2. 1 Ch. 32: International Finance James R. Russell, Ph.D., Professor of Economics & Management, Oral Roberts University ©2005 Thomson Business & Professional Publishing, A Division of Thomson Learning

3. 2 The Balance of Payments Balance of Payments: a periodic statement (usually annual) of the money value of all transactions between residents of one country and residents of all other countries. Balance of Payments: a periodic statement (usually annual) of the money value of all transactions between residents of one country and residents of all other countries. Provides information about a nation’s: Provides information about a nation’s: – imports and exports –domestic residents’ earnings on assets located abroad –foreign earnings on domestic assets –gifts to and from foreign countries (including foreign aid) –official transactions by governments and central banks.

4. 3 The Balance of Payments Debit: any transaction that supplies the country’s currency in the foreign exchange market. Debit: any transaction that supplies the country’s currency in the foreign exchange market. Foreign Exchange Market: the market in which currencies of different countries are exchanged. Foreign Exchange Market: the market in which currencies of different countries are exchanged. Credit: any transaction that creates a demand for the country’s currency in the foreign exchange market. Credit: any transaction that creates a demand for the country’s currency in the foreign exchange market. Current Account: includes all payments related to the purchase and sale of goods and services. Components include: exports, imports, and net unilateral transfers abroad. Current Account: includes all payments related to the purchase and sale of goods and services. Components include: exports, imports, and net unilateral transfers abroad.

5. 4 Exhibit 1: Debits and Credits

6. 5 Exhibit 2: U.S. Balance of Payments, Year Z

7. 6

8. 7 Current Account Current Account : includes all payments related to the purchase and sale of goods and services. Includes: Exports of Goods and Services: exports of goods, exports of services, and income from assets owned abroad. Recorded as credits (+). Exports of Goods and Services: exports of goods, exports of services, and income from assets owned abroad. Recorded as credits (+). Imports of Goods and Services: imports of goods, imports of services, and income from foreign owned domestic assets. Recorded as a debit (-). Imports of Goods and Services: imports of goods, imports of services, and income from foreign owned domestic assets. Recorded as a debit (-).

9. 8 Current Account Net Unilateral Transfers Abroad: Net one-way money payments. From Americans or U.S. Government to foreigners or foreign governments (-). or From Americans or U.S. Government to foreigners or foreign governments (-). or From foreigners or foreign governments to Americans or the U.S. Government (+). From foreigners or foreign governments to Americans or the U.S. Government (+).

10. 9 Current Account Merchandise Trade Balance: the difference between the value of merchandise exports and imports. Merchandise Trade Balance: the difference between the value of merchandise exports and imports. Merchandise Trade Deficit: amount that merchandise exports is less than merchandise imports. Merchandise Trade Deficit: amount that merchandise exports is less than merchandise imports. Merchandise Trade Surplus: amount that merchandise exports is greater than merchandise imports Merchandise Trade Surplus: amount that merchandise exports is greater than merchandise imports

11. 10 Exhibit 3: U.S. Merchandise Trade Balance

12. 11 Capital Account Capital Account: all payments related to the purchase and sale of assets and to borrowing and lending activities. Outflow of U.S. Capital: American purchases of foreign assets and U.S. loans to foreigners are outflows of U.S. Capital Outflow of U.S. Capital: American purchases of foreign assets and U.S. loans to foreigners are outflows of U.S. Capital Inflow of Foreign Capital: Foreign purchases of U.S. assets and foreign loans to Americans are inflows of foreign capital. Inflow of Foreign Capital: Foreign purchases of U.S. assets and foreign loans to Americans are inflows of foreign capital.

13. 12 Official Reserve Account and Statistical Discrepancy Official Reserve Account: official reserve balances in the form of foreign currencies, gold, its reserve position in the International Monetary Fund, and Special Drawing Rights. Official Reserve Account: official reserve balances in the form of foreign currencies, gold, its reserve position in the International Monetary Fund, and Special Drawing Rights. Statistical Discrepancy: adjustment to the balance of payments due to incomplete or inaccurate information. Statistical Discrepancy: adjustment to the balance of payments due to incomplete or inaccurate information.

