Chapter 38 The Balance of Payments, Exchange Rates, and Trade Deficits 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 - interest Net transfers Balance on current account 38-4

Balance of Payments Capital and financial account Capital account – Debt forgiveness Financial account - Assets Balance of payments accounts sum to zero Current account deficits generate asset transfers to foreigners Official reserves 38-6

1945 - 2009

U.S. Trade Balances Goods and Services, Select Nations, 2007 Australia Deficit Surplus Australia +10.0 Belgium +9.8 Canada -67.0 China -256.6 Germany -45.3 Japan -85.0 Mexico -77.3 Netherlands +14.3 -10 -20 -30 -40 -50 -60 -70 -250 10 20 Source: Bureau of Economic Analysis 38-9

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 38-10

Flexible Exchange Rates The Market for Foreign Currency (Pounds) Q Dollar Price of 1 Pound Quantity of Pounds P S1 Exchange Rate: $2 = £1 $2 $3 $1 Dollar Depreciates (Pound Appreciates) Dollar Appreciates (Pound Depreciates) D1 Q1 38-11

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 38-12

Change in Tastes Vs.

Change in Relative Income

Change in Relative Price Level

Change in Relative Interest Rates Change in Relative Expected Returns on Investment

Currency Speculation Self-fulfilling prophecy

Flexible Exchange Rates The Market for Foreign Currency (Pounds) Q Dollar Price of 1 Pound Quantity of Pounds P S1 Exchange Rate: $3 = £1 c $2 $3 $1 Balance Of Payments Deficit a x b D2 Exchange Rate: $2 = £1 D1 Q1 Q2 38-18

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 Depreciation of dollar = more exports = higher prices (inflation) Appreciation of dollar = more imports/less exports = more unemployment 38-19

Fixed Exchange Rates Government intervention Alter Supply/Demand Use of reserves (show on graph) Selling pounds = transfer of assets Trade policies – tariffs, subsidies Exchange controls and rationing Distorted trade lessens advantages Favoritism to certain importers Restricted choice for consumers Black markets – LEVIS! 38-20

Macroeconomic Adjustments Monetary/Fiscal Policy Trade deficit with Britain Reduce demand for British Pounds by undertaking contractionary policy, reducing American incomes and thus imports of British goods The cost? Recession.

Exchange Rate Systems Gold standard 1879-1934 Bretton Woods 1944-1971 Fixed exchange rate system Bretton Woods 1944-1971 Fixed exchange rate system indirectly tied to gold International Monetary Fund Managed float 1971-present 38-22

Managed Float In support of managed float Dependence on foreign exchange markets Occasional intervention (IMF) Tsunami In support of managed float Track Record Concerns with managed float Volatility Manipulation 38-23

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 38-24

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 38-25

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 38-26