1. The Balance of Payments, Exchange Rates, and Trade Deficits Chapter 21 Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

2. 21-2 International Transactions International trade Buy/sell current goods or services Imports and exports International asset transactions Buy/sell real or financial assets Buy stock Sell your house to a foreigner Requires currency exchange LO1

3. 21-3 Balance of Payments Sum of international financial transactions Current account Balance on goods and services Net investment income Net transfers Balance on current account LO2

4. 21-4 Balance of Payments Capital and financial account Capital account Financial account Balance of payments accounts sum to zero Current account deficits generate asset transfers to foreigners Official reserves LO2

5. 21-5 Official Reserves Foreign currencies, certain reserves with the IMF, and stocks of gold Owned by government or central bank Used as balancing mechanism in balance of payments LO2

6. 21-6 Q 0 Dollar Price of 1 Pound Quantity of Pounds P Flexible Exchange Rates The Market for Foreign Currency (Pounds) D1D1 S1S1 Dollar Appreciates (Pound Depreciates) Dollar Depreciates (Pound Appreciates) Exchange Rate: $2 = £1 $2 $3 $1 Q1Q1 LO3

7. 21-7 Flexible Exchange Rates Determinants of exchange rates Factors that shift demand/supply Changes in tastes Relative income changes Relative price-level changes Purchasing-power-parity theory Relative interest rates Relative expected returns on assets Speculation LO3

8. 21-8 Q 0 Dollar Price of 1 Pound Quantity of Pounds P Flexible Exchange Rates The Market for Foreign Currency (Pounds) D1D1 S1S1 Exchange Rate: $2 = £1 $2 $3 $1 Q1Q1 D2D2 Exchange Rate: $3 = £1 Balance Of Payments Deficit Q2Q2 x a b c LO3

9. 21-9 Flexible Exchange Rates Eliminate balance of payments deficit or surplus Disadvantages of flexible exchange rates Volatility Uncertainty and diminished trade Terms-of-trade changes Instability LO4 LO3

10. 21-10 Fixed Exchange Rates Government intervention Use of reserves Trade policies Exchange controls and rationing Distorted trade Favoritism Restricted choice Black markets Macroeconomic adjustments LO4

11. 21-11 The Managed Float Gold standard 1879-1934 Fixed exchange rate system Bretton Woods 1944-1971 Fixed exchange rate system indirectly tied to gold Managed float 1971-present LO4 LO5

12. 21-12 The Managed Float Dependence on foreign exchange markets Occasional intervention In support of managed float Concerns with managed float LO4 LO5

13. 21-13 U.S. Trade Deficit Large and persistent Causes of trade deficits High U.S. growth (relatively) China Price of oil Low U.S. saving rate Implications of trade deficits Increased current consumption Increased indebtedness LO5 LO6

14. 21-14 Speculation in Currency Markets Positive or negative influence? Contributes to currency market fluctuations Self-fulfilling expectations Smoothing short-term fluctuations Absorbing risk Futures market at work Positive role played overall LO5