Exchange Rates, the Balance of Payments, and Trade Deficits

1. 36 Exchange Rates, the Balance of Payments, and Trade Deficits

2. Chapter Objectives • How Currencies of Different Nations are Exchanged When International Transactions Take Place • About the Balance Sheet the United States Uses to Account for the International Payments it Makes and Receives • How Exchange Rates are Determined in Currency Markets • The Difference Between Flexible Exchange Rates and Fixed Exchange Rates • The Causes and Consequences of Recent Record-High U.S. Trade Deficits

3. W36.1 Financing International Trade • U.S. Export Transactions • U.S. Import Transactions • Balance of Payments • The Current Account • Balance on Goods • Balance on Services • Trade Deficit • Trade Surplus • Balance on Current Account

4. Financing International Trade • Involves different national currencies • When U.S. firm exports to Mexico, they want to be paid in USDs • Problem resolved in foreign exchange (currency) markets • Foreign exchange markets facilitate exports and imports

5. U.S. Export Transaction • Assume U.S. is selling to GB • GB buyer draws a check on its checking account at British bank and sends it to U.S. exporter • U.S. bank sells its check in pounds to its bank, which is a dealer in foreign exchange • Bank deposits the pounds into a correspondent London bank for future sale to a U.S. buyer who needs pounds

6. U.S. Export Transaction • U.S. exports create a foreign demand for dollars, and the fulfillment of that demand increases the supply of foreign currencies owned by U.S. banks and available to U.S. buyers

7. U.S. Import Transaction See p.697 U.S. imports create domestic demand for foreign currencies, and the fulfillment of that demand reduces the supply of foreign currencies

8. The Balance of Payments • The sum of all the transactions that take place b/w its residents and the residents of all foreign nations • Include exports and imports, tourist expenditures, interest and dividends, purchases and sales of financial assets • Compiled annually • Shows “flows” of in-payments and out-payments for the U.S.

9. Current Account • Summarizes U.S. trade in currently produced g/s • Balance on goods – the difference between its exports and its imports on goods (typically a deficit) • Balance on services – difference b/w its exports and imports on goods • Balance on goods and services – will show an overall trade deficit or surplus

10. Balance on Current Account • Net investment income – difference b/w interest and dividend payments foreigners paid to U.S. for use of exported U.S. capital and the interest and dividends the U.S. paid for the use of foreign capital invested in the United States • Balance on current account – add all transactions in the current account

11. Capital and Financial Account • Capital account – a “net” account that mainly measures debt forgiveness • Financial account – summarizes the purchase or sale of real or financial assets and the flows of monetary payments that accompany them • Balance on the capital and financial account – sums the capital and financial accounts

12. Payments, Deficits and Surpluses • Balance of payments must always sum zero, but economists will discuss balance-of-payments deficits and surpluses • Balance of payments deficit – in some years a nation must make an inpayment of official reserves to its capital and financial account to balance it w/ current account • Balance of payments surplus – in some years an outpayment of official reserves from the capital and financial account must be needed to balance

13. GLOBAL PERSPECTIVE -160 -70 -60 -50 -40 -30 -20 -10 20 10 Financing International Trade U.S. Trade Balances in Goods and Services Select Nations, 2004 Good and Services Deficit Goods and Services Surplus +6.8 Australia Belgium +4.4 Canada -66.5 China -162 Germany -45.8 Japan -75.6 -45.1 Mexico +11.8 Netherlands Source: BEA

14. Capital and Financial Account • Capital Account • Financial Account • Balance on the Capital and Financial Account • Payments, Deficits, and Surpluses • Balance-of-Payments Deficits and Surpluses • Official Reserves

15. G36.1 Flexible Exchange Rates • Flexible or Floating Exchange Rates • Fixed Exchange Rate system • Depreciation and Appreciation • Determinants of Exchange Rates • Changes in Tastes • Relative Income Changes • Relative Price-Level Changes • Purchasing-Power-Parity Theory • Relative Interest Rates • Speculation

16. Flexible Exchange Rates • 2 Types: • 1. flexible- or floating- exchange-rate system – demand and supply determine exchange rates w/o gov. involvement • 2. fixed-exchange-rate system – governments determine exchange rates and make necessary adjustments to those rates

17. Depreciation and Appreciation • If the dollar price of a foreign currency rises, the dollar depreciates in value relative to the foreign currency • If the dollar price of a foreign currency falls, the dollar appreciates in value relative to the foreign currency

18. Determinants of Exchange Rates • 3 generalizations: • 1. if demand for a nation’s currency increases, that currency will appreciate, and vice versa • 2. if the supply of a nation’s currency increases, the currency will depreciate and vice versa • 3. if a nation’s currency appreciates, some foreign currency depreciates relative to it

19. Factors that Shift S/D Curves • Changes in tastes • Relative income changes – nation’s currency likely to depreciate if its growth of national income is more rapid than that of other nations b/c imports vary directly w/ income level

20. Factors that Shift S/D Curves • Relative Price-Level Changes – if domestic price levels rise, nation will import more and currency will depreciate • Relative interest rates – higher interest rates will cause currency to appreciate in nation w/higher rates • Speculation – self-fulfilling prophecies may result

