Chapter 20: International Finance

1. Chapter 20: International Finance What are the Balance of Payments Accounts? 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. What is Purchasing Power Parity?

2. Financing International Trade • Balance of Payments Accounts • Balance of payments accounts record a country’s international trading, borrowing, and lending. • Accounts: • Current account: Records trade in goods and services • Capital account: Records net foreign investment. • Official settlements account: Records change in official U.S. reserves • Current account • Records payments for imports of goods and service from abroad, receipts from exports of goods and services sold abroad, net interest paid abroad, and net transfers (e.g. foreign aid) • Current account balance equals exports minus imports, net interest, and net transfers

3. The balance of payments • Capital account • Records foreign investment in the United States minus U.S. investment abroad • Net Foreign Investment provides foreign reserves to US. • Tells us how much US borrowed from rest of world. • It is often the mirror image of the current account • When U.S interest rate is high relative to others, NFI will increase. • Official settlements account • Records the change in official U.S. reserves • Official U.S reserves are the government’s holdings of foreign currency • If official reserves increase, the official settlements accounts balance is negative

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

5. The Balance of Payments:1975-1996

6. Financing International Trade • Borrowers and Lenders. • 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. • Debtors and Creditors • Debtor nations are countries that during their entire history has borrowed more from the rest of the world than it has lent to it. • Creditor nations are countries that have invested more in the rest of the world than other countries have invested in it. • The United States is both a net borrower and a debtor nation. • We became a debtor as a result of a string of current account deficits. • Is there any reason to be concerned?

7. 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. • Current Account Balance • The current account balance (CAB) equals: • Net Exports • Net exports have the largest impact on the current account balance. • They are determined by the government budget and private saving and investment.

8. The Twin Deficits • Net Exports • Net exports is exports of goods and services minus imports of goods and services. • A government sector surplus or deficit is net taxes minus government purchases of goods and services. • A private sector surplus or deficit is saving minus investment. Variables Symbols and equations United States in 1996 (billions of $) Exports X 855 Imports M 954 Government purchases G 1,407 Net Taxes T 1,340 Investment I 1,116 Saving S 1,084

9. The Twin Deficits Surpluses and deficits Net Exports X - M 855 – 954 = –99 Government sector T - G 1,340 – 1,407 = –67 Private sector S - I 1,084 – 1,116 = –32 Relationship among surpluses and deficits National accounts Y = C + I + G + X – M = C + S + T Rearranging: X – M = S – I + T – G

10. The Twin Deficits

11. The Twin Deficits • Why the close linkage: • International capital flows in response to changes in interest rate • Large deficit pushes up interest rates • 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. • Our borrowing is financing investment

12. 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 July 1997==>$1 = 114 Japanese yen • 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. • The quantity of dollars demanded in the foreign exchange market depends upon: The exchange rate Interest rates in the U.S. and other countries The expected future exchange rate

13. The Exchange Rate • The Law of Demand for Foreign Exchange • The demand for dollars is a derived demand. • Other countries 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. • Why do exchange rates influence the quantity of dollars demanded? 1) Exports Effect. The lower the exchange rate, the cheaper are US produced goods, and so the greater the quantity of US exports, and the greater the value of US exports. So the quantity of dollars demanded is greater as well. 2) Expected Profit Effect. If you expect that the US dollar will be worth 120 yen tomorrow, and if it is worth 115 yen today, you will hold US dollars. So the lower the exchange rate, the more dollars you will hold, and therefore demand.

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

15. The Exchange Rate • The other factors that change the demand for dollars are: 1) Interest rates in the United States and other countries. 2) The expected future exchange rate. • A change in any of these factors shifts the demand curve for dollars. The demand for dollars increases if: The demand for dollars decreases if: • 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

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

17. The Exchange Rate • The Law of Supply for Foreign Exchange • People supply dollars in the foreign exchange market when they buy U.S. imports. • Holding other things the same, the higher the exchange rate, the higher is the quantity of dollars supplied. • Why do exchange rates influence the quantity of dollars supplied? 1) Imports Effect. The higher the exchange rate, the greater the value of US imports. The more people import, the more foreign currency they need to finance the imports. They sell dollars to buy foreign currency, and the supply of dollars goes up. 2) Expected Profit Effect. If the exchange rate is high, holding foreign currency is attractive. So the higher the supply of dollars.

