Chapter 6 -- International Finance and the Economy zMeasures of international finance. zExchange rates, how they’re determined, and effects upon economy. zCloser look at theory of Net Exports, and the role of exchange rates within them.

Measures of International Finance zRecord of transactions between American residents and residents of other countries over a flow interval. zCurrent Account zCapital Account zBalance of Payments

The Current Account zCurrent Account = {Exports + Foreign Transfers to US + Income earned from American holdings of investments abroad} -- {Imports + US Transfers to Foreigners + Income earned from foreign investments in US}

The Current Account: Interpretation zItems in the first set of { } -- current account inflows, ways that dollars enter into the US from international transactions in the current account. zItems in the second set of { } -- current account outflows, ways that dollars leave the US from international transactions in the current account.

The Current Account: Characteristics zComprehensive measure of the Balance of Trade (NX is a close approximation).

The Capital Account zCapital Account = {Net Foreign Purchases of US Assets by foreign residents} - {Net US Purchases of Foreign Assets by US residents} zCapital Account = {Capital Account Inflows} - {Capital Account Outflows} zCan be interpreted as “net private borrowing” from the foreign sector.

The Balance of Payments (BOP) zBalance of Payments outcome = Current Account + Capital Account zRepresents “what’s left over” after all international transactions between residents of the US (other than government) and residents of other countries (other than government) during a flow period. zPositive sign: Surplus, Negative Sign: Deficit zBalance of Payments deficits – financed by government borrowing from foreign sector.

The Recent US Record -- International Transactions zCurrent Account < 0 zCapital Account > 0, but less than |Current Account| zBalance of Payments < 0 zNegative Balance of Payments – financed by US borrowing from foreign sector.

Balance of Payments and Government Borrowing zResulting equation: BOP + (Net Government Borrowing from Foreign Sector) = 0  ( Current Account + Capital Account) + (Net Government Borrowing from Foreign Sector) = 0  (Current Account) + (Total Net Borrowing from Foreign Sector) = 0

The Balance of Payments and the “Magic Equation” z“Magic Equation”: S + (T – G) + (-NX) = I. zBalance of Payments equation:  Current Account + (Total Net Borrowing from Foreign Sector) = 0. zAlso recall that NX  (Current Account). zSubstitute the two expressions into Macro Identity for (-NX)  S + (T – G) + (Total Net Borrowing from Foreign Sector) = I.

Exchange Rates z(Nominal) Exchange Rate (e’) -- the amount of foreign currency needed to be exchanged for one (US) dollar. zAlso known as the “value of the dollar”. zConversion Ratio, in units of (foreign currency)/(US dollar)

Types of Exchange Rates zBilateral Exchange Rates -- exchange rates between the US and an individual country. zMultilateral (Trade Weighted) Exchange Rate -- weighted average of bilateral exchange rates expressed as an index (macro measure of exchange rate).

Exchange Rate Changes e’   price of American goods and services to foreigners   price of foreign goods and services to Americans  e’   price of American goods and services to foreigners   price of foreign goods and services to Americans 

The Real Exchange Rate (e) e = (P)(e’) (P f ) P = US Price Level P f = Foreign Price Level Key cause of net exports.

The Real Exchange Rate: An Interpretation e = (P)(e’) (P f ) Units of e: = ($/Quantity)(Foreign Currency/$) (Foreign Currency/Quantity) = (Foreign Currency/Quantity) (Foreign Currency/Quantity)

The Real Exchange Rate and Price Comparison e = (P)(e’) (P f ) zIt consists of the ratio of the price level of American goods and services -- expressed in units of foreign currency -- to the price level of (corresponding) foreign goods and services.

The Real Exchange Rate and Net Exports ze  (P , P f , or e’  )  substitution away from the relatively more expensive US goods and services  (US) Exports , (US) Imports   NX  ze  (P , P f , or e’  )  substitution into the relatively cheaper US goods and services  Exports , Imports   NX 

Exchange Rate Regimes zFixed (Pegged) Exchange Rates -- e’ fixed, unless changed by economic policy. zFloating Exchange Rates -- e’ determined by natural forces in the foreign exchange market. zManaged Float -- floating e’ with occasional Treasury/Federal Reserve intervention.

The Foreign Exchange Market -- Determination of e’ zThe Foreign Exchange Market -- the demand and supply for dollars for use in international transactions.

Concepts to Understand Foreign Exchange Behavior zItems (goods, services, financial assets) are priced in a country’s home currency. zIf one wishes to buy from another country, he/she must convert from their own currency to the currency of the country selling the item.

More Concepts: Foreign Exchange zThe nominal exchange rate (e’) specifies the ratio of conversion. zOne exchange rate (e’) is the conversion ratio for all foreign transactions (goods, services, financial assets) – Law of One Exchange Rate.

The Demand for Dollars zThe Demand for Dollars -- foreigners demand for US dollars, to buy American goods, services, or financial assets. zInversely related to the nominal exchange rate, with other causes (shift variables) as well.

The Supply of Dollars zThe Supply of Dollars -- Americans supplying dollars to the foreign exchange market, in order to buy foreign goods, services, or financial assets. zPositively related to the nominal exchange rate, with other causes (shift variables) as well.

Foreign Exchange Market Equilibrium zEquilibrium exchange rate (foreign currency)/(US$) -- “price of dollars.” zAt equilibrium: Current Account + Capital Account = 0 zAt equilibrium, the Balance of Payments = 0.

