Sally Meek Revised by Lori Leachman

VII. Open Economy: International Trade and Finance  Balance of Payments Accounts  Foreign Exchange Market  Net Exports and capital flows  Links to financial and goods markets

(Handout page 1)  The exchange rate is the price of one country’s money in terms of another- there are 2 ways to report:  E= foreign price of a dollar= #FC units/$1  e=dollar price of foreign currency=$1/#FC units  Focus on money coming in as a credit (sell) and money going out as a debit (buy) – or alternatively one person’s buy is another person’s sell  2 major accounts: Current account and financial account

 (Handout page 2) BP = Current Account (CA) + Financial Account(FA) = 0 If BP≠0, then there is an official change in foreign currency reserves (this role of official reserves is critical in fixed exchange rate systems) so really BP= CA + FA + ∆ off reserves = 0  Current account deficits must be offset by financial account surpluses (increasing capital inflows)  (CA‹0)=( FA›0) so BP=0  Current account surpluses must be offset by financial account deficits (increasing capital outflows)  (CA›0) = (FA‹0) so BP=0

(Handout page 2)  All transactions impact foreign currency markets of the participants – because to buy or sell foreign goods or asset you must exchange currency  Financial account transactions impact the loanable funds market of the participants:  Capital inflows will increase the supply of loanable funds (as foreigners buy bonds)  Capital outflows will decrease the supply of loanable funds( as foreigners and domestic investors sell bonds)

 Department of Commerce  – International Transactions  Examples of current articles (relatively)  Bloomberg - March 19, 2009  WSJ – September 11, 2008  WSJ- Feb. 16, 2010

 Balance of Payments – An Activity  (Handout pages 3 – 10)  2 groups (countries)  Classifying transactions as current account or financial/capital account  Classifying transactions as inflows of money or outflows of money  Creating forex models to illustrate transactions impact on currency value  Creating loanable funds markets to illustrate impact on real interest rates from financial/capital account transactions

1. increase D$=increase SFC; E rises or e falls Practice Questions: (page 11) Euros /$ =E Q USD S$ D$ S Euros D Euros $/ Euro =e Q Euros D1 S1 USD appreciates and the Euro depreciates

2. Increase S$ = increase DSGD; E falls or e rises Practice Questions: (page 11) SGD/$ =E Q USD S$ D$ S SGD D SGD $/ SGD =e Q SGD D1 S1 USD depreciates and the SGD appreciates

3. Practice Questions: (page 11) Peso /$ Q USD S$ D$ S Peso D Peso $/ Peso Q Peso D1 S1 USD depreciates and the Peso appreciates

4. Practice Questions: (page 11) Yen /$ Q USD S$ D$ S Yen D Yen $/ Yen Q Yen D1 S1 USD appreciates and the Yen depreciates

5. Practice Questions: (page 11) Real Interest rate Q Loanable Funds S LF D LF S1 Capital flows into the US (increased demand for dollars), increasing the supply of loanable funds and decreasing the real interest rate. The US dollar would appreciate as more dollars are demanded in order to purchase US government bonds.

6. Practice Questions: (page 11) Real Interest rate Zambia’s Loanable Funds Market Q S LF D LF S1 Capital flows out of Zambia, decreasing the supply of loanable funds and increasing the real interest rate. Zambia’s currency would depreciate as the currency is used to purchase other currencies.