Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. Economics: Principles, Applications, and Tools OSullivan, Sheffrin, Perez 6/e. 1 of 28

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. Economics: Principles, Applications, and Tools OSullivan, Sheffrin, Perez 6/e. 2 of 28

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. Economics: Principles, Applications, and Tools OSullivan, Sheffrin, Perez 6/e. 3 of 28 The World of International Finance Economics: Principles, Applications, and Tools OSullivan, Sheffrin, Perez 6/e. F ERNANDO Q UIJANO, Y VONN Q UIJANO, AND X IAO X UAN X U P R E P A R E D B Y Today, the world currency markets are always open. When foreign exchange traders in New York City are sound asleep at 3:00 A.M., their counterparts in London are already on their phones and computers at 8:00 A.M.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. Economics: Principles, Applications, and Tools OSullivan, Sheffrin, Perez 6/e. 4 of 28 C H A P T E R 19 The World of International Finance A P P L Y I N G T H E C O N C E P T S Can the price of hamburgers around the world give us a clue to the proper value for exchange rates? Big Macs and Purchasing Power Parity What factors may allow the United States to continue running large trade deficits with the rest of the world? World Savings and U.S. Current Account Deficits How well has the new European central bank managed monetary policy? Managing the Euro: The European Central Bank What are the causes of financial collapses that occur throughout the globe? The Argentine Financial Crisis 4

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. Economics: Principles, Applications, and Tools OSullivan, Sheffrin, Perez 6/e. 5 of 28 C H A P T E R 19 The World of International Finance What Are Exchange Rates? exchange rate The price at which currencies trade for one another in the market. euro The common currency in Europe. An increase in the value of a currency relative to the currency of another nation is called an appreciation of a currency. A decrease in the value of a currency relative to the currency of another nation is called a depreciation of a currency. HOW EXCHANGE RATES ARE DETERMINED 19.1

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. Economics: Principles, Applications, and Tools OSullivan, Sheffrin, Perez 6/e. 6 of 28 C H A P T E R 19 The World of International Finance How Demand and Supply Determine Exchange Rates FIGURE 19.1 The Demand for and Supply of U.S. Dollars HOW EXCHANGE RATES ARE DETERMINED 19.1 Market equilibrium occurs where the demand for U.S. dollars equals the supply.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. Economics: Principles, Applications, and Tools OSullivan, Sheffrin, Perez 6/e. 7 of 28 C H A P T E R 19 The World of International Finance Changes in Demand or Supply FIGURE 19.2 Shifts in the Demand for U.S. Dollars HOW EXCHANGE RATES ARE DETERMINED 19.1 An increase in the demand for dollars will increase (appreciate) the dollars exchange rate. Higher U.S. interest rates or lower U.S. prices will increase the demand for dollars.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. Economics: Principles, Applications, and Tools OSullivan, Sheffrin, Perez 6/e. 8 of 28 C H A P T E R 19 The World of International Finance Changes in Demand or Supply FIGURE 19.3 Shifts in the Supply of U.S. Dollars HOW EXCHANGE RATES ARE DETERMINED 19.1 An increase in the supply of dollars will decrease (depreciate) the dollar exchange rate. Higher European interest rates or lower European prices will increase the supply of dollars.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. Economics: Principles, Applications, and Tools OSullivan, Sheffrin, Perez 6/e. 9 of 28 C H A P T E R 19 The World of International Finance Changes in Demand or Supply Lets summarize the key facts about the foreign exchange market, using euros as our example: 1The demand curve for dollars represents the demand for dollars in exchange for euros. The curve slopes downward. As the dollar depreciates, there will be an increase in the quantity of dollars demanded in exchange for euros. 2The supply curve for dollars is the supply of dollars in exchange for euros. The curve slopes upward. As the dollar appreciates, there will be an increase in the quantity of dollars supplied in exchange for euros. 3Increases in U.S. interest rates and decreases in U.S. prices will increase the demand for dollars, leading to an appreciation of the dollar. 4Increases in European interest rates and decreases in European prices will increase the supply of dollars in exchange for euros, leading to a depreciation of the dollar. HOW EXCHANGE RATES ARE DETERMINED 19.1

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. Economics: Principles, Applications, and Tools OSullivan, Sheffrin, Perez 6/e. 10 of 28 C H A P T E R 19 The World of International Finance real exchange rate The price of U.S. goods and services relative to foreign goods and services, expressed in a common currency. REAL EXCHANGE RATES AND PURCHASING POWER PARITY 19.2 R E A L - N O M I N A L P R I N C I P L E What matters to people is the real value of money or incomeits purchasing powernot the face value of money or income..

