Chapter 5: Foreign Exchange Markets and the Balance of Payments

1. Chapter 5: Foreign Exchange Markets and the Balance of Payments

2. Foreign exchange market • Foreign exchange = money denominated in foreign currency • Foreign exchange market = global market in which currencies are exchanged for each other • Most foreign exchange transactions involve purchase and sale of bank deposits

3. Exchange rate • Exchange rate = price of one currency in terms of another • Reciprocal exchange rates – If $1 is worth 1/2 British pounds, each British pound is worth 2 of a dollar. • Domestic currency price = foreign currency price x exchange rate

4. Appreciation and depreciation • If the domestic currency appreciates, • Imports become less expensive • Imports rise • Exports become more expensive in the rest of the world. • Exports decline • If the domestic currency depreciates, • Imports become more expensive • Imports decline • Exports become less expensive in the rest of the world. • Exports rise

5. Balance of payments • Double-entry bookkeeping • Two sides to each transaction • Dollar value of money flowing into the country must equal the dollar value of the money flowing out (two sides of the same transaction) • Credits • activities that brings payments into the country • Debits • activities that involve payments to the rest of the world

6. Current and Financial accounts • Current account = trade in goods and services • Financial account = trade in financial assets • Net balance on current account + net balance on capital account + statistical discrepancy = 0 (overall balance of payments = 0)

7. Current account • Merchandise – trade in goods • Services – trade in services • Investment income = payment for capital services (interest payments) • Unilateral transfers – payments for which no goods or services are provided in return

8. Balance of payment accounts – 2000 (in millions)