International Finance http://www.oanda.com/converter/classic

1. International Finance http://www.oanda.com/converter/classic

2. Learning Objectives • Explain how international trade is financed • Describe a country’s balance of payments accounts • Explain what determines the amount of international borrowing and lending

3. Learning Objectives (cont.) • Explain why the United States changed from being a lender to being a borrower in the mid-1980s • Explain how the foreign exchange value of the dollar is determined • Explain why the foreign exchange value of the dollar fluctuates

4. Financing International Trade Balance of Payments Accounts Balance of payments accounts record a country’s international trading, borrowing, and lending.

5. Balance of Payments: Credits • Credits, + (receipts from foreigners) • Exports of goods and services • Income receipts • Unilateral current transfers to the US • Financial inflows • “Dollars in”

6. Balance of Payments: Debits • Debits, - (payment to foreigners) • Imports of goods and services • Income payments • Unilateral current transfers to foreigners • Financial outflows • “Dollars out”

7. Balance of Payments Paired Transactions • Every international transaction enters the balance of payments twice, once as a credit and once as a debit • If you buy something from a foreigner, you must pay her. She must then spend or store your payment.

8. Examples of Paired Transactions

9. Examples of Paired Transactions

10. Examples of Paired Transactions

11. Credits to the Current Account • Credits, + (receipts from foreigners) • Exports of goods and services • income receipts • unilateral current transfers to the US

12. Debits to the Current Account • Debits, - (payment to foreigners) • Imports of goods and services • Income payments • Unilateral current transfers to foreigners

13. Credits to the Financial Account • Credits, + (receipts from foreigners) • Financial inflows • Increase in foreign-owned assets (U.S. liabilities) • Decrease in U.S.-owned assets (U.S. claims).

14. Debits to the Financial Account • Debits, - (payment to foreigners) • Financial outflows • Decrease in foreign-owned assets (U.S. liabilities) • Increase in U.S.-owned assets (U.S. claims)

15. Financing International Trade The balance of payments accounts include: 1) Current account • Exports of goods and services + US income receipts • Imports of goods and services+US income payments • Unilateral current transfers, net • US receipts – US payments • “Net interest income” = US income receipts –US income payments

16. Financing International Trade The balance of payments accounts include: 2) Financial account* • Records changes in foreign assets in the United States minus changes US assets abroad * Prior to 1997, the Financial account was known as the Capital account

17. Financing International Trade The balance of payments accounts include: 3) Official settlements account • Records the change in official U.S. reserves. • Official U.S reserves -- mainly the government’s holdings of foreign currency. • If official reserves increase, the official settlements accounts balance is negative. Part of the Financial account & it’s small!

18. Financing International Trade Fundamental balance of payments accounts identity: Current account + Financial account = 0

19. U.S. Balance of Payments Accounts in 1996 Current account (billion $) Import of goods and services -940 Exports of goods and services +830 Net interest income –10 Net transfers –40 Current account balance –160 Financial account (increases in ...) Foreign investment in the United States +430 U.S. investment abroad -240 Statistical discrepancy –40 Financial account balance +150 Official settlements account Decrease in official U.S. reserves +10

20. U.S. Balance of Payments Accounts in 1998 Current account (billion $) Import of goods and services -1,120 Exports of goods and services +910 Net interest income +20 Net transfers –40 Current account balance –230 Financial account (increases in ...) Foreign investment in the United States +540 U.S. investment abroad -310 Statistical discrepancy –40 Financial account balance +230 Official settlements account Increase in official U.S. reserves -

21. U.S. Balance of Payments • Let’s visit the Bureau of Economic Analysis http://www.bea.doc.gov/bea/di1.htm

22. The Balance of Payments:1975-1998

23. Financing International Trade Borrowers and Lenders, Debtors and Creditors • A net borrower is a country that is borrowing more from the rest of the world than it is lending. • A net lender is a country that is lending more than it is borrowing.

24. Financing International Trade Borrowers and Lenders, Debtors and Creditors • Debtor nations are countries that during their entire history have borrowed more from the rest of the world than they have lent to it. • Creditor nations are countries that have invested more in the rest of the world than other countries have invested in it.

25. Financing International Trade Borrowers and Lenders, Debtors and Creditors • The United States is both a net borrower and a debtor nation. • We became a borrower as a result of a string of current account deficits. Is there any reason to be concerned?

26. Financing International Trade No — if the borrowing is financing investment that is generating economic growth and higher income. Yes — if the money is being used to finance consumption. This will result in higher interest payments and consumption will eventually have to be reduced.

