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CHAPTER 20: International Finance

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  1. CHAPTER 20:International Finance

  2. In this Chapter we will . . . • Explain what is meant by a balance of trade deficit as well as its importance. • Explain why the US changed from being a lender to being a borrower in the mid-1980s. • Explain how the foreign exchange value of the dollar is determined.

  3. Balance of Payments Accounts • Definition: therecord of all payments from/to residents of a country to or from residents of other countries. • Categories of the balance of payment accounts: 1) Current Account:- records payments for imports/exports of goods and services, net interest and other factor payments from abroad, and net unilateral [unrequited] transfers. 2) Capital Account:- records foreign investments/loans into the US minus US investments/loans abroad. 3) Official Settlements Account:- records the change in official reserves in the US.

  4. Balance of Payments Accounts • The current and capital accounts are financial accounts • Items therefore enter the accounts according to who gets the payment: exports are positives, because a US resident is paid; imports are negatives, a foreigner is paid; investment in the US from abroad is +, spending by Japanese tourists in Orlando is +, etc -- the payment comes in.

  5. U.S. Balance of Payments Accounts in 1999, $ billions Current account Imports of goods and services -1,221 Exports of goods and services +956 Net factor income from abroad –18 Net transfers (mostly private) –48 Current account balance –331 Capital account Foreign investment in the United States +711 U.S. investment abroad -442 Statistical discrepancy +12 Capital account balance +281 Official settlements account Increase in official reserves (both US +50 and foreign held in the US)

  6. The Balance of Payments:1975-1996

  7. Balance of Payments Accounts (cont.) • The balance of payments accounts add up to zero. • In 1999 we had a “trade deficit” as we imported more goods than we sold abroad (exported). • We paid for the deficit by: 1) Borrowing net from abroad which translates into a capital account surplus. 2) Investing less abroad than foreigners invested in the US.

  8. Balance of Payments Accounts (cont.) • A country that in aggregate over its entire history has borrowed more from the rest of the world than it has lent is a debtor country. • A partial list of debtor countries: - Mexico - Brazil - The United States

  9. Balance of Payments Accounts (cont.) • Is there any reason to be concerned that the US is a debtor country? - 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 could result in higher interest payments to foreigners and lower consumption sometime in the future.

  10. Is the US a debtor? • The official data show the US as a debtor • This is dubious; actual loans are fairly accurately measured, but ‘direct investment’ -- e.g. the value of General Motors’ or Ford’s investments in Europe and Australia -- is very hard to estimate. • Much US foreign direct investment is older than most foreign direct investment in the US -- so probably more valuable; estimates of US foreign assets are probably too low.

  11. - or - C + I + G + X - M = C + S + T - or - (X - M) = (S - I) + (T - G) Balance of Payments Accounts (cont.) • The US has a large current account deficit, why? • Our discussion of national income and product accounting taught us that expenditures and income are equal, when properly measured. • Expenditure = C + I + G + X - M • Income [uses of income] = C + S + T

  12. (X - M) = (S - I) + (T - G) Balance of Payments Accounts (cont.) • This says that a balance of trade deficit (X - M) < 0 is due to: 1) A government sector deficit: (T - G) < 0 and/or 2) A private sector deficit: (S - I) < 0

  13. United States in 1999 (billions of dollars) Symbols Numbers for 1999 [approximate, national income account estimates] Variables Exports X 956 Imports M 1221 Gov’nment purchases G 1,536 Net Taxes T 1,710 Investment I 1,670 Saving S 1,231

  14. Net Exports, the Government Budget, Saving and Investment Net Exports X - M = 956 – 1221 = -265 Government sector T - G = 1,710 – 1,536 = +174 Private sector S - I = 1,231 – 1,670 = –439 Surpluses and deficits, 1999

  15. Net Exports, the Government Budget, Saving, and Investment Relationship among surpluses and deficits National accounts Y = C + I + G + X – M = C + S + T Rearranging X – M = (S – I) + (T – G) Net exports X – M –265 equals: Government sector T – G +174 plus Private sector S – I –439 Overall balance [+174 -439] = -265 = ‘Net exports’

  16. The Twin Deficits

  17. Borrowing for what? Is the U.S. Borrowing for Consumption or Investment? • Net exports were –$265 billion in 1999 • Governments in the US buy structures (e.g. highways, schools, dams) worth more than $200 billion/year. • Governments also spend on education and health care—increases human capital. • Looks like mostly investment, not consumption.

  18. Foreign Exchange Markets • In the US, we use the US dollar as currency • Most countries have their own currencies • To exchange one currency for another, a price for one currency in terms of the other is needed -- hence “foreign exchange markets.”