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. Economics: Principles, Applications, and Tools OSullivan, Sheffrin, Perez 6/e. 11 of 28 C H A P T E R 19 The World of International Finance FIGURE 19.4 Real Exchange Rate and Net Exports as Percent of GDP, 1980–2007 REAL EXCHANGE RATES AND PURCHASING POWER PARITY 19.2 The figure shows the real exchange rate for the United States compared to its net exports as a share of GDP. Notice that, in general, when the real (multilateral) exchange rate increased, U.S. net exports fell.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. Economics: Principles, Applications, and Tools OSullivan, Sheffrin, Perez 6/e. 12 of 28 C H A P T E R 19 The World of International Finance law of one price The theory that goods easily tradable across countries should sell at the same price expressed in a common currency. purchasing power parity A theory of exchange rates whereby a unit of any given currency should be able to buy the same quantity of goods in all countries. REAL EXCHANGE RATES AND PURCHASING POWER PARITY 19.2

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. Economics: Principles, Applications, and Tools OSullivan, Sheffrin, Perez 6/e. 13 of 28 C H A P T E R 19 The World of International Finance BIG MACS AND PURCHASING POWER PARITY APPLYING THE CONCEPTS #1: Can the price of hamburgers around the world give us a clue to the proper value for exchange rates? For several years, the Economist measured the price of a Big Mac throughout the world and checked to see whether the law of one price held. Table 19.1 contains the results for selected countries and the market-exchange rate predicted by the theory of purchasing power parity. To obtain the exchange rate, divide the price of Big Macs in the foreign country by the dollar price. TABLE 19.1BIG MAC PRICING AROUND THE WORLD VERSUS ACTUAL EXCHANGE RATES CountryPrice of a Big Mac in Local Currency Price of a Big Mac in Dollars Predicted Purchasing Power Exchange Rate Based on Big Mac Pricing (Foreign Currency per U.S. Dollar) Actual Exchange Rate (Foreign Currency per U.S. Dollar) United States3.41 dollars$3.41 ____ United Kingdom1.99 pounds Hong Kong12.0 HK dollars Switzerland6.30 Swiss francs Mexico29.0 pesos Japan250 yen A P P L I C A T I O N 1

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. Economics: Principles, Applications, and Tools OSullivan, Sheffrin, Perez 6/e. 14 of 28 C H A P T E R 19 The World of International Finance balance of payments A system of accounts that measures transactions of goods, services, income, and financial assets between domestic households, businesses, and governments and residents of the rest of the world during a specific time period. current account The sum of net exports (exports minus imports) plus net income received from abroad plus net transfers from abroad. THE CURRENT ACCOUNT, THE FINANCIAL ACCOUNT, AND THE CAPITAL ACCOUNT 19.3

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. Economics: Principles, Applications, and Tools OSullivan, Sheffrin, Perez 6/e. 15 of 28 C H A P T E R 19 The World of International Finance financial account The value of a countrys net sales (sales minus purchases) of assets. capital account The value of capital transfer and transaction in nonproduced, nonfinancial assets in the international accounts. THE CURRENT ACCOUNT, THE FINANCIAL ACCOUNT, AND THE CAPITAL ACCOUNT 19.3

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. Economics: Principles, Applications, and Tools OSullivan, Sheffrin, Perez 6/e. 16 of 28 C H A P T E R 19 The World of International Finance Rules for Calculating the Current, Financial, and Capital Accounts Here is a simple rule for understanding transactions on the current, financial, and capital accounts: Any action that gives rise to a demand for foreign currency is a deficit item. Any action that gives rise to a supply of foreign currency is a surplus item. The current, financial, and capital accounts of a country are linked by a very important relationship: current account + financial account + capital account = 0 THE CURRENT ACCOUNT, THE FINANCIAL ACCOUNT, AND THE CAPITAL ACCOUNT 19.3