27. Financing International Trade Current Account Balance The current account balance (CAB) equals:

28. Financing International Trade Net Exports • Largest part of the current account balance. • Determined by the government budget and private saving and investment.

29. Financing International Trade Net Exports • Net exports is exports of goods and services minus imports of goods and services (X-M) • A government sector surplus or deficit is net taxes minus government purchases of goods and services (T – G) • A private sector surplus or deficit is saving minus investment (S – I)

30. United States in 1998 (billions of dollars) Symbols and equations Net Exports, the Government Budget, Saving, and Investment Variables Exports X 959 Imports M 1,110 Government purchases G 1,487 Net Taxes T 1,563 Investment I 1,367 Saving S 1,140

31. Net Exports, the Government Budget, Saving, and Investment Net Exports X - M = 959 – 1,110 = – 151 Government sector T - G = 1,563 – 1,487 = 76 Private sector S - I = 1,140 – 1,367 = –227 Surpluses and deficits in 1998

32. Net Exports, the Government Budget, Saving, and Investment Relationship among surpluses and deficits in 1998 National accounts Y = C + I + G + X – M = C + S + T Rearranging X – M = S – I + T – G Net exports X – M –151 equals: Government sector T – G 76 plus Private sector S – I –227

33. Financing International Trade The Twin Deficits • The government sector balance (T-G) and the Current Account balance (X-M) tend to move in the same direction • The US has frequently had a deficit on both • Hence, they are known as the twin deficits.

34. The Twin Deficits

35. Financing International Trade Is U.S. Borrowing for Consumption or Investment • Net exports were –$99 billion in 1996 • The government buys structures (e.g. highways, dams) that exceed $200 billion/year. • The government spends on education and health care—increases human capital.

36. Financing International Trade Is U.S. Borrowing for Consumption or Investment Our borrowing is financing investment

37. The Exchange Rate • The foreign exchange market is the market in which the currency of one country is exchanged for the currency of another. • The foreign exchange rate is the price at which one currency exchanges for another. • In April 1997==>$1 = 123 Japanese yen

38. The Exchange Rate

39. The Exchange Rate Currency depreciation is the fall in the value of one currency in terms of another. • The dollar depreciates if in later months it will buy less yen than before (e.g. 90 yen as compared to 114). Currency appreciation is the rise in the value of one currency in terms of another currency.

40. The Exchange Rate Demand in the Foreign Exchange Market The quantity of dollars demanded in the foreign exchange market depends upon: 1) The exchange rate 2) Interest rates in the United States and other countries 3) The expected future exchange rate

41. The Exchange Rate The Law of Demand for Foreign Exchange • The demand for dollars is a derived demand. • They (RoW) buy dollars in order to buy U.S.-made goods and services. • Holding other things the same, the higher the exchange rate, the less is the quantity of dollars demanded.

42. Other things remaining the same, a rise in the exchange rate decreases the quantity of dollars demanded... …and a fall in the exchange rate increases the quantity of dollars demanded D The Demand for Dollars 150 100 Exchange rate (yen per dollar) 50 0 1.1 1.2 1.3 1.4 1.5 Quantity (trillions of dollars per day)

43. The Exchange Rate Why do exchange rates influence the quantity of dollars demanded? 1) Exports Effect 2) Expected Profit Effect

44. The Exchange Rate Changes in the Demand for Dollars A change in any other influence on the dollars that people plan to buy in the foreign exchange market: • Changes the demand for dollars • Shifts the demand curve for dollars

45. The Exchange Rate The other factors that change the demand for dollars are: 1) Interest rates in the United States and other countries interest rate differential = US rate – other rate 2) The expected future exchange rate

46. Increase in the demand for dollars Decrease in the demand for dollars D1 D2 Changes in the Demand for Dollars 150 Exchange rate (yen per dollar) 100 50 D0 0 1.1 1.2 1.3 1.4 1.5 Quantity (trillions of dollars per day)

47. The U.S interest rate differential increases The expected future exchange rate rises The U.S. interest rate differential decreases The expected future exchange rate falls Changes in theDemand for Dollars The demand for dollars increases if: The demand for dollars decreases if:

48. The Exchange Rate Supply in the Foreign Exchange Market The quantity of dollars supplied in the foreign exchange market depends upon: 1) The exchange rate 2) Interest rates in the United States and other countries 3) The expected future exchange rate

49. The Exchange Rate The Law of Supply for Foreign Exchange • U.S. residents supply dollars in the foreign exchange market when they buy imports. • Holding other things the same, the higher the exchange rate, the higher is the quantity of dollars supplied.

50. The Exchange Rate Why do exchange rates influence the quantity of dollars supplied? 1) Imports Effect 2) Expected Profit Effect