  19. Ex: Japan Ex: Japan 11/26/0 11/26/0 Perdollarquotes Foreign currency Yen = = = US Dollar US Dollar Perforeign currencyquotes US Dollar US Dollar = = = Foreign currency Yen Exchange Rate Measures • 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 nominal price for which one currency is exchanged for another. 111.33 .00898

  20. Wall Street Journal 9/98

  21. An Example: • Suppose you can buy a CD in Canada or in the US, where should you buy it? • PUS= US $ 15.00 • PCA = C$ 20.00 (CAN)

  22. PerUS dollarquotes PerCANdollarquotes ( ( ) ) = = US Dollar CAN Dollar e e = = US Dollar CAN Dollar Exchange Rate Measures (cont.) PUS= $ 15.00 PCA = C$ 20.00 (CAN) 1.51 .65

  23. Price of CanadianCD in US * = PCAN ( ) C$20 (CAN) $0.65 (US) e = US Dollar X $13.00 (US) C$1.00 (CAN) 1 CAN Dollar • In order to make a decision, you must convert the Canadian CD to US dollars: • Recall the price of the same CD in the U.S. was US $15.00. • Since the price of the US CD was more than the US Dollar price of the Canadian CD, you buy the CD in Canada.

  24. Reality Check • This ignores transaction costs • Transaction costs on LARGE exchanges -- millions of $s -- are small, fractions of a % • Transaction costs on small exchanges -- for tourists or travelers -- can be large; in North America and Western Europe, a fixed fee (say $5) per exchange plus commission of 1 or 2 per cent. Travelers be warned!

  25. Some Terminology: • Currency depreciation:- a currency depreciates if its value in terms of foreign currency goes down. • That automatically means it costs more of the depreciated currency to buy a unit of the foreign currency - i.e. the price of the foreign currency has gone up in terms of domestic currency.

  26. Example: Say that currently one US dollar is worth 2 DM (German currency), or , • If the new exchange rate isthen one US dollar buys 1 DM. • Currency depreciation: (an example) • The US dollar buys less and has thus depreciated.

  27. Depreciation and Appreciation • One DM used to cost $0.50, 50 cents, but now it costs a dollar -- the price of the DM in dollars has gone up, the price of the $ in DM has gone down (from DM2 to DM1) • The DM appreciated, the $ depreciated. • German goods, priced in DM, now cost more in $’s; so are more expensive compared to US goods, so German exports, [US imports], go down. US goods, priced in $’s, now cost fewer DM’s, US exports [German imports] go up.

  28. Real Exchange Rate: = X ) ( ) ( Foreign currency Foreign currency Re e US Dollar US Dollar PUS PFC • Exchange Rate Measures (cont.) • The real exchange rate is the nominal exchange rate adjusted for prices • That means we multiply the nominal exchange rate by the ratio of the US and foreign price indices:

  29. The Demand for Dollarsis a derived demand -- it comes from holders of other currencies wanting US dollars to make payments in dollars -- e.g. to buy US goods, services, or assets. • What determines the quantity of dollars demanded in the foreign exchange market? • The exchange rate, the price of the $ in terms of the other currency.- other things remaining the same, an increase in the exchange rate reduces the quantity demanded (of dollars) and causes a movement along the demand curve (for dollars in the foreign exchange market).

  30. Suppose the current exchange rate is - - - This means that 100 yen (Japanese currency) will buy you $1.00. • Suppose the exchange rate increases to 200 yen. Now someone in Japan has to give up twice as many yen to get $1.00. • Quantity demanded for dollars (an example) • The price of a dollar has gone up, so less willbe demanded.

  31. Other things remaining the same, a rise in the exchange rate decreases the quantity of dollars demanded... 100 D 1.3 The Demand for Dollars ExchangeRate(Yen for $) 150 100 50 0 1.1 1.2 1.4 1.5 1.3 Quantity (trillions of $ per day)

  32. Other determinants cause the demand for dollars curve to shift 1) Interest rates in the US and other countries. Example: Suppose US interest rates go up. What will happen to the demand for the dollar? • At the same exchange rate, Japanese investors will want to take advantage of the higher returns by investing more in (lending more to) the US. • This means more US dollars will be purchased and the demand for dollars will shift to the right.

