1. C hapter 32 Exchange Rates, Balance of Payments, and International Debt © 2002 South-Western

2. 2 Economic Principles Exchange Rates Foreign Exchange Markets Appreciation and Depreciation of Currencies

3. 3 Economic Principles Floating and Fixed Exchange Rates Arbitrage Devaluation

4. 4 Economic Principles Balance of Payments International Debt and Debt Service

5. 5 The Foreign Exchange Market: The Buying and Selling of Currencies Foreign exchange market A market in which currencies of different nations are bought and sold.

6. 6 The Foreign Exchange Market: The Buying and Selling of Currencies Exchange rate The number of units of foreign currency that can be purchased with one unit of domestic currency.

7. 7 The Foreign Exchange Market: The Buying and Selling of Currencies 1. Suppose that a kite costs 40 pesos, and the exchange rate is 10 pesos to the dollar. What is the dollar price of the kite? 40 pesos/10 = 4 dollars.

8. 8 EXHIBIT 1FOREIGN EXCHANGE MARKET

9. 9 Exhibit 1: Foreign Exchange Market At $2 per yap, is the foreign exchange market in Exhibit 1 in equilibrium, or is there an excess demand or excess supply of yaps? Since the equilibrium price is $3 per yap, at $2 per yap there would be an excess demand for yaps.

10. 10 Exhibit 1: Foreign Exchange Market At $4 per yap, is the foreign exchange market in Exhibit 1 in equilibrium, or is there an excess demand or excess supply of yaps? Since the equilibrium price is $3 per yap, at $4 per yap there would be an excess supply of yaps.

11. 11 The Foreign Exchange Market: The Buying and Selling of Currencies 2. Why is the demand curve for foreign currency downward- sloping? When the price of a foreign currency declines, the quantity of that foreign currency demanded increases.

12. 12 The Foreign Exchange Market: The Buying and Selling of Currencies 2. Why is the demand curve for foreign currency downward- sloping? For example, if a dollar can buy more Mexican pesos than before, then a dollar can also buy more Mexican goods and services than before.

13. 13 The Foreign Exchange Market: The Buying and Selling of Currencies 2. Why is the demand curve for foreign currency downward- sloping? As a result, Americans wish to exchange dollars for more pesos in order to buy more Mexican goods, increasing the quantity of pesos demanded in the foreign exchange market.

14. 14 The Foreign Exchange Market: The Buying and Selling of Currencies 3. Why is the supply curve for foreign currency upward- sloping? When the price of a foreign currency rises, then the purchasing power of the foreign currency rises when it comes to buying imported goods and services.

15. 15 The Foreign Exchange Market: The Buying and Selling of Currencies 3. Why is the supply curve for foreign currency upward- sloping? For example, if it takes more dollars to buy a Mexican peso, then it takes fewer pesos to buy a dollar, and so the price of American goods are cheaper for Mexicans.

16. 16 The Foreign Exchange Market: The Buying and Selling of Currencies 3. Why is the supply curve for foreign currency upward- sloping? As a result, Mexicans wish to exchange more pesos for dollars in order to buy more American goods, increasing the quantity of pesos supplied in the foreign exchange market.

17. 17 The Foreign Exchange Market: The Buying and Selling of Currencies 4. Which of the following will cause an increase in the demand for Mexican pesos? a. Decreasing American incomes. b. Increasing Mexican interest rates. c. Increasing American interest rates.

18. 18 The Foreign Exchange Market: The Buying and Selling of Currencies 4. Which of the following will cause an increase in the demand for Mexican pesos? b. Increasing Mexican interest rates.

19. 19 EXHIBIT 2EFFECT OF AN INCREASE IN THE DEMAND FOR YAPS ON THE DOLLARS-FOR-YAPS RATE OF EXCHANGE

20. 20 Exhibit 2: Effect of an Increase in the Demand for Yaps on the Dollars-for-Yaps Rate of Exchange 1. After the increase in demand from D 1 to D 2, Is there excess supply, excess demand, or equilibrium at an exchange rate of $3 per yap? There is excess demand of (70-30) = 40 thousand yaps.

21. 21 Exhibit 2: Effect of an Increase in the Demand for Yaps on the Dollars-for-Yaps Rate of Exchange 2. After the increase in demand from D 1 to D 2, what is the new equilibrium exchange rate? The new equilibrium exchange rate is $5 per yap.

22. 22 The Foreign Exchange Market: The Buying and Selling of Currencies 5. Which of the following will cause a decrease in the supply of Mexican pesos? a. Decreasing American tastes for Mexican goods. b. Decreasing Mexican interest rates. c. Decreasing Mexican incomes.

23. 23 The Foreign Exchange Market: The Buying and Selling of Currencies 5. Which of the following will cause a decrease in the supply of Mexican pesos? c. Decreasing Mexican incomes.

