1. Exchange Rates, the Balance of Payments, & Trade Deficits Chapter 21 10/5/2015 1

2. 21.1 Learning Target  I can explain how the U.S. Balance of payments is calculated. 10/5/2015 2

3. Financing International Trade  U.S. export transaction  U.S. exports create a foreign demand for dollars  Fulfilling that demand increases the supply of foreign currencies owned by U.S. banks & available to U.S. buyers  U.S. import transaction  Creates a domestic demand for foreign currencies  Fulfilling that demand reduces the supplies of foreign currencies held by U.S. banks & available to U.S. consumers 10/5/2015 3

4. The balance of payments  Sum of all the transactions that take place between its residents & the residents of foreign nations  Includes: imports & exports of goods, services, tourist expenditures, interest & dividends received or paid abroad, & purchases and sales of financial or real assets abroad.  The U.S. Commerce Department’s Bureau of Economic Analysis compiles the balance-of- payments statement annually  Shows flow of payments into & out of the country 10/5/2015 4

5. Current account  The section in a nation’s international balance of payments that records:  Exports & imports of goods & services, its net investment income & net transfers  Exports have a (+) symbol (credit)…imports have a (-) symbol (debit)  Balance of trade – difference between its exports & imports of goods  Trade deficit – import more than export  Trade surplus- export more than import  Balance on current account – sum of all transactions in the current account 10/5/2015 5

6. Capital & financial account  Capital  Measures debt forgiveness  Financial  Summarizes the purchase or sale of real or financial assets and the corresponding flows of monetary payments that accompany them 10/5/2015 6

7. Payments, deficits, & surpluses  Balance-of-payments deficit  Occurs when a nation must draw down its official reserves to balance the capital & financial account with the current account  Balance-of-payments surplus  Occurs when a nation adds to its official reserves in order to balance the two accounts 10/5/2015 7

8. 21.2 Learning Targets  I can explain how exchange rates are determined in currency markets.  I can discuss the difference between flexible exchange rates and fixed exchange rates. 10/5/2015 8

9. Flexible (Floating) Exchange Rates  Demand & supply determine exchange rates & in which no government intervention occurs  Depreciation & appreciation  Depreciation – more of its currency is needed to buy a single unit of some other currency  Appreciation – fewer units of the currency is needed to buy some other currency 10/5/2015 9

10. Determinants of exchange rates  The following factors cause a nation’s currency to appreciate or depreciate in the foreign exchange market 1. Changes in tastes 2. Relative income changes 3. Relative price-level changes 4. Relative interest rates 5. Speculation 6. Changes in Relative Expected Returns on Stocks, Real Estate, & Production Facilities 10/5/2015 10

11. Flexible rates & the balance of payments  Proponents of flexible exchange rates say they have an important feature:  They automatically adjust & eventually eliminate balance-of-payments deficits or surpluses.  Disadvantages of flexible exchange rates  Uncertainty & diminished trade  Instability  Wide fluctuations stimulate & then depress industries producing exported goods 10/5/2015 11

12. Fixed (Pegged) exchange rates  Governments determine exchange rates & make necessary adjustments in their economies to maintain those rates  How a fixed exchange rate is maintained: 1. Use of reserves  Currency interventions 2. Trade policies 3. Exchange controls & rationing Objections  Distorted trade, favoritism, restricted choice (controls would limit freedom of consumer choice), & black markets 4. Domestic macroeconomic adjustments 10/5/2015 12

13. 21.3 Learning Targets  I can explain the causes & consequences of U.S. trade deficits. 10/5/2015 13

14. The Current System: The Managed Float  Managed floating exchange rates  Exchange rates among major currencies are free to float  In support of the Managed Float  Concerns with the Managed Float 10/5/2015 14

15. Recent U.S. trade deficits  Causes of the trade deficits  Economic growth  China (fixed exchange rate)  Rapid rise in price of oil  Decline in U.S. savings rate  Implications of U.S. trade deficits  Increase U.S. indebtedness  Trade deficits must be financed by borrowing from the rest of the world 10/5/2015 15