© OnlineTexts.com p. 1 Chapter 7 Foreign Exchange and the Balance of Payments Foreign Exchange and the Balance of Payments

© OnlineTexts.com p. 2 Foreign Exchange Foreign exchange is currency and bank deposits that are denominated in foreign money. –Consumers indirectly deal in the foreign exchange market every time they purchase an import. –A purchase by a person in the U.S. of a German automobile ultimately means that dollars are converted into euros to pay for the car. Foreign exchange is currency and bank deposits that are denominated in foreign money. –Consumers indirectly deal in the foreign exchange market every time they purchase an import. –A purchase by a person in the U.S. of a German automobile ultimately means that dollars are converted into euros to pay for the car.

© OnlineTexts.com p. 3 Exchange Rate The exchange rate (e) is the amount of domestic currency that it takes to purchase one unit of foreign currency. –We will view everything from the U.S. perspective. –Example: if US$1 purchases 5 pesos, then it takes US$0.20 to purchase 1 peso, so the exchange rate is 0.2 or 1/5. –Alternatively, if US$1 purchases 0.50 pounds, then it takes US$2 to purchase one pound so the exchange rate is 2.0. The exchange rate (e) is the amount of domestic currency that it takes to purchase one unit of foreign currency. –We will view everything from the U.S. perspective. –Example: if US$1 purchases 5 pesos, then it takes US$0.20 to purchase 1 peso, so the exchange rate is 0.2 or 1/5. –Alternatively, if US$1 purchases 0.50 pounds, then it takes US$2 to purchase one pound so the exchange rate is 2.0.

© OnlineTexts.com p. 4 Exchange Rate Tables Exchange rates are often quoted two ways. The definition this book uses is “U.S. $ Equivalent.” Exchange rates are often quoted two ways. The definition this book uses is “U.S. $ Equivalent.” TABLE 1 Exchange Rates CountryCurrency U.S.$ Equivalent Currency per U.S. $ BrazilReal BritainPound CanadaDollar E.M.U.Euro IndiaRupee JapanYen MexicoPeso TaiwanDollar Note: Many exchange listings use the Currency per U.S. $ method except when quoting the British pound. The British pound is almost always quoted as the U.S. $ Equivalent.

© OnlineTexts.com p. 5 Changes in exchange rates Currencies are traded continuously much like stocks so that their relative prices (exchange rates) fluctuate minute by minute. –Suppose 1 U.S. dollar = 1 Argentine peso, e = 1.0. –The U.S. dollar then appreciates--becomes stronger--relative to the peso so that one U.S. dollar purchases 1.25 pesos, or 1 peso costs US$0.80. The exchange rate declines from 1.0 to –An appreciation of the domestic currency corresponds with a decrease in the exchange rate. Currencies are traded continuously much like stocks so that their relative prices (exchange rates) fluctuate minute by minute. –Suppose 1 U.S. dollar = 1 Argentine peso, e = 1.0. –The U.S. dollar then appreciates--becomes stronger--relative to the peso so that one U.S. dollar purchases 1.25 pesos, or 1 peso costs US$0.80. The exchange rate declines from 1.0 to –An appreciation of the domestic currency corresponds with a decrease in the exchange rate.

© OnlineTexts.com p. 6 Changes in exchange rates The converse is also true. –Suppose 1 U.S. dollar = 1 Argentine peso, e = 1.0. –The U.S. dollar then depreciates--becomes weaker- -relative to the peso so that $1.25 purchases one peso. The exchange rate rises from 1.0 to –A depreciation of the domestic currency corresponds with an increase in the exchange rate. The converse is also true. –Suppose 1 U.S. dollar = 1 Argentine peso, e = 1.0. –The U.S. dollar then depreciates--becomes weaker- -relative to the peso so that $1.25 purchases one peso. The exchange rate rises from 1.0 to –A depreciation of the domestic currency corresponds with an increase in the exchange rate.

© OnlineTexts.com p. 7 Historical U.S. Exchange Rates U.S. exchange rates have fluctuated widely over time.

© OnlineTexts.com p. 8 Determination of the Exchange Rate The forces of supply and demand interact to determine the exchange rate. Currency is supplied and demanded, and the equilibrium price of the currency is the exchange rate. The forces of supply and demand interact to determine the exchange rate. Currency is supplied and demanded, and the equilibrium price of the currency is the exchange rate.

© OnlineTexts.com p. 9 Demand for Foreign Exchange Demand for foreign exchange is domestic demand for foreign currency. The demand curve for foreign exchange is negatively sloped; as the exchange rate rises, quantity demanded of foreign exchange falls. Demand for foreign exchange is domestic demand for foreign currency. The demand curve for foreign exchange is negatively sloped; as the exchange rate rises, quantity demanded of foreign exchange falls.

© OnlineTexts.com p. 10 Supply of Foreign Exchange The U.S. supplies foreign exchange when it makes the U.S. dollar available for purchase by a foreign entity. The supply curve for foreign exchange is positively sloped; as the exchange rate rises supply of foreign exchange also rises. The U.S. supplies foreign exchange when it makes the U.S. dollar available for purchase by a foreign entity. The supply curve for foreign exchange is positively sloped; as the exchange rate rises supply of foreign exchange also rises.

© OnlineTexts.com p. 11 The Equilibrium Exchange Rate The forces of supply and demand interact to determine the exchange rate.

