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International Finance http://www.oanda.com/converter/classic Learning Objectives Explain how international trade is financed Describe a country’s balance of payments accounts Explain what determines the amount of international borrowing and lending Learning Objectives (cont.)

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International Finance

http://www.oanda.com/converter/classic


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Learning Objectives

  • Explain how international trade is financed

  • Describe a country’s balance of payments accounts

  • Explain what determines the amount of international borrowing and lending


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Learning Objectives (cont.)

  • 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


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Financing International Trade

Balance of Payments Accounts

Balance of payments accounts record a country’s international trading, borrowing, and lending.


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Balance of Payments: Credits

  • Credits, + (receipts from foreigners)

    • Exports of goods and services

    • Income receipts

    • Unilateral current transfers to the US

    • Financial inflows

  • “Dollars in”


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Balance of Payments: Debits

  • Debits, - (payment to foreigners)

    • Imports of goods and services

    • Income payments

    • Unilateral current transfers to foreigners

    • Financial outflows

  • “Dollars out”


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Balance of Payments Paired Transactions

  • Every international transaction enters the balance of payments twice, once as a credit and once as a debit

  • If you buy something from a foreigner, you must pay her. She must then spend or store your payment.


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Examples of Paired Transactions


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Examples of Paired Transactions


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Examples of Paired Transactions


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Credits to the Current Account

  • Credits, + (receipts from foreigners)

    • Exports of goods and services

    • income receipts

    • unilateral current transfers to the US


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Debits to the Current Account

  • Debits, - (payment to foreigners)

    • Imports of goods and services

    • Income payments

    • Unilateral current transfers to foreigners


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Credits to the Financial Account

  • Credits, + (receipts from foreigners)

    • Financial inflows

      • Increase in foreign-owned assets (U.S. liabilities)

      • Decrease in U.S.-owned assets (U.S. claims).


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Debits to the Financial Account

  • Debits, - (payment to foreigners)

  • Financial outflows

    • Decrease in foreign-owned assets (U.S. liabilities)

    • Increase in U.S.-owned assets (U.S. claims)


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Financing International Trade

The balance of payments accounts include:

1) Current account

  • Exports of goods and services + US income receipts

  • Imports of goods and services+US income payments

  • Unilateral current transfers, net

    • US receipts – US payments

  • “Net interest income” = US income receipts –US income payments


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Financing International Trade

The balance of payments accounts include:

2) Financial account*

  • Records changes in foreign assets in the United States minus changes US assets abroad

    * Prior to 1997, the Financial account was known as the Capital account


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Financing International Trade

The balance of payments accounts include:

3) Official settlements account

  • Records the change in official U.S. reserves.

  • Official U.S reserves -- mainly the government’s holdings of foreign currency.

    • If official reserves increase, the official settlements accounts balance is negative.

      Part of the Financial account & it’s small!


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Financing International Trade

Fundamental balance of payments accounts identity:

Current account + Financial account = 0


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U.S. Balance of Payments Accounts in 1996

Current account (billion $)

Import of goods and services -940

Exports of goods and services +830

Net interest income –10

Net transfers –40

Current account balance –160

Financial account (increases in ...)

Foreign investment in the United States +430

U.S. investment abroad -240

Statistical discrepancy –40

Financial account balance +150

Official settlements account

Decrease in official U.S. reserves +10


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U.S. Balance of Payments Accounts in 1998

Current account (billion $)

Import of goods and services -1,120

Exports of goods and services +910

Net interest income +20

Net transfers –40

Current account balance –230

Financial account (increases in ...)

Foreign investment in the United States +540

U.S. investment abroad -310

Statistical discrepancy –40

Financial account balance +230

Official settlements account

Increase in official U.S. reserves -


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U.S. Balance of Payments

  • Let’s visit the Bureau of Economic Analysis

    http://www.bea.doc.gov/bea/di1.htm



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Financing International Trade

Borrowers and Lenders, Debtors and Creditors

  • 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.


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Financing International Trade

Borrowers and Lenders, Debtors and Creditors

  • Debtor nations are countries that during their entire history have borrowed more from the rest of the world than they have lent to it.