Example 1 -- Increase in US Interest Rates (i) zIncrease in i leads to substitution away from foreign financial assets to US financial assets. zForeigners substitute  Demand for Dollars Increases (curve shifts rightward). zAmericans Substitute  Supply of Dollars (Abroad) Decreases (curve shifts leftward). zAs a result, the equilibrium exchange rate (e’*) Increases.

Example 2 -- Increase in Foreign Interest Rates (i f ) zIncrease in i f leads to substitution away from US financial assets to foreign financial assets. zForeigners substitute  Demand for Dollars Decreases (curve shifts leftward). zAmericans Substitute  Supply of Dollars (Abroad) Increases (curve shifts rightward). zAs a result, the equilibrium exchange rate (e’*) Decreases.

Speculation -- Expectations of Exchange Rate Changes zExample 3 -- consider the exchange rate in units of foreign currency (abbreviation -- fcu) per dollar. ze’ = (5 fcu)/($1), and you expect (correctly) that it will decrease in the future to (4 fcu)/($1). zResponse -- sell dollars now, buy them back when “cheaper.”

Capital Gains in the Foreign Exchange Market zContinue example, start with $100. zStep #1 -- buy foreign currency at the current exchange rate. (100$)[(5 fcu)/($1)] = 500 fcu. zStep #2 -- convert back to dollars when e’ decreases in the future. (500 fcu)[($1)/(4 fcu)] = $125. zCapital gain of $25.

Floating Exchange Rates zAdvantages -- At market equilibrium, Balance of Payments = 0, i.e.  current account + capital account = Federal Reserve does not need to participate in foreign exchange market, it can use the money supply to focus solely on domestic policy.

Floating Exchange Rates (Continued) zDisadvantages -- Fluctuating exchange rate is disruptive to International Trade (exchange rate risk). -- Exchange rates can fluctuate a great deal, especially due to speculation (speculative bubbles).

Fixed Exchange Rates zAdvantages -- exchange rate is constant, stability in International Trade (exchange rate risk = 0).

Fixed Exchange Rates (Continued) zDisadvantages -- Federal Reserve must intervene constantly in the foreign exchange market to keep BOP = 0  loses control of money supply. -- Or country faces distorted Balance of Payments position (negative or positive) -- Fed might be forced into contractionary monetary policy to raise i* and increase e’* to the fixed rate.

Exchange Rate Regimes -- Overall zIdeal system: floating exchange rates which do not exhibit much movement. zActual system (US): Managed Float -- floating exchange rates with occasional Federal Reserve intervention.

Exchange Rates and the Macro Models zReview concepts: -- Real exchange rate (e), e = (P)(e’)/(P f ). -- Real exchange rate is inversely related to net exports, i.e. e   NX .

Causes of Net Exports -- Fixed and Floating e’ zForeign Output or Income (Y f ) zUS Output or Income (Y) zBarriers to Trade

Causes of Net Exports, Continued zReal Exchange Rate (e) -- US Price Level (P), P   e   NX  -- Foreign Price Level, P f   e   NX  -- Nominal Exchange Rate (e’) e’   e   NX 

Further Decomposition -- Causes of Net Exports zReal Exchange Rate (e) Nominal Exchange Rate (e’) (a) US interest rate (i) i   e’*   e   NX  (b) Foreign interest rate (i f ) i f   e’*   e   NX  (c) Expectations of Future e’

Exchange Rates and the IS-LM Model zNote -- causes (a), (b), and (c) apply only to floating exchange rates. zFixed Exchange Rates and the IS-LM Model -- e’ inflexible, cause of autonomous Net Exports, shifts IS curve.

Floating Exchange Rates and the IS-LM Model zSince the nominal interest rate is a cause of the nominal exchange rate and Net Exports, this behavior affects the slope of the IS curve. z Under floating exchange rates: i*   C , I , NX . zAdditional response to interest rate change  greater elasticity  flatter IS curve.

Floating Exchange Rates and Policy Effectiveness zFlatter IS curve under floating exchange rates makes fiscal policy less effective and monetary policy more effective.

Recent Developments – Exchange Rates z : US Transitions From System of Fixed Exchange Rates to Floating Exchange Rates Against Major Industrialized Economies. z2006-: US pressuring China to convert from Fixed Exchange Rate Regime to purely Floating Exchange Rate (How Much Will Yuan/$ Exchange Rate Decrease as a Result?).

Recent Developments -- International Trade zMovement toward reducing or removing trade barriers -- General Agreement on Tariffs and Trade (GATT) -- Replaced by World Trade Organization (WTO)

Free Trade Agreements Involving the US -- North American Free Trade Agreement (NAFTA), Central American Free Trade Agreement (CAFTA), Free Trade Agreement of the Americas (FTAA), Proposed.

More Developments zCreation of the European Union -- economic bonding of major European countries. -- removing barriers to trade among member nations -- common currency (Euro) -- one central bank for the community

Challenges to the European Union zUniform currency equivalent to fixed exchange rate regime among member nations. zTo avoid large scale foreign borrowing associated with fixed exchange rates and BOP < 0, need for coordinated economic policies among members. zWill nations with large budget deficits and very sluggish economies (e.g. Greece) accede to Germany’s fiscal-discipline based economy?