The International Flows of Goods and Capital

1. The International Flows of Goods and Capital International trade in goods and capital increase consumption possibilities beyond production possibilities

2. Factors Influencing the International Flow of Goods • Domestic Income and Foreign Income; • Relative Price Level--The Ratio of the Domestic Price Level to the Foreign Price Level; • The Exchange Rate; and • Other Non-Economic Factors such as Tastes, Preferences, etc.

3. Exchange Rates Nominal Exchange Rate (r): Price of a foreign currency in the units of home currency: $0.50 = DM1 or DM2 = $1.00 $/DM = 0.50 or DM/$ = 2 Nominal Exchange Rates: • Spot Exchange Rate (rs) • Forward Exchange Rate (rf)

4. Functions of the Foreign Exchange Market • Clearing • the act of helping international traders to end up with the kind of currency they prefer; • Hedging • the act of reducing or eliminating a net asset or a net liability position in a foreign currency; and • Speculating • the act of taking a net asset position (long) or a net liability (short) position in a foreign currency

5. If Trade is Balanced: • Goods, services and assets move internationally from exporters to importers; • Payments move domestically from importers to exporters; and • Foreign exchange market’s holdings of each currency are unchanged.

6. If Trade is not Balanced: • Goods, services and assets move internationally from exporters to importers; • Payments move domestically from importers to exporters; and • Foreign exchange market’s holdings of each currency change, i.e., • currency of the surplus country becomes scarce; • currency of the deficit country becomes abundant.

7. If Trade Imbalance Persists: • Currency of the deficit country depreciates • this results in improvement in the competitive position of the deficit country’s goods in world markets (i.e., exports will increase and imports will decrease); and • Currency of the surplus country appreciates • this results in deterioration in the competitive position of the surplus country’s goods in world markets (i.e., exports will decrease and imports will increase).

8. Exchange Rate Management Systems (Regimes) • Flexible (Floating) Exchange Rate System • Markets determine and manage exchange rates • Fixed Exchange Rate System • Governments manage exchange rates • Managed Float Exchange Rate System • Combination of Flexible and Fixed Systems • Exchange Controls • Governments monopolize currency markets

9. The Flexible (Floating) Exchange Rate Regime Under a flexible (floating) exchange rate regime, demand and supply determine the exchange rate without intervention by governments or central banks. The major countries have been on something close to this system since 1973.

10. Sources of Demand for the U.S.$: • American exports of goods and services; • American capital inflows; • U.S.$ being used as a medium of exchange by other countries; • U.S.$ being used as an official reserve by other countries; and • Foreign speculators dealing in U.S.$

11. Sources of Supply of U.S.$: • American imports of goods and services; • American capital outflows; • American speculators dealing in foreign currencies; and • The Federal Reserve System