  33. Other determinants cause the demand for dollar curve to shift (cont.) 2) relative prices in the United States and other countries [affects X and M, which require currency transactions]. 3) GDP in the foreign country [affect our exports -- income effect] 4) the expected future exchange rate [affects asset holdings -- foreigners won’t hold $’s if they expect the value to fall]

  34. 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)

  35. The U.S interest rate differential increases Japanese prices rise, relative to US prices. Japanese GDP rises. The expected future exchange rate rises The U.S. interest rate differential decreases Japanese prices fall, relative to US prices. Japanese GDP falls. The expected future exchange rate falls The demand for dollars increases if: The demand for dollars decreases if: Summary: Changes in the Demand for Dollars

  36. The Supply of Dollarsis derived -- it arises from holders of dollars wanting foreign currency to make payments in foreign currency -- e.g. to buy goods, services, or assets abroad. • What determines the quantity of dollars supplied in the foreign exchange market? • The exchange rate, i.e. the $’s price- other things remaining the same, if the exchange rate rises, the quantity of dollars supplied increases and causes a movement along the supply curve (of dollars in the foreign exchange market).

  37. Suppose the current exchange rate is - - - And, further, suppose that 1.3 trillion dollars are supplied. • If the exchange rate increases to 200 yen. One dollar buys more yen. • Quantity supplied of dollars (an example) • Japanese goods are cheaper so you will supply more dollars in order to get the yen needed to purchase the cheaper Japanese goods.

  38. S 100 Other things remaining the same, a rise in the exchange rate increases the quantity of dollars supplied... 1.3 The Supply of Dollars ExchangeRate(Yen for $) 150 100 50 0 1.1 1.2 1.4 1.5 1.3 Quantity (trillions of $ per day)

  39. Other determinants cause the supply of dollars curve to shift 1) Interest rates in the US and other countries. 2) relative prices in the United States and other countries. 3) GDP in the US 4) the expected future exchange rate [reasoning is all symmetric to the demand curve shifts -- supply of $’s is demand for Yen if we just consider these two currencies]

  40. 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)

  41. The U.S interest rate differential decreases Japanese price level falls relative to the US price level. U.S. GDP increases. The expected future exchange rate falls The U.S. interest rate differential increases Japanese price level increases, relative to the US price level. US GDP decreases. The expected future exchange rate rises The supply of dollars increases if: The supply of dollars decreases if: Summary: Changes in the Supply of Dollars

  42. Equilibrium Exchange Rate: • The equilibrium exchange rate occurs where the quantity of dollars demanded is just equal to the quantity of dollars supplied.

  43. Surplus at 150 yen per dollar S Equilibrium at 100 yen per dollar 100 D Shortage at 50 yen per dollar 1.3 Equilibrium Exchange Rate ExchangeRate(Yen for $) 150 100 50 0 1.1 1.2 1.4 1.5 1.3 Quantity (trillions of $ per day)

  44. S2 D2 An Application: Interest rates fluctuate up. • If the US interest rate goes up, what will happen to the dollar? S1 • With higher interest rates in the US, investors abroad demand more dollars with which to invest in the US. e1 • With higher interest rates in the US, investors in the US are less willing to buy foreign currency (supply dollars) and more willing to invest at higher interest rates at home. D1 Q1 0 Quantity of $

  45. S2 e2 D2 Q2= An Application: Interest rates fluctuate up. • The equilibrium exchange rate occurs where the quantity of dollars demanded is just equal to the quantity of dollarssupplied. S1 e1 • The new equilibrium results in a higher exchange rate (yen for $). • Prediction: The dollar shouldappreciate in relation to the yen. D1 Q1 0 Quantity of $

  46. e2 D2 An Application: Foreign Exchange Intervention. • Foreign exchange intervention is when a govt. tries to maintain an exchange rate in the foreign exchange model. S1 • Suppose the Japanese yen is rising w/respect to the US dollar. e1 • The Fed could intervene in the market to “prop up” the dollar. D1 • Without intervention, the exchange rate will fall to e2. Q1 0 Quantity of $

  47. e1 D2 An Application: Foreign Exchange Intervention. • In order for the Fed to intervene and attempt to maintain the exchange rate between dollars and yen at e1, it would have to demand (buy) dollars to shift the demand curve back to D1 S1 e1 e2 D1 D1 Q1 0 Quantity of $

  48. Reality Check • Nowadays, intervention rarely works • The volume of foreign exchange transactions is of the order of $2 trillion a day • This is massively larger than any country’s foreign exchange reserves, so in most cases intervention alone is inadequate -- it does not shift the curves enough.

  49. 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 changes both supply and demand. • Day-to-day movements in exchange rates are dominated by the large amounts of internationally mobile liquid capital and changes in sentiment -- i.e. expectations about the future

  50. 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)