24. 24 EXHIBIT 3EFFECT OF AN INCREASE IN THE SUPPLY OF YAPS ON THE DOLLARS-FOR-YAPS RATE OF EXCHANGE

25. 25 Exhibit 3: Effect of an Increase in the Supply of Yaps on the Dollars-for-Yaps Rate of Exchange 1. After the increase in supply from S 1 to S 2, is there excess supply, excess demand, or equilibrium at an exchange rate of $3 per yap? There is an excess supply of (50-30) = 20 thousand yaps.

26. 26 Exhibit 3: Effect of an Increase in the Supply of Yaps on the Dollars-for-Yaps Rate of Exchange 1. After the increase in supply from S 1 to S 2, what is the new equilibrium exchange rate? The new equilibrium exchange rate is $2 per yap.

27. 27 Floating Exchange Rates Floating exchange rate An exchange rate determined strictly by the demands and supplies for a nation’s currency.

28. 28 Floating Exchange Rates Appreciation A rise in the price of a nation’s currency relative to foreign currencies.

29. 29 Floating Exchange Rates Depreciation A fall in the price of a nation’s currency relative to foreign currencies.

30. 30 Floating Exchange Rates 1. Complete the sentence: When journalists say that the dollar has “weakened,” they mean that the dollar has _____ in value.

31. 31 Floating Exchange Rates 1. Complete the sentence: When journalists say that the dollar has “weakened,” they mean that the dollar has depreciated in value.

32. 32 Floating Exchange Rates 2. If the dollar has appreciated in value relative to the Mexican peso, then which of the following is true: a. The exchange rate has more pesos per dollar than before. b. The exchange rate has fewer pesos per dollar than before.

33. 33 Floating Exchange Rates 2. If the dollar has appreciated in value relative to the Mexican peso, then which of the following is true: a. The exchange rate has more pesos per dollar than before.

34. 34 Tourists at the Mall Has the U.S. dollar appreciated or depreciated in value relative to the Japanese yen between 1960 and 1996? Depreciated in value.

35. 35 Tourists at the Mall Has the U.S. dollar appreciated or depreciated in value relative to the Japanese yen between 1960 and 1996? In 1960 the exchange rate was 358 yen per dollar. By 1996 there were only 131 yen per dollar.

36. 36 Floating Exchange Rates Arbitrage The practice of buying a foreign currency in one market at a low price and selling it in another at a higher price.

37. 37 Floating Exchange Rates 3. How might floating exchange rates make international trade riskier? Suppose that the price of an internationally traded good changes during the time between when a purchase is negotiated and the product is delivered.

38. 38 Floating Exchange Rates 3. How might floating exchange rates make international trade riskier? Then the change in exchange rates is like an unforeseen change in the price of the good, which redistributes the gains from trade in an unforeseen way.

39. 39 Floating Exchange Rates Fixed exchange rate A rate determined by government and then maintained through the process of buying and selling quantities of its own currency on the foreign exchange market.

40. 40 EXHIBIT 4ATRADE UNDER FREE AND FIXED EXCHANGE RATES

41. 41 EXHIBIT 4BTRADE UNDER FREE AND FIXED EXCHANGE RATES

42. 42 Exhibit 4: Trade Under Free and Fixed Exchange Rates 1. If there is a system of free or floating exchange rates, then what happens if the demand for a foreign currency increases? The exchange rate (dollars per unit of foreign currency) increases and there is neither excess demand nor excess supply of the foreign currency.

43. 43 Exhibit 4: Trade Under Free and Fixed Exchange Rates 2. If there is a system of fixed exchange rates, then what happens if the demand for a foreign currency increases? Since the exchange rate cannot change, an increase in demand will create excess demand for the foreign currency.

44. 44 Exhibit 4: Trade Under Free and Fixed Exchange Rates 3. If there is excess demand for Mexican pesos under a system of fixed exchange rates, what will the Mexican government need to do to eliminate the excess demand for the peso? Mexico will need to exchange some of its own pesos for dollars on the foreign exchange market.

45. 45 Exhibit 4: Trade Under Free and Fixed Exchange Rates 3. If there is excess demand for Mexican pesos under a system of fixed exchange rates, what will the Mexican government need to do to eliminate the excess demand for the peso? This will increase the supply of pesos on the foreign exchange market and eliminate the excess demand.

46. 46 Exhibit 4: Trade Under Free and Fixed Exchange Rates 3. If there is excess demand for Mexican pesos under a system of fixed exchange rates, what will the Mexican government need to do to eliminate the excess demand for the peso? In order for Mexico to do this, it must have sufficient stock of pesos to exchange for dollars.

47. 47 Exhibit 4: Trade Under Free and Fixed Exchange Rates 4. Continuing the Mexican peso example, what might Mexico be forced to do if it did not have a sufficient quantity of pesos on reserve to eliminate the excess demand? Mexico might be forced to borrow pesos from another country, or even agree to increase the exchange rate ($ per peso).

