The Balance of Payments, Exchange Rates, and Trade Deficits Chapter 38 McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter Objectives How currencies are exchanged Balance sheet for recording international payments How exchange rates are determined Flexible vs. fixed exchange rates Causes and consequences of trade deficits 38-2

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 38-3

Balance of Payments Sum of international financial transactions Current account –Balance on goods and services –Net investment income –Net transfers –Balance on current account 38-4

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 38-5

U.S. Trade Balances Goods and Services, Select Nations, 2007 Surplus Deficit Australia Belgium Canada China Germany Mexico Netherlands Source: Bureau of Economic Analysis Japan

Flexible Exchange Rates Demand for pounds Supply of pounds Market equilibrium Increase in dollar price of pounds –Dollar depreciates –Pound appreciates Decrease in dollar price of pounds –Dollar appreciates –Pound depreciates 38-7

Q 0 Dollar Price of 1 Pound Quantity of Pounds P Flexible Exchange Rates The Market for Foreign Currency (Pounds) D1D1 S1S1 Dollar Depreciates (Pound Appreciates) Dollar Appreciates (Pound Depreciates) Exchange Rate: $2 = £1 $2 $3 $1 Q1Q1 38-8

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 38-9

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 38-10

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 38-11

Fixed Exchange Rates Government intervention –Use of reserves Trade policies Exchange controls and rationing –Distorted trade –Favoritism –Restricted choice –Black markets Macroeconomic adjustments 38-12

Exchange Rate Systems Gold standard –Fixed exchange rate system Bretton Woods –Fixed exchange rate system indirectly tied to gold Managed float 1971-present 38-13

Managed Float Dependence on foreign exchange markets Occasional intervention In support of managed float Concerns with managed float 38-14

U.S. Trade Deficit Large and persistent Causes of trade deficits –High U.S. growth (relatively) –China –Price oil –Low U.S. saving rate Implications of trade deficits –Increased current consumption –Increased indebtedness 38-15

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 38-16

Key Terms balance of payments current account balance on goods and services trade deficit trade surplus balance on current account capital and financial account balance on capital and financial balance-of-payments deficits and surpluses official reserves flexible- or floating- exchange-rate system fixed-exchange-rate system purchasing-power- parity theory currency interventions managed floating exchange rate 38-17