14. 13 What the Balance Of Payments Equals Current Account Balance Current Account Balance –Exports of goods and services –Imports of goods and services –Net unilateral transfers Capital Account Balance Capital Account Balance –Outflow of U.S. capital –Inflow of foreign capital Official Reserve Balance Official Reserve Balance –Increase in U.S. official reserve assets –Increase in foreign official assets in the U.S. Statistical Discrepancy Statistical Discrepancy

15. 14 Self-Test If an American retailer buys Japanese cars from a Japanese manufacturer, is this transaction recorded as a debit or a credit? Explain your answer. If an American retailer buys Japanese cars from a Japanese manufacturer, is this transaction recorded as a debit or a credit? Explain your answer. Exports of goods and services equal $200 billion and imports of goods and services equal $300 billion. What is the merchandise trade balance? Exports of goods and services equal $200 billion and imports of goods and services equal $300 billion. What is the merchandise trade balance? What is the difference between the merchandise trade balance and the current account balance? What is the difference between the merchandise trade balance and the current account balance?

16. 15 Flexible Exchange Rates Exchange Rate: the price of one currency in terms of another currency. Exchange Rate: the price of one currency in terms of another currency. Flexible Exchange Rate System: A system whereby exchange rates are determined by the forces of supply and demand for a currency. Flexible Exchange Rate System: A system whereby exchange rates are determined by the forces of supply and demand for a currency.

17. 16 The Demand For Goods and Currencies Country A’s demand for Country B’s goods leads to a demand for B’s currency and a supply of A’s currency on the foreign exchange market. Country A’s demand for Country B’s goods leads to a demand for B’s currency and a supply of A’s currency on the foreign exchange market. B’s demand for A’s goods leads to a demand for A’s currency and a supply of B’s currency on the foreign exchange market. B’s demand for A’s goods leads to a demand for A’s currency and a supply of B’s currency on the foreign exchange market.

18. 17 Exhibit 4: The Demand for Goods and the Supply of Currencies

19. 18 Exhibit 5: Translating U.S. Demand for Pesos into U.S. Supply of Dollars and Mexican Demand for Dollars into Mexican Supply of Pesos

20. 19 Exhibit 6: A Flexible Exchange Rate System

21. 20 Changes in the Equilibrium Rate Difference in Income Growth Rates Difference in Income Growth Rates –Higher Relative Growth = Weaker Currency –Lower Relative Growth = Stronger Currency Difference in Relative Inflation Rates Difference in Relative Inflation Rates –Higher Relative Inflation = Weaker Currency –Lower Relative Inflation = Stronger Currency Changes in Real Interest Rates Changes in Real Interest Rates –Higher Relative Real Interest Rates = Stronger Currency –Lower Relative Interest Rates = Weaker Currency

22. 21 Exhibit 7: The Growth Rate of Income and the Exchange Rate (US Growth Higher)

23. 22 Exhibit 8: Inflation, Exchange Rates, and Purchasing Power Parity (PPP) Higher US Inflation

24. 23 Purchasing Power Parity Theory Purchasing Power Parity Theory: the exchange rates between any two currencies will adjust to reflect changes in the relative price levels of the two countries.

25. 24 Self-Test In the foreign exchange market, how is the demand for dollars linked to the supply of pesos? In the foreign exchange market, how is the demand for dollars linked to the supply of pesos? What could cause the U.S. dollar to appreciate against the Mexican peso on the foreign exchange market? What could cause the U.S. dollar to appreciate against the Mexican peso on the foreign exchange market? Suppose the U.S. economy grows while the Swiss economy does not. How will this affect the exchange rate between the dollar and the Swiss franc? Why? Suppose the U.S. economy grows while the Swiss economy does not. How will this affect the exchange rate between the dollar and the Swiss franc? Why? What does the Purchasing Power Parity Theory say? Give an example to illustrate your answer. What does the Purchasing Power Parity Theory say? Give an example to illustrate your answer.