© OnlineTexts.com p. 12 Exports, Imports and Trade Deficits International trade has surged in recent years. –In 2005 the United States exported US$1.3 trillion in goods and services. –In 2005 the United States imported US$2.0 trillion in goods and services. –The excess of imports over exports is referred to as the trade deficit or the (negative) balance on goods and services. –In 2005 the trade deficit was U.S.$717 billion. International trade has surged in recent years. –In 2005 the United States exported US$1.3 trillion in goods and services. –In 2005 the United States imported US$2.0 trillion in goods and services. –The excess of imports over exports is referred to as the trade deficit or the (negative) balance on goods and services. –In 2005 the trade deficit was U.S.$717 billion.

© OnlineTexts.com p. 13 Recent U.S. Trade Deficits The U.S. has run persistent and growing trade deficits since the 1980s. TABLE 2 U.S. Trade Deficits Year Trade Deficit (US$ Billions)

© OnlineTexts.com p. 14 How are Trade Deficits Financed? Trade deficits suggest that the demand for foreign exchange exceeds the supply of foreign exchange. Thought question: –If the U.S. demands US$1.5 trillion in foreign exchange to purchase imports but it supplies just US$1.0 trillion to provide exports, does that not imply that the market is in disequilibrium? Trade deficits suggest that the demand for foreign exchange exceeds the supply of foreign exchange. Thought question: –If the U.S. demands US$1.5 trillion in foreign exchange to purchase imports but it supplies just US$1.0 trillion to provide exports, does that not imply that the market is in disequilibrium?

© OnlineTexts.com p. 15 International Capital Flows Besides imports, another source of demand for foreign currency comes from investing in foreign assets. A capital outflow is the purchase of a foreign asset by a domestic entity. –If Coca-Cola Inc. builds a production plant in Singapore, the U.S. experiences a capital outflow when U.S. dollars are converted to the Singapore currency. Besides imports, another source of demand for foreign currency comes from investing in foreign assets. A capital outflow is the purchase of a foreign asset by a domestic entity. –If Coca-Cola Inc. builds a production plant in Singapore, the U.S. experiences a capital outflow when U.S. dollars are converted to the Singapore currency.

© OnlineTexts.com p. 16 Capital Outflows and the Exchange Rate An increase in capital outflows increases the demand for foreign exchange, or shifts the demand for foreign exchange to the right, increasing both the exchange rate and the quantity of foreign exchange traded.

© OnlineTexts.com p. 17 Capital Inflows Supply of foreign exchange is also affected by international capital flows. When foreigners decide to invest in U.S. assets, the U.S. economy receives a capital inflow. –purchase of a U.S. stock or bond by a Mexican citizen. –a Japanese firm purchases builds an auto plant in the U.S. Supply of foreign exchange is also affected by international capital flows. When foreigners decide to invest in U.S. assets, the U.S. economy receives a capital inflow. –purchase of a U.S. stock or bond by a Mexican citizen. –a Japanese firm purchases builds an auto plant in the U.S.

© OnlineTexts.com p. 18 Capital Inflows and the Exchange Rate An increase in capital inflows increases the supply of foreign exchange and shifts the supply curve for foreign exchange to the right, decreasing the exchange rate and increasing the quantity of foreign exchange traded.

© OnlineTexts.com p. 19 The Paradox Resolved We can now explain the paradox of persistent trade deficits. –If foreigners are willing to invest more funds each year in U.S. assets than U.S. citizens are willing to invest in foreign assets, then the U.S. can run a persistent trade deficit year after year. –The difference is made up in international capital flows. Ultimately, the supply and demand for foreign exchange are equal. We can now explain the paradox of persistent trade deficits. –If foreigners are willing to invest more funds each year in U.S. assets than U.S. citizens are willing to invest in foreign assets, then the U.S. can run a persistent trade deficit year after year. –The difference is made up in international capital flows. Ultimately, the supply and demand for foreign exchange are equal.

© OnlineTexts.com p. 20 The Balance of Payments The Balance of Payments is a record of a country's trade in goods, services, and financial assets with the rest of the world. Debits are items that represent demand for foreign exchange. Credits are items that represent supply of foreign exchange. The Balance of Payments is a record of a country's trade in goods, services, and financial assets with the rest of the world. Debits are items that represent demand for foreign exchange. Credits are items that represent supply of foreign exchange.

© OnlineTexts.com p. 21 The Balance of Payments The Balance of Payments is composed of two major accounts: –The current account primarily tracks the international flow of goods and services. Exports and imports dominate the current account. – The capital account primarily tracks the international flow of financial assets. Capital inflows are credits while capital outflows are debits. The Balance of Payments is composed of two major accounts: –The current account primarily tracks the international flow of goods and services. Exports and imports dominate the current account. – The capital account primarily tracks the international flow of financial assets. Capital inflows are credits while capital outflows are debits.

© OnlineTexts.com p. 22 The Balance of Payments Because the current and capital accounts must sum to zero in theory, but rarely do in practice, the statistical discrepancy account corrects for errors and omissions in the accounts to ensure that the balance of payments sums to zero, or Current Account + Capital Account = 0 Because the current and capital accounts must sum to zero in theory, but rarely do in practice, the statistical discrepancy account corrects for errors and omissions in the accounts to ensure that the balance of payments sums to zero, or Current Account + Capital Account = 0

© OnlineTexts.com p. 23 The Balance of Payments