Exchange Rates, The Balance of Payments, and Trade Deficits Chapter 38

Money Market Graph If the supply of money decreases interest rates increase This causes a chain reaction i↑= foreign investors buy USA bonds and assets↑= D$↑= $ appreciates= X↓, M↑= AD↓= RGDP↓, PL↓ Interest Rate M2 M1 10% 5% Dm Quantity of Money

Interest Rate’s affect on Trade foreign investors buy USA bonds and assets↑= D$↑ (demand for $) because foreigners need US$ to buy bonds $ appreciates because the exchange rate will increase X↓ (exports), M↑ (surplus of $) We will not be able to sell goods over seas because the dollar is more expensive so X decrease. Since the dollar is more expensive, we too will buy stuff from places with cheaper currencies AD↓ Because we are buying more than we are selling (Xn) RGDP↓, PL↓ (price level)

Interest Rate’s affect on Trade QUS$ SUS$ DUS$ ERe ER1 Qe Q1 DUS$1 Exchange Rate (ER) (Foreign Currency price per dollar) M2 Interest Rate M1 10% 5% Dm Quantity of Money **The increase in the interest rate causes in increase in demand for the U.S. dollar

Interest Rate’s affect on Trade QUS$ SUS$ DUS$ ERe ER1 Qe Q1 DUS$1 Exchange Rate (ER) (Dollar price per foreign currency) AS PL PLe PL1 AD AD2 Y1 Ye RGDP When the dollar appreciates it causes exports (and AD) to decrease and therefore RGDP decreases which drops PL too

Financing International Trade Best Buy wants to buy $1 million of Sony TVs Japan, who produces the TVs, wants to be paid in Yen—how does Best Buy pay them? Best Buy will have to purchase Yen from a foreign exchange market (these markets are found in larger cities or areas with large tourism populations) Once completed they can purchase the TVs using Yen

Current exchange rates are: Money that is MORE valuable than the U.S. Dollar Money that is LESS valuable than the U.S. Dollar British Pound (£)= $1.42 Euro (€)= $1.23 Swiss Franc = $1.02 Canadian Dollar (C$) = $0.79 Chinese Yuan (¥) = $0.16 Australian Dollar (AUD$) = $0.77 Mexican Peso ($) = $0.054 Japanese Yen (¥) = $0.00915 ($1 = 109.32 Yen) As of Apr 26, 2018

And the worst is… 1 Vietnamese Dong (đ) = $0.000044

Financing International Trade Let’s look at the example again… Best Buy wants to buy $1,000,000 worth of product from Japan’s Sony division How many Yen will it take to make the purchase? $1,000,000 = 1,093,200,000 Yen

Financing International Trade Business transactions are not the only reason that currencies need to be exchanged Vacations Purchasing stocks/investments Loan payments

Flexible Exchange Rates There are two types of exchange rates: Flexible (floating): demand and supply of currency determines the exchange rate (no government involvement) Fixed: government sets the exchange rate and makes changes to the economy to insure those rates stay accurate/consistent

Flexible Exchange Rates The exchange rate would be wherever the supply curve intersects the demand curve Here it would be $1.57 dollars = 1 £ When using the Flexible Exchange Rate system the price is subject to change based on the demand or supply of the product Dollar price per £ Quantity of £ $1.57 S £ D £ $4.00 $0.25 Qe

Flexible Exchange Rates Exchange Rate (ER) (Dollar price per £) Quantity of £ $1.57 S £ D £ $4.00 $0.25 Qe What could cause the supply or demand of a currency to change? Change in taste: British tea declines in popularity in the US What happens to the British Pound? U.S. dollar? It now takes less U.S. dollar to purchase a British pound Dollar appreciates, Pound depreciates $0.90 D £2 Q2

Flexible Exchange Rates Exchange Rate (ER) (Dollar price per £) Quantity of £ $1.57 S £ D £ $4.00 $0.25 Qe If ER goes down then Dollar appreciates, Pound depreciates If ER goes up Dollar depreciates, Pound appreciates $0.90 D £2 Q2

Pitfalls of Flexible Exchange Rates Uncertainty and Diminished Trade Because you don’t know what is going to happen, you might be discouraged to engage in trade Terms-of-Trade Changes An increase in the dollar price per British pound could mean that the US has to export more to get the same amount of pounds Instability Wild fluctuations can depress industries and cause a nightmare for making decisions with fiscal and monetary policy

Fixed Exchange Rates In a fixed system two countries agree on a fixed rate between them Britain and the US agree that the ration will be 2 US dollars = 1 British pound Problem: What if demand for the pound goes up? If demand goes up (meaning the pound should be more valuable) but the price doesn’t change a SHORTAGE of British pound will occur

Fixed Exchange Rates How do you adjust for this scenario? There are 4 possible solutions: Use of Reserves—if you need to meet the demand without changing the price, take some of the money that was in reserve (not in circulation) and put it in circulation Trade Policies—If the US is facing a shortage of British pound they can discourage imports from Britain (in other words, put a tariff on British goods to prevent trade)

Fixed Exchange Rates Other techniques for controlling shortages: Exchange controls and rationing—the US government could require that all pounds being brought into circulation in the US have to go through the Federal Government first. Therefore, we can control how much is allowed in the nation There are 4 issues that come with this option

Fixed Exchange Rates Four objections to exchange controls: Distorted trade—would disrupt the natural flow of trade and thus interrupt comparative advantage Favoritism—in other words, nations who support certain candidates could get “favored nation” status Restricted choice—Freedom of choice would be limited since the government is blocking access to certain goods/countries Black markets—duh…

Fixed Exchange Rates A final attempt to deal with concerns is: Domestic macroeconomic adjustments In other words use monetary and fiscal policy to adjust the inflation value of your money

Monetary Exchange Video http://www.youtube.com/watch?v=xwtgByffoUw

Balance of Payments A balance of payments is the sum of all transactions that take place between its residents and foreigners This balance sheet is divided into three categories: Current Account—U.S. trade in currently produced goods/services Capital Account—purchase/sell of assets (stocks, factories, equipment) Official Reserves Account—The nation’s stock of foreign currencies that are held in the Federal Reserve system

2010 Balance of Payments Goods and services exported = $1.837T Goods and services imported = $2.337T Balance on goods/services = - $ 500B Capital accounts transaction = -$152M Official Reserves Account US owned assets in foreign countries are the same as imports when balancing the books (a hotel in Japan owned by an American) Likewise foreign owned assets in the US are considered exports (a Canadian owning a business in the US)

2010 Balance of Payments US owned assets abroad = -$1.005T Foreign owned assets in US = $1.246T Official Reserves Balance = $241B Balance on goods/services = -$ 500B Capital accounts transaction = -$152M Official Reserves Balance = $241B Basic Balance of Payments = -$499B All BOPs have to equal $0 so how does this -$499B turn into $0 (where does the money come from)?

And now…a video http://www.learner.org/series/econusa/unit28/