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. Economics: Principles, Applications, and Tools OSullivan, Sheffrin, Perez 6/e. 17 of 28 C H A P T E R 19 The World of International Finance Rules for Calculating the Current, Financial, and Capital Accounts THE CURRENT ACCOUNT, THE FINANCIAL ACCOUNT, AND THE CAPITAL ACCOUNT 19.3

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. Economics: Principles, Applications, and Tools OSullivan, Sheffrin, Perez 6/e. 18 of 28 C H A P T E R 19 The World of International Finance Rules for Calculating the Current, Financial, and Capital Accounts net international investment position Domestic holding of foreign assets minus foreign holdings of domestic assets. THE CURRENT ACCOUNT, THE FINANCIAL ACCOUNT, AND THE CAPITAL ACCOUNT 19.3 sovereign investment fund Assets accumulated by foreign governments that are invested abroad.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. Economics: Principles, Applications, and Tools OSullivan, Sheffrin, Perez 6/e. 19 of 28 C H A P T E R 19 The World of International Finance WORLD SAVINGS AND U.S. CURRENT ACCOUNT DEFICITS APPLYING THE CONCEPTS #2: What factors may allow the United States to continue running large trade deficits with the rest of the world? The 2006 Economic Report of the President directly addressed whether the United States can continue to run large current account deficits and, of course, financial account surpluses. In the report, the government recognized that the current account deficits would eventually be reduced. However, it also highlighted a number of factors suggesting the deficits could continue for a long period of time. For the United States to continue to run a current account deficit, other countries in the world need to continue to purchase U.S. assets. In recent years, four major countries experienced circumstances that encouraged them to save by purchasing assets from abroad: Japan, Germany, Russia, and China. For the United States to continue to run trade deficits in the future, these or other countries must want to continue to save more than they want to invest domestically. A P P L I C A T I O N 2

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. Economics: Principles, Applications, and Tools OSullivan, Sheffrin, Perez 6/e. 20 of 28 C H A P T E R 19 The World of International Finance To set the stage for understanding exchange rate systems, lets recall what happens when a countrys exchange rate appreciatesincreases in value. There are two distinct effects: 1The increased value of the exchange rate makes imports less expensive for the residents of the country where the exchange rate appreciated. 2The increased value of the exchange rate makes U.S. goods more expensive on world markets. FIXED AND FLEXIBLE EXCHANGE RATES 19.4

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. Economics: Principles, Applications, and Tools OSullivan, Sheffrin, Perez 6/e. 21 of 28 C H A P T E R 19 The World of International Finance Fixing the Exchange Rate foreign exchange market intervention The purchase or sale of currencies by government to influence the market exchange rate. FIGURE 19.5 Government Intervention to Raise the Price of the Dollar FIXED AND FLEXIBLE EXCHANGE RATES 19.4 To increase the price of dollars, the U.S. government sells euros in exchange for dollars. This shifts the demand curve for dollars to the right.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. Economics: Principles, Applications, and Tools OSullivan, Sheffrin, Perez 6/e. 22 of 28 C H A P T E R 19 The World of International Finance Fixed versus Flexible Exchange Rates flexible exchange rate system A currency system in which exchange rates are determined by free markets. FLEXIBLE EXCHANGE RATE SYSTEM fixed exchange rate system A system in which governments peg exchange rates to prevent their currencies from fluctuating. FIXED EXCHANGE RATES FIXED AND FLEXIBLE EXCHANGE RATES 19.4

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. Economics: Principles, Applications, and Tools OSullivan, Sheffrin, Perez 6/e. 23 of 28 C H A P T E R 19 The World of International Finance Fixed versus Flexible Exchange Rates balance of payments deficit Under a fixed exchange rate system, a situation in which the supply of a countrys currency exceeds the demand for the currency at the current exchange rate. BALANCE OF PAYMENTS DEFICITS AND SURPLUSES balance of payments surplus Under a fixed exchange rate system, a situation in which the demand of a countrys currency exceeds the supply for the currency at the current exchange rate. devaluation A decrease in the exchange rate to which a currency is pegged under a fixed exchange rate system. revaluation An increase in the exchange rate to which a currency is pegged under a fixed exchange rate system. FIXED AND FLEXIBLE EXCHANGE RATES 19.4

