1. Financing and Trade Deficits
Econ 12/5

2. Warm Up
What are two costs and two benefits to free trade?

3. Foreign Exchange
Foreign Exchange: foreign currencies used to facilitate international trade
Bought and sold in the foreign exchange market with banks who help secure foreign currency for importers and accept foreign currency from exporters
Some US exporters accept foreign currency and deposit it into their banks which helps the US banking system build a supply of foreign currency
This money is then sold to US firms that want to import goods from other countries

4. Foreign Exchange Rates
Foreign Exchange Rate: the price of one country’s currency in terms of another country’s currency
Two kinds of exchange rates: fixed and flexible

5. Fixed Exchange Rates
Fixed exchange rate: a system under which the price of one currency is fixed in terms of another so that the rate does not change
Popular when the world was on the gold standard (countries had the right to demand other countries covert their currency into gold because every country wanted it and valued it)
1971 US no longer redeemed foreign held dollars for gold
Now countries fix or “peg” their currency to another currency

7. Flexible Exchange Rates
Flexible exchange rates (floating exchange rates): forces of supply and demand establish the value of one country’s currency in terms of another country’s currency

8. Trade Deficits and Surpluses
Trade deficit: whenever the value of the products it imports exceeds the value of the products it imports
Trade surplus: value of exports exceeds the value of imports
These are dependent on the value of currency
Trade-weighted value of the dollar: an index by the Fed that shows the strength of the dollar against a group of foreign currencies (Euro, Peso, Yen, Pound, etc.)
When the index falls, the dollar is weak in relation to other currency
When it rises, the dollar is strong

9. Trade Weighted Value of the Dollar
2001—trade deficit because the US dollar was strong. That means foreign goods became less expensive, but US exports were more expensive so imports ride and exports fall.
2008 is the opposite of this

11. Effects of Trade Deficits
Large deficits can flood the foreign exchange market with dollars.
This leads to the dollar losing some of its value, and a weaker dollar can cause unemployment in import industries because imports are more expensive but decrease in unemployment in export industries because they get more competitive
The shift in employment between import and export industries is a big problem for trade deficits and can hurt the US economy
However they tend to correct themselves if the exchange rate is flexible and therefore do not need much government regulation or interference