Ch. 18: International Finance Financing international trade Balance of payments accounts International borrowing and lending Explanations for U.S. change from lender to borrower. Exchange rate determination. Interest rate differentials

Financing International Trade Balance of Payments Accounts Records international trading, borrowing and lending. Three accounts: Current account Capital account Official settlements account + in balance of payments = inflows of currency - In balance of payments = outflows of currency Something new almost every day. This topic is one that is easily kept current. Frequent news reports about the balance of payments appear in the Wall Street Journal and on the news Web sites. And the Bureau of Economic Analysis and Commerce Department report the latest data that you can access using the links of the Economics Place. Herb Stein’s Dictum. Larry Summers, in his interview on pp. 54–56 reminds us of Herb Stein’s dictum: “the unsustainable cannot be sustained and must surely end!” Ask your students what will happen to end the unsustainable current account deficit. They will want to say, a change in the exchange rate. And that is surely part of the answer. But fundamentally, unless American’s save more relative to U.S. investment, the current account will be in deficit no matter what the exchange rate does. Understanding this fundamental fact is the first big lesson in this chapter

Financing International Trade Current account: net exports + net investment income + net transfers Capital account (financial account): Foreign investment in U.S. - U.S. investment in foreign co.’s Official settlements: – net change in U.S. official holdings of foreign currency Current + Capital + official settlements = 0 (approx.) Something new almost every day. This topic is one that is easily kept current. Frequent news reports about the balance of payments appear in the Wall Street Journal and on the news Web sites. And the Bureau of Economic Analysis and Commerce Department report the latest data that you can access using the links of the Economics Place. Herb Stein’s Dictum. Larry Summers, in his interview on pp. 54–56 reminds us of Herb Stein’s dictum: “the unsustainable cannot be sustained and must surely end!” Ask your students what will happen to end the unsustainable current account deficit. They will want to say, a change in the exchange rate. And that is surely part of the answer. But fundamentally, unless American’s save more relative to U.S. investment, the current account will be in deficit no matter what the exchange rate does. Understanding this fundamental fact is the first big lesson in this chapter

Financing International Trade The balance of payments (as a % of GDP) over the period 1983 to 2003.

Borrowers and Lenders, Debtors and Creditors A country that is borrowing more from the rest of the world than it is lending to it is a net borrower. has a current account deficit and a capital account surplus (assume official settlements acc=0) A country that is lending more to the rest of the world than it is borrowing from it is a net lender. has a current account surplus, and capital account deficit (assume official settlements=0) The U.S. is currently a net borrower (but as late as the 1970s it was a net lender.)

Borrowers and Lenders, Debtors and Creditors Debtor nation during its entire history has borrowed more from the rest of the world than it has lent to it. Creditor nation invested more in the rest of the world than other countries have invested in it over its entire history Difference between borrower/lender nation & creditor/ debtor difference between stocks and flows of financial capital.

Borrowers and Lenders, Debtors and Creditors Being a net borrower is not a problem provided the borrowed funds are used to finance capital accumulation that increases income. Being a net borrower is a problem if the borrowed funds are used to finance consumption.

Borrowers and Lenders, Debtors and Creditors Current Account Balance NX + Net int. income + Net transfers NX is largest item in current account. The other two items are much smaller and don’t fluctuate much. NX = (T – G) + (S – I ) (T-G): govt surplus/deficit. (S-I): private sector saving (surplus/deficit).

Financing International Trade Net exports for the U.S. for 2003 –$506 billion = +$42 b (priv sector surplus) - 548 b (govt sector deficit)

Borrowers and Lenders, Debtors and Creditors S-I has moved in the opposite direction of (T-G) No strong relationship between NX and the other two balances individually.

Borrowers and Lenders, Debtors and Creditors Is U.S. Borrowing for Consumption or Investment? U.S. borrowing from abroad finances investment. It is much less than private investment and almost equal to government investment in public infrastructure capital.

The Exchange Rate Foreign exchange market currency of one country is exchanged for the currency of another. Foreign exchange rate The price at which one currency exchanges for another Currency depreciation/appreciation fall/rise in the value of the currency in terms of another currency. The data. You and your students can get up to the minute exchange rate data and useful historical exchange rate data at PACIFICA (http://pacific.commerce.ubc.ca/xr/) by using the link of the Economics Place Web site. This site also has data on deviations from purchasing power parity. The strength of a nation’s currency matters, but it isn’t a sign of manhood or womanhood! A lot of silly ideas about the exchange rate find their way into the popular media. The most notable on is that the strength of a nation’s currency on the foreign exchange market is somehow a sign of the nation’s overall strength—its manhood/womanhood so to speak. Explain that the exchange rate is just a price. And it is the relative price of two currencies that ultimately depends on the price levels in two countries. A downward trend in an exchange rate means that a country is experiencing more rapid inflation that another country. That is all. The exchange rate trend tells us nothing—absolutely nothing—about productivity and real income growth in the two countries.