  • Creditor nations are countries that have invested more in the rest of the world than other countries have invested in it.


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Financing International Trade

Borrowers and Lenders, Debtors and Creditors

  • The United States is both a net borrower and a debtor nation.

  • We became a borrower as a result of a string of current account deficits.

    Is there any reason to be concerned?


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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.


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Financing International Trade

Current Account Balance

The current account balance (CAB) equals:


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Financing International Trade

Net Exports

  • Largest part of the current account balance.

  • Determined by the government budget and private saving and investment.


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Financing International Trade

Net Exports

  • Net exports is exports of goods and services minus imports of goods and services (X-M)

  • A government sector surplus or deficit is net taxes minus government purchases of goods and services (T – G)

  • A private sector surplus or deficit is saving minus investment (S – I)


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United States

in 1998

(billions of dollars)

Symbols and

equations

Net Exports, the Government Budget, Saving, and Investment

Variables

Exports X 959

Imports M 1,110

Government purchases G 1,487

Net Taxes T 1,563

Investment I 1,367

Saving S 1,140


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Net Exports, the Government Budget, Saving, and Investment

Net Exports X - M = 959 – 1,110 = – 151

Government sector T - G = 1,563 – 1,487 = 76

Private sector S - I = 1,140 – 1,367 = –227

Surpluses and deficits in 1998


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Net Exports, the Government Budget, Saving, and Investment

Relationship among surpluses and deficits in 1998

National accounts Y = C + I + G + X – M

= C + S + T

Rearranging X – M = S – I + T – G

Net exports X – M –151

equals:

Government sector T – G 76

plus

Private sector S – I –227


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Financing International Trade

The Twin Deficits

  • The government sector balance (T-G) and the Current Account balance (X-M) tend to move in the same direction

  • The US has frequently had a deficit on both

  • Hence, they are known as the twin deficits.



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Financing International Trade

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.


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Financing International Trade

Is U.S. Borrowing for Consumption or Investment

Our borrowing is financing investment


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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 April 1997==>$1 = 123 Japanese yen



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The Exchange Rate

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.


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The Exchange Rate

Demand in the Foreign Exchange Market

The quantity of dollars demanded in the foreign exchange market depends upon:

1) The exchange rate

2) Interest rates in the United States and other countries

3) The expected future exchange rate


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The Exchange Rate

The Law of Demand for Foreign Exchange

  • The demand for dollars is a derived demand.

    • They (RoW) 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.


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Other things remaining

the same, a rise in the

exchange rate decreases

the quantity of dollars

demanded...

…and a fall in the

exchange rate

increases the quantity

of dollars demanded

D

The Demand for Dollars

150

100

Exchange rate (yen per dollar)

50

0

1.1

1.2

1.3

1.4

1.5

Quantity (trillions of dollars per day)


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The Exchange Rate

Why do exchange rates influence the quantity of dollars demanded?

1) Exports Effect

2) Expected Profit Effect


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The Exchange Rate

Changes in the Demand for Dollars

A change in any other influence on the dollars that people plan to buy in the foreign exchange market:

  • Changes the demand for dollars

  • Shifts the demand curve for dollars


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The Exchange Rate

The other factors that change the demand for dollars are:

1) Interest rates in the United States and other countries

interest rate differential = US rate – other rate

2) The expected future exchange rate


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Increase in the

demand for dollars

Decrease

in the

demand for

dollars

D1

D2

Changes in the Demand for Dollars

150

Exchange rate (yen per dollar)

100

50

D0

0

1.1

1.2

1.3

1.4

1.5

Quantity (trillions of dollars per day)


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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

Changes in theDemand for Dollars

The demand for dollars

increases if:

The demand for dollars

decreases if:


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The Exchange Rate

Supply in the Foreign Exchange Market

The quantity of dollars supplied in the foreign exchange market depends upon:

1) The exchange rate

2) Interest rates in the United States and other countries

3) The expected future exchange rate


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The Exchange Rate

The Law of Supply for Foreign Exchange

  • U.S. residents supply dollars in the foreign exchange market when they buy imports.

