recent currency trends at http://finance.yahoo.com/currency

14. The Exchange Rate

15. The Exchange Rate • Demand for $ in the Foreign Exchange Market • Quantity of dollars that traders plan to buy in the foreign exchange market during a given period: • Depends on • The exchange rate • Interest rates in the U.S. and other countries • Expected future exchange rate

16. The Exchange Rate • Law of Demand for Foreign Exchange • The demand for dollars is a derived demand. • People in foreign countries buy $ so that they can buy U.S.-made goods and services or U.S. assets. • As the exchange rate rises (f.c. per $), U.S. exports become more expensive for foreigners and the quantity of $ demanded falls.

17. The Exchange Rate

18. The Exchange Rate • Changes in the Demand for Dollars • Interest rates in the U.S. and in other countries • Changes in the expected future exchange rate • U.S. prices relative to foreign prices • Changes in expected relative profitability of investments in U.S. • Changes in income in foreign countries

19. The Exchange Rate • Supply in the Foreign Exchange Market • Ceteris paribus, the higher the exchange rate (f.c. per $), the greater is the quantity of dollars supplied in the foreign exchange market. • As f.c. per $ increases, imports from foreign countries become cheaper to U.S., and U.S. wants to sell more $ to purchase imports.

21. The Exchange Rate • Changes in the Supply of Dollars • Shift in the supply curve. • Interest rates in the U.S. and in other countries • Changes in the expected future exchange rate • U.S. prices relative to foreign prices • Changes in expected relative profitability of investments in U.S.

23. The Equilibrium

24. The Exchange Rate • Changes in the Exchange Rate • Changes in demand and supply in the foreign exchange market change the exchange rate (just like they change the price in any market). • interest rates. • inflation rates • investment opportunities • expected future exchange rates

25. Movements in exchange rates • Increase in U.S. interest rates relative to rest of world. • Increase in expected investment returns relative to rest of world. • Increase in U.S. inflation relative to rest of world. • Expected increase in value of $ in future.

26. Other Exchange Rate Considerations. • Purchasing power parity: • A currency should buy the same amount of goods and services in every country. • If PPP does not hold, there may be an opportunity for profit-making through arbitrage. • Example • Gold costs $300 per ounce in U.S.; 200 Euros in Europe. PPP exchange rate should be $300=200 Euros (i.e. .67 Euros per dollar). • If exchange rate is 1 Euro per dollar, • how can profits be made? • how will this affect exchange rate?

27. The Exchange Rate • If PPP holds, •  e = P in f.c./ P in $ • % ch in e = inflation in f.c. – inflation in U.S.

28. The Exchange Rate • Interest rate parity • The return on a currency is the interest rate on that currency plus the expected rate of appreciation over a given period. • When the returns on two currencies are equal, interest rate parity prevails. • Market forces achieve interest rate parity very quickly.

29. The Exchange Rate • Return in $ = return in f.c. - % change in P of $ • If a German bond pays 10% over next year and value of $ increases 10%, what’s return in $? • If a German bond pays 10% over next year and value of $ decreases 10%, what’s return in $? • Interest differentials across countries reflect expected movements in exchange rates. • If German bonds pay 10% and U.S. bonds pay 4%, what is • expected movement in exchange rate? • Expected difference in inflation rate?

30. The Exchange Rate • The Fed in the Foreign Exchange Market • Through its influence on the interest rate, the Fed can influence the exchange rate. • The Fed can also intervene directly • By buying $ in foreign exch. market (selling f.c.) • Fed can increase demand for $ • Strengthen $ • Incur net loss of official reserves. • By selling $ in foreign exch. Market (buying f.c.) • Fed can increase supply of $ • Weaken $ • Incur net gain of official reserves.