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Understanding Foreign Exchange and Balance of Payments Market

Learn about the determinants of exchange rates, the impact of income changes and inflation, and the relationship between demand for imports and foreign currency. Explore the concept of balance of payments and its components, such as the current account and financial account.

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Understanding Foreign Exchange and Balance of Payments Market

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  1. Unit-5 Macro Review Foreign Exchange & Balance of Payments

  2. Market for Foreign Exchange U.S. Income Rises Demand Imports Demand Foreign Currency Determinants of Exchange Rates 1.Changes in Consumer Tastes 2. Relative Income Changes 3. Relative Inflation 4. Relative Real Interest Rates 5. Speculation & Investment Dollar Depreciates Foreign Appreciates

  3. Euro Price of a dollar S1 S1 Dollar Price of a Euro S2 .75 Euro 1.3 $ -------------- -------------- D2 -------------- -------------- D1 D1 Q1 Q1 Qty of Dollars Qty of Euros Graphing Exchange Rates = Market for Foreign Exchange Dollars Euros U.S. Price Level Falls => U.S. goods look “cheap” => Europeans ↑U.S. exports => Demand for dollars ↑ => Dollar appreciates

  4. If one account is positive the other must Be negative. They generally sum to ZERO! Balance of Payments • Current Account (NX) • U.S. Trade Balance • Exports - Imports & Investment Income (bond interest, stock dividends) • Financial Account(formerly called capital account) • Foreign purchase of US assets – U.S. purchase of foreign assets • Assets = Stocks, bonds, factories, land, etc… • Example:Capital Surplus = Capital flows into US

  5. China & Balance of Payments • The USA imports more goods from China than we export to them… • Balance of Payments: China buys U.S. Bonds Capital Account Surplus Imports > Exports Current Account Deficit

  6. If one is positive the other is negative. They generally sum to ZERO! Balance of Payments • Current Account (NX) • U.S. Trade Balance • Exports - Imports & Investment Income (bond interest, stock dividends) • Financial Account(formerly called capital account) • Foreign purchase of US assets – U.S. purchase of foreign assets • Assets = Stocks, bonds, factories, land, etc… • Example:Capital Surplus = Capital flows into US • Official Reserves • Fed holds quantities of foreign currency called reserves • Used to offset discrepancy in current account vs. capital account If both accounts do Not sum to zero, reserves are used to Offset minor difference

  7. 2005 AP Macroeconomics Question 1

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