Chapter 17: International Trade Section 3: Measuring the Value of Trade pgs.526-531

Foreign Exchange If a certain good costs $100, how many euros does it cost? So nations have worked out systems that facilitate the exchange of currencies between buyers and sellers. One key element is foreign exchange market, a market in which currencies of different countries are bought and sold. This market is a network of major commercial and investment banks that link the economies of the world. Another key element in facilitating international trade is the foreign exchange rate, the price of one currency in the currencies of other nations.

Rates of Exchange-1 During the 1800s and 1900s, gold was the standard against which the value of a nation’s currency was determined. Nations traded on basis of a fixed rate of exchange, a system in which the currency of one nation is constant, in relation to other currencies—in this case gold. After the profound economic disruption of WWII, other currencies were “pegged” to the stable U.S. dollar. The price of an ounce of gold was fixed at $35.

Rates of Exchange-2 The volatile 1970s brought another change. As the U.S. ran up a trade deficit and the dollar declined in value, the standard $35 per ounce of gold was no longer sustainable, and the flexible rate of exchange, also called the floating rate, became predominant. This is a system in which the exchange rates for currencies change as the supply of the demand for the currencies change. Over time, the flexible exchange rate acts as a regulator on foreign exchange, balancing imports and exports.

Strong and Weak Currencies The Federal Reserve keeps a measure of the international value of the dollar called the trade-weighted value of the dollar. It determines if the dollar is strong or weak as measured against another currency. B/c of the flexible exchange rate, as currencies are traded, some increase or decrease in value when measured against another currency. For example, if the USD becomes stronger than the GBP, Americans would be able to buy more from Great Britain. As the value of the USD increases, imports to the U.S. become less expensive and increase, but exports from the U.S. become more expensive and decrease.

Balance of Trade Another name for the difference between the value of a country’s imports and exports is its balance of trade. It is tallied through the balance of payments, a record of all the transactions that occurred between the individuals, businesses, and government units of one nation and those of the rest of the world. The U.S. balance of payment includes the goods and services traded between it and other nations, as well as the investments foreign interests make in the U.S. and those made by Americans in a foreign country. A nation is said to have a favorable balance of trade if it has a trade surplus—that is, it exports more than it imports. If a nation imports more than it exports it has a trade deficit, also known as an unfavorable balance of trade.

Balance of Trade—Example: U.S.-China In recent years, China has undergone one of the most rapid industrializations in history. In addition to its fast-growing output of manufactured goods, the Chinese currency, the RenMinBi (RMR), or yuan, has also been weak compared to the U.S. dollar. The yuan’s weakness versus the dollar resulted from China’s decision to peg its value at a fixed rate versus the dollar, beginning in 1994. This artificially weak position helped make the U.S. the number-one destination for Chinese exports. By 2005, China had a record trade surplus of just over $200 billion with the U.S. The surplus helps China fuel its continued manufacturing growth.

Example: The U.S. Trade Balance The balance of trade in the U.S. has gone through roughly five phases. From 1770 to 1870 our nation had a deficit in goods and services but a surplus in capital investment from foreign nations, that recognized our potential for growth. Between 1870 and 1920, the nation was paying back foreign debts from the previous phase, but exporting more goods and services than it was importing. In the years 1920 and 1945, the U.S. had a surplus in exports but a deficit in foreign investments, as the nation sought to help rebuilt Europe after WWI. From 1945 to 1980, the nation had a deficit in merchandise and continued its deficit in foreign investments as large amounts of money went to post-WWII reconstruction.

Example: The U.S. Trade Balance-2 The fifth and current phase, has a large surplus of foreign investment which is attracted by a relatively low inflation rate and generally stable economy. However, high rates of consumer spending (versus low rates of saving), as well as high oil prices (which significantly increased the dollar value of U.S. imports) have helped create a very large merchandise deficit. An advantage of this deficit is that it allows U.S. consumers to buy low-priced imports. A disadvantage is that financing the deficit may require borrowing money from the rest of the world, selling off assets, or tapping into foreign currency reserves.