1 Foreign Exchange Foreign Exchange Foreign Exchange Foreign money, including paper money and bank deposits that are denominated in foreign currency Foreign Exchange Market Foreign Exchange Market A global market in which people trade one currency for another Exchange Rate Exchange Rate The price of one country’s currency in terms of another country’s currency

2 Trading Hours

3 Exchange Rates There is one exchange rate for every currency in terms of every other currency. The U.S. price of a foreign good is: U.S. price = foreign currency price x exchange rate If a shirt in a Canadian store costs CAD25 and the U.S. to Canada exchange rate is $0.6825/CAD, then the price in U.S. dollars is CAD25 x $0.6825/CAD = US$ – It costs $17.06 of our dollars to buy 25 Canadian dollars at a price of 68 ¼ ¢ per CAD.

4 Exchange Rates: March 10, 2003

5 Appreciation and Depreciation A currency appreciates when it buys more of a foreign currency. A currency appreciates when it buys more of a foreign currency. – Appreciation of a nation’s currency makes foreign goods cheaper. – Appreciation  Imports and Exports. A currency depreciates when it buys less of a foreign currency. A currency depreciates when it buys less of a foreign currency. – Depreciation makes foreign goods more expensive. – Depreciation  Imports and Exports.

6 Balance of Payments A record of a country’s trade in goods, services, and financial assets with the rest of the world. Three Major Accounts: – Current Account = Merchandise + Services + Income Earned Abroad + Unilateral Transfers + Income Earned Abroad + Unilateral Transfers All international payments (and gifts) related to currently produced goods and services, including labor and capital services. All international payments (and gifts) related to currently produced goods and services, including labor and capital services. – Financial Account Records the flows of financial assets and international investment into and out of a country. Records the flows of financial assets and international investment into and out of a country. – Statistical Discrepancy Account Must add to Zero—the BOP must balance! Must add to Zero—the BOP must balance! – Statisical discrepancy makes up the difference.

7 Categories of current account transactions: 1.Merchandise trade -- import and export of goods 2.Service trade -- import and export of services 3.Income -- both investment income and employee compensation 4.Unilateral transfers -- gifts to and from foreigners Current Account

8 Current Account Balance

9 Current Account vs. Financial Account The balance of payments must balance—that is, Current Account + Financial Account = 0 If there is a current account deficit, then there must be a financial account surplus that exactly offsets that deficit. – If we buy more goods and services from foreigners than they buy from us, we have to borrow the difference  sell them our IOUs.

10 Debtors and Creditors A net debtor (nation) owes more to the rest of the world than it is owed. A net creditor (nation) is owed more than it owes. – The U.S. was an international net creditor from the end of WWI until the mid-1980s. – In 1985, the U.S. became a net debtor.