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. Economics: Principles, Applications, and Tools OSullivan, Sheffrin, Perez 6/e. 24 of 28 C H A P T E R 19 The World of International Finance The U.S. Experience with Fixed and Flexible Exchange Rates Exchange Rate Systems Today Fixed exchange rate systems provide benefits, but they require countries to maintain similar economic policiesespecially to maintain similar inflation rates and interest rates. Higher prices in the United States cause the U.S. real exchange rate to rise. This increase in the real exchange rate over time causes a trade deficit to emerge. The flexible exchange rate system has worked well enough since the breakdown of Bretton Woods. Some economists believe that the world will eventually settle into three large currency blocs: the euro, the dollar, and the yen. FIXED AND FLEXIBLE EXCHANGE RATES 19.4

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. Economics: Principles, Applications, and Tools OSullivan, Sheffrin, Perez 6/e. 25 of 28 C H A P T E R 19 The World of International Finance MANAGING THE EURO: THE EUROPEAN CENTRAL BANK APPLYING THE CONCEPTS #3: How well has the new European central bank managed monetary policy? The European Central Bank (ECB) was founded in 1998, one year before the euro was launched. The bank was charged with managing monetary policythe money supply, interest rates, and the exchange rate. Monetary policy at the ECB is set by six members of an executive board plus 13 heads of the euro-zones national banks. Inflation is their primary focus. Decisions are made by consensus. How well has the ECB performed? In its early days, the ECB was viewed as somewhat clumsy at managing its communications, and the euro initially fell in value. But in recent years, its reputation has increased. The euro has appreciated against the U.S. dollar. The ECB also demonstrated considerable financial skill as it responded decisively to the global mortgage-related financial crisis in the summer of It had carefully prepared for a financial crisis several years in advance, and its actions to provide liquidity to banks even spurred the Fed to take similar steps to combat the crisis. The ECB has now earned the respect of global financial market participants. A P P L I C A T I O N 3

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. Economics: Principles, Applications, and Tools OSullivan, Sheffrin, Perez 6/e. 26 of 28 C H A P T E R 19 The World of International Finance Hardly a year goes by without some international financial crisis. Even when a country takes strong, institutional steps to peg its currency, a collapse is still possible. MANAGING FINANCIAL CRISES 19.5

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. Economics: Principles, Applications, and Tools OSullivan, Sheffrin, Perez 6/e. 27 of 28 C H A P T E R 19 The World of International Finance THE ARGENTINE FINANCIAL CRISIS APPLYING THE CONCEPTS #4: What are the causes of financial collapses that occur throughout the globe? During the late 1980s, Argentina suffered from hyperinflation. As part of its financial reforms, it pegged its currency to the U.S. dollar, making pesos convertible into dollars. To issue pesos, the central bank had to have an equal amount of dollars, or its equivalent in other hard currencies, on hand. Some economists believed this reform would bring stability to the financial system. Unfortunately, they were proved wrong. Several problems developed: As the dollar appreciated, Argentina began to suffer from a large trade deficit. Wage increases also pushed up the real exchange rate. Argentina had to borrow extensively in dollar-denominated loans. Eventually, Argentina was forced to default on its international debt in 2002 and freeze bank accounts. The hopes of the reforms in the early 1990s had become a bitter memory. A P P L I C A T I O N 4

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. Economics: Principles, Applications, and Tools OSullivan, Sheffrin, Perez 6/e. 28 of 28 C H A P T E R 19 The World of International Finance balance of payments balance of payments deficit balance of payments surplus capital account current account devaluation euro exchange rate financial account fixed exchange rate system flexible exchange rate system foreign exchange market intervention law of one price net international investment position purchasing power parity real exchange rate revaluation sovereign investment funds K E Y T E R M S