McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. INTERNATIONAL FINANCIAL POLICY INTERNATIONAL FINANCIAL POLICY Chapter 33

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Today’s lecture will: Describe the balance of payments and the trade balance, and relate them to the supply and demand for currencies. Explain four important fundamental determinants of exchange rates. Discuss how a country influences its exchange rate by using monetary and fiscal policy. Explain how a country stabilizes or fixes an exchange rate.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Today’s lecture will: Discuss purchasing power parity and the real exchange rate. Differentiate fixed, flexible, and partially flexible exchange rates, and discuss the advantages and disadvantages of each. Examine the advantages and disadvantages of a common currency.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved The Balance of Payments The balance of payments is a country’s record of all transactions between its residents and the residents of foreign countries. Current account Balance of merchandise trade -665 Balance on services + 48 Balance on goods and services -617 Investment and transfers balance - 49 Balance on current account -666 Financial and capital account Capital balance + 1 Balance on private financial account +256 Balance on government financial account +358 Balance on financial and capital account +615 Statistical discrepancy -51 Total 0

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved The Current Account Current Account Merchandise Exports Imports -1,472 Balance of merchandise trade -665 Services Exports +339 Imports -291 Balance on services + 48 Balance on goods and services -617 (Balance of trade) Net investment income + 24 Net transfers - 73 Investment, transfer balance - 49 Balance on current account -666 The current account lists all short-term payments. The balance of merchandise trade is the difference between the import and export of goods. The balance of trade includes goods and services. Payments from past investments and net transfers are included in the current account.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved The Financial and Capital Account Financial and capital account Capital balance + 1 Private financial account Private financial inflows +1,078 Private financial outflows Balance on private financial +256 account Government financial account Foreign government +355 financial balance U.S. government + 3 financial balance Balance on government +358 financial account Balance on financial and capital account +615 The financial and capital account measures payments for assets, such as stocks, bonds, and ownership of real estate. The government financial account reflects governments’ buying and selling reserves.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Exchange Rates An exchange rate is the rate at which one country’s currency can be traded for another country’s currency. The exchange rate is determined by demand and supply in the forex (foreign exchange) markets where traders buy and sell currencies. The forex markets are very busy with over $1.5 trillion traded every day.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Exchange Rates The supply of euros (demand for dollars) comes from Europeans who want to use them to buy dollars in order to buy U.S. goods or assets.  The supply of euros is positively sloped because if the value of the euro is high, U.S. goods are cheaper for Europeans. The demand for euros comes from Americans who want to buy European goods or assets.  The demand for euros is negatively sloped because if the dollar price of euros is low, Americans want to buy more European goods because they are cheaper for them.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved The Supply and Demand for Euros The equilibrium exchange rate is 1 euro = $1.10 or $1 =.77 euros. If the exchange rate is too high ($1.50) there is a surplus of euros and Europe has a deficit in its balance of payments. If the exchange rate is too low ($1.20) there is a shortage of euros and Europe has a balance of payments surplus. S D QSQS QDQD $ Quantity of euros Price of euros (in dollars)

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Fundamental Forces Determining Exchange Rates Fundamental forces determine the demand and supply for currencies and can cause them to shift:  A country’s income  Changes in a country’s prices  The interest rate in a country  A country’s trade policy

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Changes in a Country’s Income Income increases in the U.S. Imports increase Demand for foreign currency to buy imports increase which means the supply of the dollar increases The increase in supply of the dollar causes the price of the dollar to decrease

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Changes in a Country’s Prices Inflation in the U.S. increases Imports increase because foreign goods are cheaper Demand for foreign currency to buy imports increases which means the supply of the dollars increases The increase in supply of dollars causes the price of dollars to decrease

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Changes in Interest Rates Interest rates in the U.S. increase Demand for U.S. interest-bearing assets increases Demand for dollars to buy U.S. assets increases The increase in the demand for dollars causes the price of dollars to increase

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Changes in Trade Policy U.S. trade restrictions on imports increase Demand for imports to the U.S. decreases The demand for foreign currencies decreases, which means the supply of dollars decreases If foreign countries retaliate with restrictions on U.S. exports, the demand for dollars decreases

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Exchange Rate Determination if Complicated Fundamentals can be overwhelmed by expectations of a change in exchange rates which become self-fulfilling. The resulting fluctuations serve no real purpose, and cause problems for international trade and the country’s economy. The government can change the value of its currency with monetary and fiscal policy.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Expansionary Monetary Policy Exchange rate L-R effect M Competi- tiveness Expansionary monetary policy i P Y Exchange rate Imports

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Contractionary Monetary Policy Exchange rate L-R effect M Competi- tiveness Contractionary monetary policy i P Y Exchange rate Imports

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Expansionary Fiscal Policy Exchange rate L-R effect Competi- tiveness Expansionary fiscal policy i P Y Exchange rate Imports

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Contractionary Fiscal Policy Exchange rate L-R effect Competi- tiveness Contractionary monetary policy i P Y Exchange rate Imports