The Exchange Rate More recent currency trends at http://finance.yahoo.com/currency

The Exchange Rate

The Exchange Rate Demand for $ in the Foreign Exchange Market Quantity of dollars that traders plan to buy in the foreign exchange market during a given period: Depends on The exchange rate Interest rates in the U.S. and other countries Expected future exchange rate

The Exchange Rate Law of Demand for Foreign Exchange The demand for dollars is a derived demand. People in foreign countries buy $ so that they can buy U.S.-made goods and services or U.S. assets. As the exchange rate rises (f.c. per $), U.S. exports become more expensive for foreigners and the quantity of $ demanded falls.

The Exchange Rate

The Exchange Rate Changes in the Demand for Dollars Interest rates in the U.S. and in other countries Changes in the expected future exchange rate U.S. prices relative to foreign prices Changes in expected relative profitability of investments in U.S. Changes in income in foreign countries

The Exchange Rate Supply in the Foreign Exchange Market Ceteris paribus, the higher the exchange rate (f.c. per $), the greater is the quantity of dollars supplied in the foreign exchange market. As f.c. per $ increases, imports from foreign countries become cheaper to U.S., and U.S. wants to sell more $ to purchase imports.

The Exchange Rate Changes in the Supply of Dollars Shift in the supply curve. Interest rates in the U.S. and in other countries Changes in the expected future exchange rate U.S. prices relative to foreign prices Changes in expected relative profitability of investments in U.S.

The Equilibrium

The Exchange Rate Changes in the Exchange Rate Changes in demand and supply in the foreign exchange market change the exchange rate (just like they change the price in any market). interest rates. inflation rates investment opportunities expected future exchange rates

Movements in exchange rates Increase in U.S. interest rates relative to rest of world. Increase in expected investment returns relative to rest of world. Increase in U.S. inflation relative to rest of world. Expected increase in value of $ in future.

Other Exchange Rate Considerations. Purchasing power parity: A currency should buy the same amount of goods and services in every country. If PPP does not hold, there may be an opportunity for profit-making through arbitrage. Example Gold costs $300 per ounce in U.S.; 200 Euros in Europe. PPP exchange rate should be $300=200 Euros (i.e. .67 Euros per dollar). If exchange rate is 1 Euro per dollar, how can profits be made? how will this affect exchange rate? Purchasing Power Parity. You can easily get your students to test purchasing power parity. Have them check the prices of some well-known titles at amazon.com and at amazon.co.uk, get the latest exchange rate for the U.S. dollar and the U.K. pound, and see whether it is cheaper to buy a given title in the United States or the United Kingdom.

The Exchange Rate If PPP holds,  e = P in f.c./ P in $ % ch in e = inflation in f.c. – inflation in U.S. Purchasing Power Parity. You can easily get your students to test purchasing power parity. Have them check the prices of some well-known titles at amazon.com and at amazon.co.uk, get the latest exchange rate for the U.S. dollar and the U.K. pound, and see whether it is cheaper to buy a given title in the United States or the United Kingdom.

The Exchange Rate Interest rate parity The return on a currency is the interest rate on that currency plus the expected rate of appreciation over a given period. When the returns on two currencies are equal, interest rate parity prevails. Market forces achieve interest rate parity very quickly. Interest Rate Parity. Be sure that your students appreciate interest rate parity. There are many horror stories of people losing their shirts by misunderstanding interest rate parity. One story concerns the once wealthy Catholic Church of Australia that decided to borrow in Japan at a low interest rate and lend the proceeds of its borrowing in Australia at higher interest rates. When the Australian dollar nosedived against the Japanese yen, the church struggled to repay its loans. Interest rate parity always holds. Interest rates might look unequal, but the market expectation of the change in the exchange rate equals the gap between interest rates. It is a fooling person (or organization) that acts as if it can beat the market.

The Exchange Rate Return in $ = return in f.c. - % change in P of $ If a German bond pays 10% over next year and value of $ increases 10%, what’s return in $? If a German bond pays 10% over next year and value of $ decreases 10%, what’s return in $? Interest differentials across countries reflect expected movements in exchange rates. If German bonds pay 10% and U.S. bonds pay 4%, what is expected movement in exchange rate? Expected difference in inflation rate? Purchasing Power Parity. You can easily get your students to test purchasing power parity. Have them check the prices of some well-known titles at amazon.com and at amazon.co.uk, get the latest exchange rate for the U.S. dollar and the U.K. pound, and see whether it is cheaper to buy a given title in the United States or the United Kingdom.

The Exchange Rate The Fed in the Foreign Exchange Market Through its influence on the interest rate, the Fed can influence the exchange rate. The Fed can also intervene directly By buying $ in foreign exch. market (selling f.c.) Fed can increase demand for $ Strengthen $ Incur net loss of official reserves. By selling $ in foreign exch. Market (buying f.c.) Fed can increase supply of $ Weaken $ Incur net gain of official reserves.