48. 48 Floating Exchange Rates Foreign exchange reserves The stock of foreign currencies a government holds.

49. 49 Floating Exchange Rates Devaluation Government policy that lowers the nation’s exchange rate; its currency instantly is worth less in the foreign exchange market.

50. 50 Floating Exchange Rates 4. In which of the following circumstances would a country most likely be forced into a devaluation of its currency: a. The excess supply of its currency in the foreign exchange market exceeds its foreign exchange reserves. b. The excess demand for its currency in the foreign exchange market exceeds its foreign exchange reserves.

51. 51 Floating Exchange Rates 4. In which of the following circumstances would a country most likely be forced into a devaluation of its currency: a. The excess supply of its currency in the foreign exchange market exceeds its foreign exchange reserves.

52. 52 Floating Exchange Rates Import controls Tariffs and quotas used by government to limit a nation’s imports.

53. 53 Floating Exchange Rates Exchange controls A system in which government, as the sole depository of foreign currencies, exercises complete control over how these currencies can be used.

54. 54 Floating Exchange Rates International Monetary Fund (IMF) An international organization formed to make loans of foreign currencies to countries facing balance of payments problems.

55. 55 Balance of Payments Balance of payments An itemized account of a nation’s foreign economic transactions.

56. 56 Balance of Payments Balance on current account A category that itemizes a nation’s imports and exports of goods and services, income receipts and payments on investment, and unilateral transfers.

57. 57 EXHIBIT 5THE U.S. BALANCE OF PAYMENTS ACCOUNT: 1999 ($ BILLIONS) Source: Survey of Current Business (Washington, D.C.: U.S. Department of Commerce, January 2001), p. 56.

58. 58 Exhibit 5: The U.S. Balance of Payments Account: 1999 ($ Billions) In which of the following categories of the U.S. balance of payments did the U.S. run a surplus in 1999? a. Balance of trade. b. Balance on current account. c. Balance on capital account.

59. 59 Exhibit 5: The U.S. Balance of Payments Account: 1999 ($ Billions) In which of the following categories of the U.S. balance of payments did the U.S. run a surplus in 1999? c. Balance on capital account.

60. 60 EXHIBIT 6U.S. BALANCE OF TRADE: 1950–2000

61. 61 Exhibit 6: U.S. Balance of Trade: 1950-2000 What has been the overall trend in the U.S. balance of trade since the mid-1970s? Since the mid-1970s the U.S. balance of trade has been in deficit.

62. 62 Balance of Payments What is an example of an export of services? When a U.S. engineering firm provides engineering design services for a project in another country.

63. 63 Balance of Payments Unilateral transfers Transfers of currency made by individuals, businesses, or government of one nation to individuals, businesses, or governments in other nations, with no designated return.

64. 64 Balance of Payments Balance on capital account A category that itemizes changes in the foreign asset holdings of a nation and that nation’s asset holdings abroad.

65. 65 What is a Balance of Payments Problem? Do trade imbalances always create problems? No. For example, a country may have a balance of trade deficit because it is importing capital equipment necessary for it to produce valuable exports in the future.

66. 66 How Deficits on Current Account Develop If foreigners make huge investments in U.S. stocks and bonds, how might this affect the current account? Foreign purchases of U.S. stocks and bonds increases the demand for U.S. dollars.

67. 67 How Deficits on Current Account Develop If foreigners make huge investments in U.S. stocks and bonds, how might this affect the current account? Increased demand for the U.S. dollar increases the value of the dollar relative to other currencies.

68. 68 How Deficits on Current Account Develop If foreigners make huge investments in U.S. stocks and bonds, how might this affect the current account? A high-valued dollar makes imports cheap for Americans, but makes American exports expensive for foreigners in other countries.

69. 69 How Deficits on Current Account Develop If foreigners make huge investments in U.S. stocks and bonds, how might this affect the current account? Consequently imports increase and exports decline, causing a current account deficit.

70. 70 International Debt International debt The total amount of outstanding IOUs a nation is obligated to repay other nations and international organizations.

71. 71 International Debt Debt service Interest payments on international debt as a percentage of a nation’s merchandise exports.

72. 72 EXHIBIT 7DEBT SERVICE OF SELECTED COUNTRIES, AS A PERCENTAGE OF EXPORTS: 1998 Source: The World Bank, World Development Indicators, 2000 (Washington, D.C.: World Bank, 2000).

73. 73 Exhibit 7: Debt Service of Selected Countries, as a Percentage of Exports: 1998 What causes countries such as Egypt and Sudan to have such high debt service as a percentage of their exports? The amount of international debt held by these countries is quite large relative to the value of their exports, making repayment difficult.