21. P $3 Dollar Price of 1 Pound $2 $1 0 Q Quantity of Pounds Flexible Exchange Rates The Market for Foreign Currency (Pounds) Sl Exchange Rate: $2 = £1 Dollar Depreciates (Pound Appreciates) Dollar Appreciates (Pound Depreciates) Dl Ql

22. P $3 Dollar Price of 1 Pound $2 $1 0 Q Quantity of Pounds Flexible Exchange Rates The Market for Foreign Currency (Pounds) Sl Exchange Rate: $3 = £1 c Balance Of Payments Deficit a x b D2 Exchange Rate: $2 = £1 Dl Q2 Ql

23. Flexible Exchange Rates • Flexible Rates and the Balance of Payments • Disadvantages of Flexible Exchange Rates • Uncertainty and Diminished Trade • Terms-of-Trade Changes • Instability

24. Flexible Rates and the Balance of Payments • Flexible exchange rates automatically adjust and eventually eliminate balance-of-payment deficits or surpluses • Will affect import/export levels

25. Disadvantages of Flexible Exchange Rates • Uncertainty and diminished trade • Terms of trade changes – decline in international value of a nation’s currency will worsen its terms of trade • Instability – may destabilize domestic economy (export industries)

26. Fixed Exchange Rates • At times nations have fixed their exchange rates to avoid disadvantages of flexible rates • Nation will have to alter market demand and supply to avoid rate changes • How??

27. Fixed Exchange Rates • Use of Reserves • Currency Interventions • Trade Policies • Exchange Controls and Rationing • Distorted Trade • Favoritism • Restricted Choice • Black Markets • Domestic Macroeconomic Adjustments

28. Use of Reserves • Currency interventions – selling reserves to maintain exchange rates • Trade policies – control flow trade directly (barriers) • Exchange Controls and Rationing – U.S. could demand all foreign currencies be sold to the U.S. gov and then rationed • Major Objections: distorted trade, favoritism, restricted choice, black markets

29. Domestic Macroeconomic Adjustments • Use fiscal and monetary policy to eliminate shortage of foreign currency • Contractionary policies would be used, but there is great opportunity cost

30. International Exchange-Rate Systems • The Gold Standard: Fixed Exchange Rates • Devaluation • Gold Flows • Domestic Macroeconomic Adjustments • Collapse of the Gold Standard

31. International Exchange-Rate Systems • The Bretton Woods System • International Monetary Fund (IMF) • IMF and Pegged Exchange Rates • Official Reserves • Gold Sales • IMF Borrowing • Fundamental Imbalances: Adjusting the Peg • Demise of the Bretton Woods System

32. International Exchange-Rate Systems • The Current System: The Managed Float • Managed Floating Exchange Rates • In Support of the Managed Float • Concerns With the Managed Float

33. International Exchange Rate Systems • Gold Standard • 1879-1974 – major nations of world were on fixed-rate system of the gold standard • Each nation had to define its currency in terms of gold, maintain a fixed relationship b/w stock of gold and $ supply, allow gold to be exported and imported

34. Collapse of Gold Standard • During Great Depression of 1930s • Devaluation of currency occurred, exchange rates no longer fixed, system broke down

35. The Bretton Woods System • Modified fixed-exchange –rate system (adjustable peg system) • Created the International Monetary Fund (IMF) – now plays a role in loaning to developing nations, nations experiencing crises, and nations transitioning to capitalism • Bretton Woods system ended in 1971 – US abandons gold standard

36. The Current System: The Managed Float • Managed floating exchange rates – rates are free to float to equilibrium market levels but nations occasionally use currency interventions to stabilize or alter market exchange rates • G8 nations meet regularly to discuss economic issues and coordinate policies (US, CAN, FR, GER, IT, JAP, RUS, UK)

37. Support of Managed Float • Has functioned well thus far • Has weathered severe economic turbulence Can adjust to world events

38. Concerns w/ Managed Float • Has not eliminated trade imbalances • Can be volatile

39. Recent U.S. Trade Deficits • Causes of Trade Deficits • Implications of U.S. Trade Deficits • Increased Current Consumption • Increased U.S. Indebtedness

40. Causes of Recent U.S. Trade Deficits • U.S. growth/growth of imports • Large trade deficits with China • Decline in U.S. savings rate

41. Implications of U.S. Trade Deficits • Increased Current Consumption – benefits U.S. consumer • Increased U.S. Indebtedness – trade deficit must be financed by borrowing from the rest of world, selling off assets, or dipping into official reserves

42. Speculation in Currency Markets Last Word Negative or Positive Influence on Currency Markets and Trade • Currency Purchases to Purchase Goods and Services • Contributing to Currency Market Fluctuations • Speculator’s Role and Activities • Smoothing Short-Term Fluctuations • Absorbing Risk • Futures Market at Work • Positive Role Played Overall

43. balance of payments current account balance on goods and services trade deficit trade surplus balance on current account capital and financial account balance on capital and financial balance-of-payments deficits and surpluses official reserves flexible- or floating- exchange-rate system fixed-exchange-rate system purchasing-power-parity theory currency interventions exchange controls gold standard devaluation Bretton Woods system International Monetary Fund (IMF) managed floating exchange rates Key Terms

44. Course Review… Final Discussions… Thanks!

45. The End I am going to miss taking notes in Econ omics class!!!!!