26. 25 Fixed Exchange Rates Fixed Exchange Rate System: the system where a nation’s currency is set at a fixed rate relative to all other currencies, and central banks intervene in the foreign exchange market to maintain the fixed rate. Fixed Exchange Rate System: the system where a nation’s currency is set at a fixed rate relative to all other currencies, and central banks intervene in the foreign exchange market to maintain the fixed rate. Overvaluation: when a currency’s current price, in terms of other currencies, is above the equilibrium price. Overvaluation: when a currency’s current price, in terms of other currencies, is above the equilibrium price. Undervaluation: when a currency’s current price, in terms of other currencies, is below the equilibrium price. Undervaluation: when a currency’s current price, in terms of other currencies, is below the equilibrium price.

27. 26 Exhibit 9: A Fixed Exchange Rate System

28. 27 Exhibit 10: Fixed Exchange Rates and an Overvalued Dollar

29. 28 What’s so Bad About An Overvalued Dollar? As U.S. exports become more expensive for other countries, they buy fewer U.S. exports. If exports fall below imports, the U.S. is in a trade deficit.

30. 29 Government Involvement in a Fixed Exchange System Suppose there is a surplus of pesos. The Fed might buy pesos with dollars, causing the demand for pesos will increase and its demand curve will shift to the right. The Fed might buy pesos with dollars, causing the demand for pesos will increase and its demand curve will shift to the right. The Banco de Mexico might buy the peso with its reserve dollars, increasing the demand for pesos and the equilibrium rate. The Banco de Mexico might buy the peso with its reserve dollars, increasing the demand for pesos and the equilibrium rate. Or, the Fed and the Banco de Mexico might both buy pesos. Or, the Fed and the Banco de Mexico might both buy pesos.

31. 30 Options Under a Fixed Exchange Rate System Devaluation and Revaluation Devaluation and Revaluation –Devaluation occurs when the official price of a currency is lowered. –Revaluation occurs when the official price of a currency is raised. Protectionist Trade Policy Protectionist Trade Policy Changes in Monetary Policy Changes in Monetary Policy

32. 31 The Gold Standard Fixed Exchange Rate System To have a gold standard, countries must: Define their currencies in terms of gold. Define their currencies in terms of gold. Stand ready and willing to convert gold into paper money and paper money into gold. Stand ready and willing to convert gold into paper money and paper money into gold. Link their money supplies to their holdings of gold. Link their money supplies to their holdings of gold.

33. 32 Economists and The Gold Standard Some economists argue “The gold system subjects domestic monetary policy to international instead of domestic considerations.” Some economists argue “The gold system subjects domestic monetary policy to international instead of domestic considerations.” Some economists argue the same thing about the fixed exchange rate system. Some economists argue the same thing about the fixed exchange rate system.

34. 33 Self-Test Under a fixed exchange rate system, if one currency is overvalued then another currency must be undervalued. Explain why this is true. Under a fixed exchange rate system, if one currency is overvalued then another currency must be undervalued. Explain why this is true. How does an overvalued dollar affect U.S. exports and imports? How does an overvalued dollar affect U.S. exports and imports?

35. 34 Self-Test In each case, identify whether the U.S. dollar is overvalued or undervalued: In each case, identify whether the U.S. dollar is overvalued or undervalued: –The fixed exchange rate is 2 dollars = 1 pound and the equilibrium exchange rate is 3 dollars = 1 pound. –The fixed exchange rate is 1.25 dollars = 1 euro and the equilibrium exchange rate is 1.10 dollars = 1 euro. –The fixed exchange rate is 1 dollars = 10 pesos and the equilibrium exchange rate is 1 dollars = 14 pesos. Under a fixed exchange rate system, why might the United States want to devalue its own currency? Under a fixed exchange rate system, why might the United States want to devalue its own currency?