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Effects of Monetary and Fiscal Policy on Exchange Rates Expansionary monetary policy lowers exchange rates. Contractionary monetary policy increases exchange rates. The net effect of fiscal policy is ambiguous because the interest rate effect and the income effect work in opposite directions.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Direct Exchange Rate Intervention To avoid the problems caused by fluctuating exchange rates, governments sometimes intervene to fix exchange rates by buying and selling its currency. If it buys its currency, it can increase its exchange rate. If it sells its currency, its value decreases.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Direct Exchange Rate Intervention If the government wishes to hold the exchange rate at $1.50 when the equilibrium is $1.30, there is an excess supply of Q 2 -Q 1. The government purchases the excess (D 1 ) to maintain $1.50 as equilibrium. Quantity of euros Price of euros (in dollars) S D0D0 Q2Q2 Q1Q1 $ D1D1 Excess supply QEQE

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Currency Stabilization A more viable long-run exchange rate policy is currency stabilization – the buying and selling of a currency by the government to offset temporary fluctuations in supply and demand for currencies. The government is not trying to change the long-run equilibrium, but is trying to keep the exchange rate at that long-run equilibrium. A central issue in exchange rate intervention policy is estimating the long-run equilibrium.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Estimating Exchange Rates with Purchasing Power Parity Purchasing power parity (PPI) – a method of calculating exchange rates that values currencies at rates such that each currency will buy an equal basket of goods. According to PPP, if a basket of goods costs $7 in the U.S. and ¥1000 in Japan, the exchange rate should be $1 = 1000/7 = ¥143.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Real Exchange Rates A real exchange rate is an exchange rate adjusted for differential inflation or differential changes in the price level. A nominal exchange rate is the actual exchange rate used when currencies are exchanged. %Δ real exchange rate = %Δ nominal exchange rate – (domestic inflation – foreign inflation)

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Alternative Exchange Rate Systems Fixed exchange rate – the government chooses an exchange rate and offers to buy and sell currencies at that rate. Flexible exchange rate – determination of exchange rates is left totally up to the market. Partially flexible exchange rate – the government sometimes buys or sells currencies to influence the exchange rate, while at other times letting private market forces operate.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Fixed Exchange Rates Advantages  They provide international monetary stability.  They force governments to make adjustments to meet international problems. Disadvantages  If they become unfixed, they create monetary instability.  They force governments to make adjustments to meet international problems.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Flexible Exchange Rates Advantages  They provide for orderly incremental adjustment of exchange rates  They allow government to be flexible in conducting monetary and fiscal policy. Disadvantages  They allow speculation to cause large jumps in exchange rates.  They allow government to be flexible in conducting monetary and fiscal policy.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Partially Flexible Exchange Rates Partially flexible exchange rate regimes combine the advantages of both fixed and flexible exchange rates. If policy makers believe there is a fundamental misalignment in a country’s exchange rate, they allow market forces to determine it. If they believe the currency’s value is falling because of speculation, they step in and fix the exchange rate.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved The Euro: A Common Currency for Europe In 2002 twelve members of the European Union adopted the euro € as a common currency.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved The Euro: A Common Currency Advantages:  Eliminates the cost of exchanging currencies  Facilitates price comparisons  Creates a larger market Disadvantages  Loss of independent monetary policy for member countries  Loss of some national identity

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Summary The balance of payments is made up of the current account and the financial and capital account. Exchange rates in perfectly flexible systems are determined by the supply of and demand for a currency. The following increase demand for foreign currencies and depreciate domestic currencies:  An increase in domestic income  An increase in domestic prices  A decrease in domestic interest rates  A reduction in trade restrictions on imports

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Summary To raise the value of domestic currency a country can either increase private demand or decrease private supply through contractionary monetary policy. Expansionary monetary policy, through its effect on interest rates, income, and price level, tends to lower a country’s exchange rate. Fiscal policy has an ambiguous effect on a country’s exchange rate.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Summary A country can stabilize or fix its exchange rate by either directly buying and selling its own currency or adjusting its monetary and fiscal policy to achieve its exchange rate goal. It is easier technically for a country to bring the value of its currency down than it is to support its currency. The purchasing power parity approach can be used to estimate the long-run equilibrium exchange rate.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Review Question 33-1 Suppose that the U.S. government budget deficit increases and it is financed with government borrowing which leads to higher U.S. interest rates. How will this affect the value of the dollar? If U.S. interest rates increase, demand for U.S. bonds will increase, causing the demand for dollars to increase. If the demand for dollars increases, the exchange rate for the dollar will increase. Review Question 33-2 How does an expansionary monetary policy cause a decrease in exchange rates? An expansionary monetary policy will decrease interest rates and increase incomes and prices. The decrease in interest rates will decrease the demand for the dollar causing its value to fall. The increase in incomes and prices will increase the demand for imports. In order to buy more imports, Americans will increase the supply of dollars to buy foreign currencies, causing a decrease in the exchange rate of the dollar.