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The World of International Finance. P R E P A R E D B Y. Today, the world currency markets are always open. When foreign exchange traders in New York City are sound asleep at 3:00 A.M., their counterparts in London are already on their phones and computers at 8:00 A.M.

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The World ofInternational Finance

P R E P A R E D B Y

Today, the world currency markets are always open. When foreign exchange traders in New York City are sound asleep at 3:00 A.M., their counterparts in London are already on their phones and computers at 8:00 A.M.

Macroeconomics: Principles, Applications, and Tools O’Sullivan, Sheffrin, Perez 6/e.

FERNANDO QUIJANO, YVONN QUIJANO, AND XIAO XUAN XU


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HOW EXCHANGE RATES ARE DETERMINED

19.1

  • What Are Exchange Rates?

  • exchange rate

    • The price at which currencies trade for one another in the market.

  • euro

    • The common currency in Europe.

An increase in the value of a currency relative to the currency of another nation is called an appreciation of a currency.

A decrease in the value of a currency relative to the currency of another nation is called a depreciation of a currency.


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HOW EXCHANGE RATES ARE DETERMINED

19.1

  • How Demand and Supply Determine Exchange Rates

  • FIGURE 19.1The Demand for and Supply of U.S. Dollars

Market equilibrium occurs where the demand for U.S. dollars equals the supply.


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HOW EXCHANGE RATES ARE DETERMINED

19.1

  • Changes in Demand or Supply

  • FIGURE 19.2Shifts in the Demand for U.S. Dollars

An increase in the demand for dollars will increase (appreciate) the dollar’s exchange rate. Higher U.S. interest rates or lower U.S. prices will increase the demand for dollars.


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HOW EXCHANGE RATES ARE DETERMINED

19.1

  • Changes in Demand or Supply

  • FIGURE 19.3Shifts in the Supply of U.S. Dollars

An increase in the supply of dollars will decrease (depreciate) the dollar exchange rate. Higher European interest rates or lower European prices will increase the supply of dollars.


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HOW EXCHANGE RATES ARE DETERMINED

19.1

  • Changes in Demand or Supply

  • Let’s summarize the key facts about the foreign exchange market, using euros as our example:

    • 1 The demand curve for dollars represents the demand for dollars in exchange for euros. The curve slopes downward. As the dollar depreciates, there will be an increase in the quantity of dollars demanded in exchange for euros.

    • 2 The supply curve for dollars is the supply of dollars in exchange for euros. The curve slopes upward. As the dollar appreciates, there will be an increase in the quantity of dollars supplied in exchange for euros.

    • 3 Increases in U.S. interest rates and decreases in U.S. prices will increase the demand for dollars, leading to an appreciation of the dollar.

    • 4 Increases in European interest rates and decreases in European prices will increase the supply of dollars in exchange for euros, leading to a depreciation of the dollar.


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REAL EXCHANGE RATES AND PURCHASING POWER PARITY

19.2

R E A L - N O M I N A L P R I N C I P L E

What matters to people is the real value of money or income—its purchasing power—not the face value of money or income..

  • real exchange rate

    • The price of U.S. goods and services relative to foreign goods and services, expressed in a common currency.


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REAL EXCHANGE RATES AND PURCHASING POWER PARITY

19.2

  • FIGURE 19.4Real Exchange Rate and Net Exports as Percent of GDP, 1980–2007

The figure shows the real exchange rate for the United States compared to its net exports as a share of GDP.

Notice that, in general, when the real (multilateral) exchange rate increased, U.S. net exports fell.


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REAL EXCHANGE RATES AND PURCHASING POWER PARITY

19.2

  • law of one price

    • The theory that goods easily tradable across countries should sell at the same price expressed in a common currency.

  • purchasing power parity

    • A theory of exchange rates whereby a

    • unit of any given currency should be

    • able to buy the same quantity of

    • goods in all countries.


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1

A P P L I C A T I O N

BIG MACS AND PURCHASING POWER PARITY

APPLYING THE CONCEPTS #1:Can the price of hamburgers around the world give us a clue to the proper value for exchange rates?

  • For several years, the Economist measured the price of a Big Mac throughout the world and checked to see whether the law of one price held. Table 19.1 contains the results for selected countries and the market-exchange rate predicted by the theory of purchasing power parity. To obtain the exchange rate, divide the price of Big Macs in the foreign country by the dollar price.


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THE CURRENT ACCOUNT, THE FINANCIALACCOUNT, AND THE CAPITAL ACCOUNT

19.3

  • balance of payments

    • A system of accounts that measures

    • transactions of goods, services, income, and financial assets between domestic households, businesses, and governments and residents of the rest of the world during a specific time period.

  • current account

    • The sum of net exports (exports

    • minus imports) plus net income received

    • from abroad plus net transfers from

    • abroad.


