Unit: International Trade Topic: Balance of Payments and the Foreign Exchange Market

Learning Targets 1. I will be able to identify the components of the balance of payments. 2. I will know how changes in the determinants of supply and demand for a currency will affect the foreign exchange market.

Basics U.S. exports create a foreign demand for U.S. dollars. The fulfillment of the demand creates a supply of foreign currencies in the U.S. U.S. imports create a domestic demand for foreign currencies. The fulfillment of that demand reduces the supply of foreign currencies.

Balance of Payments Statement of all of the payments a nation receives from foreign countries and all of the payments it makes to them. Three components:  Current account  Capital account  Official reserves account

1. Current Account Exports (+) and imports (-) of goods Exports increase foreign currency in the U.S. Imports decrease foreign currency in the U.S. Balance of trade = exports – imports Net investment income = interest and dividends foreigners paid to the U.S. for U.S. exported capital – interest and dividends the U.S. paid for the use of foreign capital invested in the U.S.

Current Account (simplified) “now” stuff Goods/services Transfer payments Interest/dividend payments

2. Capital Account Summarizes the purchase or sale of real or financial assets and the corresponding flows of monetary payments that accompany them. Exports of ownership of assets (foreign purchases of U.S. assets) are inpayments (+) Imports of ownership of assets (U.S. purchases of assets abroad) are outpayments (-)

Capital Account (simplified) “future” stuff Assets Stocks Investments

3. Official Reserves Account Quantities of foreign currencies that the central bank holds Functions the same way a savings account does – use it for special big purchases and to balance your checking when you have overdrawn.

Payment Deficits and Surpluses The balance of payments must always equal zero. However, the current and capital accounts do not always do so; the official reserves are used to make up the difference. A positive official reserves entry indicates a drawing down of official reserves (measures the deficit) and a negative is the building up of official reserves (measures the surplus).

Exchange Rates Three types:  Flexible (or floating): supply and demand determine (no government intervention)  Fixed: governments determine and make necessary adjustments in their economies to maintain rates.  Managed float: supply and demand determine; gov’t and central bank use intervention to manipulate exchange rate.

Flexible Exchange Rates Dollar price of 1 pound Quantity of pounds S D Qe Pe Dollar depreciates; pound appreciates Dollar appreciates; pound depreciates Demand for pounds is downward-sloping because at lower prices for pounds, the U.S. can get more pounds and more British goods and services. In order to buy those goods, the U.S. will increase the QD of pounds. Supply of pounds is upward-sloping because British will buy more U.S. goods when the pound price of a dollar falls. Pounds

Determinants of Exchange Rates Certain factors will cause the supply and demand for a currency to change (appreciation or depreciation):  Change in tastes  Relative income changes  Relative price-level changes (stability of PL and resource prices)  Relative interest rates  Speculation  Changes in technology

Depreciation vs. Devaluation Depreciation is when the exchange rate for one currency in terms of the other decreases. Devaluation is when the reduction of the value of currency in comparison with other currencies.

Fixed Exchange Rates Nations can set their exchange rate. When there is a change in supply or demand, it obviously causes disequililbrium. In order to solve this problem, the central bank and the government have to make some changes. Ways they do this:  Currency interventions (manipulation of official reserves)  Trade policies (discouraging imports, encouraging exports, etc.)  Exchange controls  Monetary and fiscal policy

One other thing to remember… If the U.S. government needs to finance their spending, then they can “borrow” money from other countries either directly or by selling bonds/securities/assets to other countries.