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

19. The Exchange Rate • The other factors that change the supply of dollars are: 1) Interest rates in the United States and other countries. 2) The expected future exchange rate. • A change in any of these factors causes the supply curve of dollars to shift. Changes in the Supply of Dollars The supply of dollars increases if: The demand for dollars decreases if: • The U.S interest rate differential decreases • The expected future exchange rate falls. • The U.S. interest rate differential increases • The expected future exchange rate rises.

20. The Supply of Dollars S1 S0 S2 Decrease in the supply of dollars 150 Exchange rate (yen per dollar) 100 Increase in the supply of dollars 50 0 1.1 1.2 1.3 1.4 1.5 Quantity (trillions of dollars per day)

21. The Exchange Rate • Market Equilibrium • If the exchange rate is too high, there is a surplus of dollars. • If the exchange rate is too low, there is a shortage of dollars. • At the equilibrium exchange rate, there is neither a shortage nor a surplus. • Exchange Rate Fluctuations • The Exchange Rate is particularly volatile because supply and demand for dollars are not independent of each other • A change in the expected future changes or U.S. interest rate differential changes both supply and demand. • Exchange Rate Expectations • Two expectations that affect the value of money are: 1) Purchasing power parity 2) Interest rate parity

22. Equilibrium Exchange Rate S Surplus at 150 yen per dollar 150 Exchange rate (yen per dollar) Equilibrium at 100 yen per dollar 100 50 D Shortage at 50 yen per dollar 0 1.1 1.2 1.3 1.4 1.5 Quantity (trillions of dollars per day)

23. Exchange Rate Fluctuations.

24. Exchange Rate Fluctuations S94 S95 Exchange rate (yen per dollar) 100 84 D94 D95 0 Q0 Quantity (trillions of dollars per day)

25. Exchange Rate Fluctuations S97 S95 123 Exchange rate (yen per dollar) D97 84 D95 0 Q0 Quantity (trillions of dollars per day)

26. The Exchange Rate • Purchasing Power Parity • Money is worth what it will buy. • Purchasing power parity means equal value of money. • If prices increase in Canada (for example) and other countries but remain constant in the U.S., people will generally expect that the value of the U.S. dollar is too low and will expect it to rise. • Supply of and demand for dollars change • The exchange rate changes • The Big Mac Index • The idea of the Big Mac Index is that the long-run exchange rate should equalize prices of identical goods across countries. • The problems with this idea is that the product contains non-traded inputs, such as rent, labor, etc. Also, the market power varies across locations, and therefore the law of one price will not necessarily hold.

29. The Exchange Rate • Interest Rate Parity • Money is worth what it can earn. • Interest rate parity means equal interest rates across countries. • If the rate of return on the dollar is higher in the U.S. than in some other country, the demand for U.S. dollars rises and the exchange rate rises correspondingly, until expected interest rates are equal. • The Fed in the Foreign Exchange Market • Since the Fed influences the supply of money, it also has an impact on the exchange rate. • The Fed can intervene in the foreign exchange market and smooth out fluctuations in the exchange rate. • Suppose the Fed wants the exchange rate to be steady at a target rate. • If the exchange rate rises above the target rate, then the Fed increases the supply of dollars. • If the exchange rate goes below the target rate, then the Fed buys dollars.

30. Foreign ExchangeMarket Intervention S0 S1 130 130 Exchange rate (yen per dollar) 120 Target exchange rate 130 D1 130 D0 0 1.1 1.2 1.3 1.4 1.5 Quantity (trillions of dollars per day)

31. Foreign ExchangeMarket Intervention S2 S0 130 Target exchange rate 130 Exchange rate (yen per dollar) 120 130 130 D0 D2 0 1.1 1.2 1.3 1.4 1.5 Quantity (trillions of dollars per day)