International Finance

The Balance of Payments Balance of Payments: a periodic statement (usually annual) of the money value of all transaction between residents of one country and residents of all other countries.

Debit and Credit Any transaction that supplies the country’s currency in the foreign exchange market is recorded as a debit (-). Any transaction that creates a demand for the country’s currency in the foreign exchange market is recorded as a credit (+).

Current Account Current Account includes all payments related to the purchase and sale of goods and services. Includes the following: Exports of Goods and Services: includes investment income, goods, and services – increases demand for U.S. dollars and supply of foreign currency. Recorded as a credit. Imports of Goods and Services: includes goods, services, and income on foreign owned assets – increases demand for foreign currencies and supply of U.S. dollars. Recorded as a debit.

Current Account (part 2) Net Unilateral Trade Abroad: one-way money payments. Go from Americans or U.S. Government to foreigners or foreign governments. Merchandise Trade Balance: The difference between the value of merchandise exports and the value of merchandise imports. Merchandise Trade Deficit: The situation where the value of merchandise exports is less than the value of merchandise imports. Merchandise Trade Surplus: The situation where the value of merchandise exports is greater than the value of merchandise imports.

Capital Account Capital Account includes all payments related to the purchase and sale of assets and to borrowing and lending activities. Outflow of U.S. Capital: American purchases of foreign assets and U.S. loans to foreigners are outflows of U.S. Capital Inflow of Foreign Capital: Foreign purchases of U.S. assets and foreign loans to Americans are inflows of foreign capital. The Capital Account Balance is the summary statistic for these two items.

Account and Discrepancy Official Reserve Account: A government possesses official reserve balances in the form of foreign currencies, gold, its reserve position in the International Monetary Fund, and Special Drawing Rights. An increase in official reserves is like an outflow of capital in the capital account and appears as a payment with a negative sign. Statistical Discrepancy: Balance of Payment accountants do not have complete information; they can only record credits and debits they observe. They use the statistical discrepancy which is part of the balance of payments that adjusts for missing information.

Alternate Balance of Payments Equals Current account balance Capital account balance Official reserve balance Statistical discrepancy.

Q & A If an American retailer buys Japanese cars from a Japanese manufacturer, is this transaction recorded as a debit or a credit? Explain your answer. Exports of goods and services equal $200 billion and imports of goods and services equal $300 billion. What is the merchandise trade balance? What is the difference between the merchandise trade balance and the current account balance?

Flexible Exchange Rates Exchange Rate is the price of one currency in terms of another currency. Flexible Exchange Rate System: The system whereby exchange rates are determined by the forces of supply and demand for a currency.

The Demand for Goods and the Supply of Currencies

The Foreign Exchange Market

The Foreign Exchange Market Comments on the graph: The demand for pounds is downward sloping. The higher the dollar price for pounds, the fewer pounds will be demanded; the lower the dollar price for pounds, the more pounds that will be demanded. At $1.90 = £1, there is a surplus of pounds, placing downward pressure on the exchange rate. At $1.10 = £ 1, there is a shortage of pounds, placing upward pressure on the exchange rate. At the equilibrium exchange rate, $1.50 = £ 1, the quantity demanded of pounds equals the quantity supplied of pounds.

Changes in the Equilibrium Rate A change in the demand or supply of a currency (or both) will change the equilibrium dollar price for that currency. The following can change the Equilibrium Rate: A Difference in Income Growth Rates Difference in Relative Inflation Rates Changes in Real Interest Rates

The Purchasing Power Parity Theory In the long run, changes in the relative price levels of two countries will affect the exchange rate in such a way that one unit of a country’s currency will continue to buy the same amount of the foreign goods as it did before the change in relative price levels.

Fixed Exchange Rates A Fixed Exchange Rate System is the system where a nation’s currency is set at a fixed rate relative to all other currencies, and central banks intervene in the foreign exchange market to maintain the fixed rate. Overvaluation occurs when a currency’s current price, in terms of other currencies, is above the equilibrium price. Undervaluation occurs when a currency’s current price, in terms of other currencies, is below the equilibrium price.