36. 35 Fixed Exchange Rates Versus Flexible Exchange Rates Fixed Exchange Rates provide certainty, and that certainty of price & exchange promotes international trade. Persistent balance of trade problems could develop. Fixed Exchange Rates provide certainty, and that certainty of price & exchange promotes international trade. Persistent balance of trade problems could develop. Flexible Exchange Rates allow a country to adopt policies to meet domestic economic goals. But, flexible exchange rates can dampen international trade. Flexible Exchange Rates allow a country to adopt policies to meet domestic economic goals. But, flexible exchange rates can dampen international trade.

37. 36 Optimal Currency Areas Optimal Currency Area: a geographic area in which exchange rates can be fixed or a common currency used without sacrificing domestic economic goals.

38. 37 Optimal Currency Areas Assume : Demand for Canadian goods is falling as demand for U.S. goods are rising: Trade and Labor Mobility: if labor is mobile, then changes in relative demand pose no major economic problems for either country. Trade and Labor Mobility: if labor is mobile, then changes in relative demand pose no major economic problems for either country. Trade and Labor Immobility: The results depend on whether the Exchange Rates are fixed of flexible: Trade and Labor Immobility: The results depend on whether the Exchange Rates are fixed of flexible: –If exchange rates are flexible, the value of U.S. currency changes vis-à-vis Canadian currency. –If exchange rates are fixed, U.S. goods will not become relatively more expensive for Canadians and Canadian goods will not become relatively less expensive for Americans..

39. 38 Costs, Benefits, and Optimal Currency Areas Costs of flexible exchange rates include the cost of exchanging one currency for another and the added risk of not knowing the value of what one’s currency will be on the foreign market. Costs of flexible exchange rates include the cost of exchanging one currency for another and the added risk of not knowing the value of what one’s currency will be on the foreign market. When labor in countries within a certain geographic area is mobile enough to move easily and quickly in response to changes in relative demand, the countries are said to constitute an optimal currency area. When labor in countries within a certain geographic area is mobile enough to move easily and quickly in response to changes in relative demand, the countries are said to constitute an optimal currency area.

40. 39 The Current International Monetary System Managed Float: a managed flexible exchange rate system, under which nations now and then intervene to adjust their official reserve holdings to moderate major swings in exchange rates. Managed Float: a managed flexible exchange rate system, under which nations now and then intervene to adjust their official reserve holdings to moderate major swings in exchange rates.

41. 40 Proponents of the Managed Float System Say: It allows nations to pursue independent monetary policies. It allows nations to pursue independent monetary policies. It solves trade problems without trade restrictions. It solves trade problems without trade restrictions. It is flexible and therefore can easily adjust to shocks. It is flexible and therefore can easily adjust to shocks.

42. 41 Opponents of the Managed Float System Say: It promotes exchange rate volatility and uncertainty and results in less international trade than would be the case under fixed exchange rates. It promotes exchange rate volatility and uncertainty and results in less international trade than would be the case under fixed exchange rates. It promotes inflation. It promotes inflation. Changes in exchange rates alter trade balances in the desired direction only after a long time. In the short run, a depreciation in a currency can make the situation worse instead of better. Changes in exchange rates alter trade balances in the desired direction only after a long time. In the short run, a depreciation in a currency can make the situation worse instead of better.

43. 42 Self-Test What is an optimal currency area? Give an example. What is an optimal currency area? Give an example. Country 1 produces good X and Country 2 produces good Y. People in both countries begin to demand more of good X and less of good Y. Assume there is no labor mobility between the two countries and that a flexible exchange rate system exists. What will happen to the unemployment rate in country 2? Explain your answer. Country 1 produces good X and Country 2 produces good Y. People in both countries begin to demand more of good X and less of good Y. Assume there is no labor mobility between the two countries and that a flexible exchange rate system exists. What will happen to the unemployment rate in country 2? Explain your answer. How important is labor mobility in determining whether or not an area is an optimal currency area? How important is labor mobility in determining whether or not an area is an optimal currency area?

44. 43 The End