  • Holding other things the same, the higher the exchange rate, the higher is the quantity of dollars supplied.


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The Exchange Rate

Why do exchange rates influence the quantity of dollars supplied?

1) Imports Effect

2) Expected Profit Effect


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Other things remaining

the same, a rise in the

exchange rate increases

the quantity of dollars

supplied...

S

…and a fall in the

exchange rate

decreases the quantity

of dollars supplied

The Supply of Dollars

150

Exchange rate (yen per dollar)

100

50

0

1.1

1.2

1.3

1.4

1.5

Quantity (trillions of dollars per day)


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The Exchange Rate

Changes in the Supply of Dollars

A change in any other influence on the dollars that people plan to sell in the foreign exchange market:

  • Changes the supply of dollars

  • Shifts the supply curve of dollars


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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


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S1

S2

Decrease in the

supply of dollars

Increase in the

supply of dollars

The Supply of Dollars

S0

150

Exchange rate (yen per dollar)

100

50

0

1.1

1.2

1.3

1.4

1.5

Quantity (trillions of dollars per day)


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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

Changes in theSupply of Dollars

The supply of dollars

increases if:

The supply of dollars

decreases if:


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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.


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The Exchange Rate

Market Equilibrium

At the equilibrium exchange rate, there is neither a shortage nor a surplus.


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Surplus at

150 yen per dollar

Equilibrium at

100 yen per dollar

Shortage at

50 yen per dollar

Equilibrium Exchange Rate

S

150

Exchange rate (yen per dollar)

100

50

D

0

1.1

1.2

1.3

1.4

1.5

Quantity (trillions of dollars per day)


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The Exchange Rate

Changes in the Exchange Rate

Why the Exchange Rate is Volatile

  • Supply and demand are not independent of each other.

  • A change in the expected future exchange rate or U.S. interest rate differential shifts both supply and demand.


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S94

S95

Exchange Rate Fluctuations

1994 to 1995

Exchange rate (yen per dollar)

100

84

D94

D95

0

Q0

Quantity (trillions of dollars per day)


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S97

D97

Exchange Rate Fluctuations

S95

1995 to 1997

123

Exchange rate (yen per dollar)

84

D95

0

Q0

Quantity (trillions of dollars per day)


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The Exchange Rate

Exchange Rate Expectations

Two expectations that effect the value of money are:

1) Purchasing power parity

2) Interest rate parity


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The Exchange Rate

Purchasing Power Parity

  • Money is worth what it will buy.

  • Purchasing power parity means equal value of money.


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The Exchange Rate

Purchasing Power Parity

  • If prices increase in other countries but remain constant in the United States, 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


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The Exchange Rate

Interest Rate Parity

  • Money is worth what it can earn.

  • Interest rate parity means equal interest rates.


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The Exchange Rate

Interest Rate Parity

If the rate of return is higher in the United States than in another country, the demand for U.S. dollars rise and the exchange rate rises until expected interest rates are equal.


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The Exchange Rate

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


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Target exchange

rate

D1

D2

Foreign ExchangeMarket Intervention

S

130

130

Exchange rate (yen per dollar)

120

130

130

D0

0

1.1

1.2

1.3

1.4

1.5

Quantity (trillions of dollars per day)


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Financing International Trade

The balance of payments accounts include:

4) Balance of official reserve transactions equals:

  • Net increase in foreign official reserve claims on the US

  • less: the net increase in US official reserves

  • Measures the degree to which monetary authorities in the US and abroad joined with other lenders to cover the US current account deficit

    • The bookkeeping offset to this is the official settlements accounts balance


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    Financing International Trade

    Official settlements accounts balance (a.k.a “the balance of payments”) equals:

    • Current account balance

    • plus: the non-reserve portion of the capital & financial account balance

    • plus: the statistical discrepancy

  • Measures the payments gap that official reserve transactions need to cover


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    Financing International Trade

    Official settlements accounts balance (a.k.a “the balance of payments”)

    • Played an important historical role as a measure of disequilibrium in international payments (still plays this role for many countries)

    • Negative balance of payments (deficit) may signal a crisis – means a country is running down its foreign reserves (or borrowing foreign reserves)


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