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THE CURRENT ACCOUNT, THE FINANCIALACCOUNT, AND THE CAPITAL ACCOUNT

19.3

  • financial account

    • The value of a country’s net sales

    • (sales minus purchases) of assets.

  • capital account

    • The value of capital transfer and

    • transaction in nonproduced,

    • nonfinancial assets in the

    • international accounts.


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THE CURRENT ACCOUNT, THE FINANCIALACCOUNT, AND THE CAPITAL ACCOUNT

19.3

  • Rules for Calculating the Current, Financial, and Capital Accounts

Here is a simple rule for understanding transactions on the current, financial, and capital accounts: Any action that gives rise to a demand for foreign currency is a deficit item. Any action that gives rise to a supply of foreign currency is a surplus item.

The current, financial, and capital accounts of a country are linked by a very important relationship:

current account + financial account + capital account = 0


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THE CURRENT ACCOUNT, THE FINANCIALACCOUNT, AND THE CAPITAL ACCOUNT

19.3

  • Rules for Calculating the Current, Financial, and Capital Accounts


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THE CURRENT ACCOUNT, THE FINANCIALACCOUNT, AND THE CAPITAL ACCOUNT

19.3

  • Rules for Calculating the Current, Financial, and Capital Accounts

  • net international investment positionDomestic holding of foreign assets minus foreign holdings of domestic assets.

  • sovereign investment fundAssets accumulated by foreign governments that are invested abroad.


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2

A P P L I C A T I O N

WORLD SAVINGS AND U.S. CURRENT ACCOUNT DEFICITS

APPLYING THE CONCEPTS #2:What factors may allow the United States to continue running large trade deficits with the rest of the world?

  • The 2006 Economic Report of the President directly addressed whether the United States can continue to run large current account deficits and, of course, financial account surpluses. In the report, the government recognized that the current account deficits would eventually be reduced. However, it also highlighted a number of factors suggesting the deficits could continue for a long period of time.

  • For the United States to continue to run a current account deficit, other countries in the world need to continue to purchase U.S. assets.

  • In recent years, four major countries experienced circumstances that encouraged them to save by purchasing assets from abroad: Japan, Germany, Russia, and China.

  • For the United States to continue to run trade deficits in the future, these or other countries must want to continue to save more than they want to invest domestically.


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FIXED AND FLEXIBLE EXCHANGE RATES

19.4

  • To set the stage for understanding exchange rate systems, let’s recall what happens when a country’s exchange rate appreciates—increases in value. There are two distinct effects:

  • 1 The increased value of the exchange rate makes imports less expensive for the residents of the country where the exchange rate appreciated.

    • 2 The increased value of the exchange rate makes U.S. goods more expensive on world markets.


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FIXED AND FLEXIBLE EXCHANGE RATES

19.4

  • Fixing the Exchange Rate

  • foreign exchange market interventionThe purchase or sale of currencies by government to influence the market exchange rate.

  • FIGURE 19.5Government Intervention toRaise the Price of the Dollar

To increase the price of dollars, the U.S. government sells euros in exchange for dollars.

This shifts the demand curve for dollars to the right.


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FIXED AND FLEXIBLE EXCHANGE RATES

19.4

  • Fixed versus Flexible Exchange Rates

FLEXIBLE EXCHANGE RATE SYSTEM

  • flexible exchange rate systemA currency system in which exchange rates are determined by free markets.

FIXED EXCHANGE RATES

  • fixed exchange rate systemA system in which governments peg exchange rates to prevent their currencies from fluctuating.


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FIXED AND FLEXIBLE EXCHANGE RATES

19.4

  • Fixed versus Flexible Exchange Rates

BALANCE OF PAYMENTS DEFICITS AND SURPLUSES

  • balance of payments deficitUnder a fixed exchange rate system, a situation in which the supply of a country’s currency exceeds the demand for the currency at the current exchange rate.

  • balance of payments surplusUnder a fixed exchange rate system, a situation in which the demand of a country’s currency exceeds the supply for the currency at the current exchange rate.

  • devaluationA decrease in the exchange rate to which a currency is pegged under a fixed exchange rate system.

  • revaluationAn increase in the exchange rate to which a currency is pegged under a fixed exchange rate system.


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FIXED AND FLEXIBLE EXCHANGE RATES

19.4

  • The U.S. Experience with Fixed and Flexible Exchange Rates

  • Fixed exchange rate systems provide benefits, but they require countries to maintain similar economic policies—especially to maintain similar inflation rates and interest rates.

  • Higher prices in the United States cause the U.S. real exchange rate to rise. This increase in the real exchange rate over time causes a trade deficit to emerge.

Exchange Rate Systems Today

  • The flexible exchange rate system has worked well enough since the breakdown of Bretton Woods.

  • Some economists believe that the world will eventually settle into three large currency blocs: the euro, the dollar, and the yen.


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