A Fixed Exchange Rate System

A Fixed Exchange Rate System Comments on the graph: In a fixed exchange rate system, the exchange rate is fixed – and it may not be fixed at the equilibrium exchange rate. The graph shows two cases. (1) If the exchange rate is fixed at price 1, the pound is overvalued, the dollar is undervalued, and a surplus of pounds exist. (2) If the exchange rate is fixed at official price 2, the dollar is overvalued, and a shortage of pounds exist.

What’s so Bad About An Overvalued Dollar? The exchange rate affects the amount of U.S. exports and imports – this then affects the merchandise trade balance. As U.S. exports become more expensive for other countries, they buy fewer U.S. exports. If the exports fall below imports, the U.S. is in a trade deficit.

Fixed Exchange Rates and an Overvalued Dollar

Fixed Exchange Rates and an Overvalued Dollar Comments on the graph: Initially, the demand for and supply of pounds are represented by D1 and S1, respectively. The equilibrium exchange rate is $1.50 = £1, which also happens to be the official (fixed) exchange rate. In time, the demand for pounds rises to D2, and the equilibrium exchange rate rises to $2 = £1. Since the official exchange rate is fixed, the dollar will be overvalued, which could lead to a trade deficit.

Government Involvement in a Flexible Exchange System Suppose there is a surplus of pounds. The Fed might buy the pounds with dollars, causing the demand for pounds to increase and the demand curve for pounds to shift to the right. This would raise the equilibrium rate. The Bank of England might buy the pounds with its reserve dollars, increasing the demand for pounds and the equilibrium rate. Or, the Fed and the Bank of England might both buy the pounds.

Options Under a Fixed Exchange Rate System Suppose there is a surplus of pounds that has lasted several weeks. What might happen? Devaluation and Revaluation: Great Britain and the U.S. could agree to reset the official price of the pound and the dollar. Devaluation occurs when the official price of a currency is lowered. Revaluation occurs when the official price of a currency is raised.

Options Under a Fixed Exchange Rate System Suppose there is a surplus of pounds that has lasted several weeks. What might happen? Protectionist Trade Policy: A drop in the domestic consumption of foreign goods goes hand in hand with a decrease in the demand for foreign currencies. Changes in Monetary Policy: The U.S. might enact a tight monetary policy to retard inflation and drive up interest rates (in the short run). The tight monetary policy will reduce the U.S. rate of inflation and thereby lower U.S. prices relative to prices in other nations.

Fixed Exchange Rates Vs. Flexible Exchange Rates Fixed Exchange Rates provide certainty in price & exchange, which promotes international trade. On the other hand, flexible exchange rates stifle International trade. Flexible Exchange Rates allow a country to adopt policies to meet domestic economic goals, instead of sacrificing domestic economic goals to maintain an exchange rate.

Fixed Exchange Rates Vs. Flexible Exchange Rates There is also a great chance the Fixed Exchange Rate will diverge greatly with the equilibrium exchange rate, creating persistent balance of trade problems.

Optimal Currency Areas Optimal Currency Area is a geographic are in which exchange rates can be fixed or a common currency used without sacrificing domestic economic goals, such as low unemployment.

Costs, Benefits, and Optimal Currency Areas The costs include the cost of exchanging one currency for another and the added risk of not knowing the value of one’s currency will be on the foreign market. When labor in countries within a certain geographic area is mobile enough to move easily and quickly in response to changes in relative demand, the countries are said to constitute an optimal currency area.

The Current International Monetary System Referred to as a Managed Float: a managed flexible exchange rate system, under which nations now and then intervene to adjust their official reserve holdings to moderate major swings in exchange rates. Like everything else, the current system has proponents and opponents.

Proponents of the Managed Float System Say: It allows nations to pursue independent monetary policies. It solves trade problems without trade restrictions (trade imbalances are usually solved through changes in exchange rates). It is flexible and therefore can easily adjust to shocks.

Opponents of the Managed Float System Say: It promotes exchange rate volatility and uncertainty and results in less international trade than would be the case under fixed exchange rates. It promotes inflation. Changes in exchange rates alter trade balances in the desired direction only after a long time, in the short run, a depreciation in a currency can make the situation worse instead of better.