Unit-5 Macro Review Foreign Exchange & Balance of Payments

Determinants of Exchange Rates 1. Changes in Consumer Tastes 2. Relative Income Changes 3. Relative Inflation 4. Relative Real Interest Rates 5. Speculation & Investment U.S. Income Rises Demand Imports Demand Foreign Currency Market for Foreign Exchange Dollar Depreciates Foreign Currency Appreciates Where people go to “swap” currencies

Euro Price of a dollar Qty of Dollars D1D1 S1S Euro Q1Q1 Graphing Exchange Rates If U.S. Price Level Falls => D2D2 U.S. goods look “cheap” => Europeans ↑U.S. exports => Demand for dollars ↑ => Dollar appreciates Dollar Price of a Euro Qty of Euros D1D1 S1S $ Q1Q1 S2S2 Dollars Euros Market for Foreign Exchange

Balance of Payments Current Account –Considered U.S. Trade Balance –Exports – Imports (NX) & Investment Income (bond interest, stock dividends) Financial Account –Foreign purchase of US assets – U.S. purchase of foreign assets –Assets = Stocks, bonds, factories, land, etc… –Example: Financial Act. Surplus = Money flows into US If one account is positive the other Must be negative. They generally sum to ZERO! USA has a current account deficit with China & Financial Account Surplus Example:

China & Balance of Payments Imports > Exports Current Account Deficit China buys U.S. Bonds Financial Account Surplus Official Reserves Fed holds quantities of foreign currency called reserves Used to offset discrepancy in current account vs. financial account If both accounts do Not sum to zero, reserves are used to Offset minor difference

Practice Test