International Finance zInternational Finance -- measures of international transactions, and determination of exchange rates in the US.

Measures of International Finance zRecord of all transactions between Americans and residents of other countries over a flow interval. zCurrent Account zCapital Account zOfficial Settlements Balance

The Current Account zCurrent Account = {Exports + Foreign Transfers to US + Income earned from American holdings of investments abroad} -- {Imports + US Transfers to Foreigners + Income earned from foreign investments in US}

The Current Account: Interpretation zItems in the first set of { } -- current account inflows, ways that dollars enter into the US from international current account transactions. zItems in the second set of { } -- current account outflows, ways that dollars leave the US from international current account transactions.

The Current Account: Characteristics zComprehensive measure of the Balance of Trade (NX is an approximation). zNet income generated to Americans as a result of international transactions.

The Capital Account zCapital Account = {New Foreign Purchases of US Assets} - {New US Purchases of Foreign Assets} zCapital Account = {Capital Inflows} - {Capital Outflows}

The Official Settlements Balance zOfficial Settlements Balance = Current Account + Capital Account zRepresents “net total dollar inflows” after all international transactions have been completed during a flow period. zRecorded as change in official reserve assets at the International Monetary Fund (IMF)

The Recent US Record -- International Transactions zCurrent Account < 0 zCapital Account > 0 zOfficial Settlements Balance  0 zExample (Billions of $) -- Current Account = -$ Capital Account = $ Settlements Balance = -$36

A Quick review About Exchange Rates zExchange Rate (e) -- the amount of foreign currency needed to be exchanged for one (US) dollar. zAlso known as the “value of the dollar”. zConversion Ratio, in units of (foreign currency)/(US dollar)

Exchange Rate Changes e   price of American goods and services to foreigners   price of foreign goods and services to Americans  e   price of American goods and services to foreigners   price of foreign goods and services to Americans 

Exchange Rate Regimes zFixed (Pegged) Exchange Rates -- exchange rates are fixed by the government, unless changed by economic policy. zFloating Exchange Rates -- exchanged rates determined by natural forces in the foreign exchange market.

The Foreign Exchange Market & the Exchange Rate zThe Foreign Exchange Market -- the demand and supply for dollars for use in international transactions.

Concepts to Understand Foreign Exchange Behavior zItems (goods, services, financial assets) are priced in a country’s home currency. zIf one wishes to buy from another country, he/she must convert from their own currency to the currency of the country selling the item.

More Important Foreign Exchange Concepts zThe exchange rate (e) specifies the ratio of conversion. zThe same exchange rate holds for all transactions – purchases or sales of goods, services and financial assets.

The Demand for Dollars zThe Demand for Dollars -- foreigners demand for US dollars, to buy American goods, services, or financial assets. zInversely related to the exchange rate (e), with other causes (shift variables) as well.

The Supply of Dollars zThe Supply of Dollars -- Americans supplying dollars to the foreign exchange market, in order to buy foreign goods, services, or financial assets. zPositively related to the exchange rate (e), with other causes (shift variables) as well.

Foreign Exchange Market Equilibrium zEquilibrium exchange rate (foreign currency)/(US$) -- “price of dollars.” zAt equilibrium, total dollar inflows equal total dollar outflows. zTherefore, at equilibrium, the Official Settlements Balance = 0 automatically without any need for policy.

Major Causes of Exchange Rate Movements zUS Interest Rates (r*) zInterest Rates of Other Nations (r W ) zSpeculation -- Expectations of future exchange rate changes.

US Interest Rates and Exchange Rate Movements zSuppose r* . zThis causes substitution away from foreign assets into US assets. zThe demand for dollars increases (D $ curve shifts rightward) and the supply of dollars decreases (S $ curve shifts leftward). zAs a result e* .

Foreign Interest Rates and Exchange Rate Movements zSuppose r W . zThis causes substitution away from US assets into foreign assets. zThe demand for dollars decreases (D $ curve shifts leftward) and the supply of dollars increases (S $ curve shifts rightward). zAs a result e* .

Speculation and Exchange Rate Movements zConstantly fluctuating exchange rate creates opportunities to make capital gains from timed purchases or sales of currency. zIncentive to buy dollars when exchange rate is low, then sell dollars when exchange rate rises. zCreates “speculative bubble” behavior -- like stock market.

Floating Exchange Rates zAdvantages -- No loss of official reserves at the IMF, market equilibrium  current account + capital account = Federal Reserve does not need to participate in foreign exchange market, can focus solely on domestic policy.

Floating Exchange Rates (Continued) zDisadvantages -- Fluctuating exchange rate is disruptive to International Trade. -- Exchange rates can fluctuate a great deal, especially due to speculation (speculative bubbles).

Fixed Exchange Rates zAdvantages -- exchange rate is constant, stability in International Trade.

Fixed Exchange Rates (Continued) zDisadvantages -- Federal Reserve must intervene constantly in the foreign exchange market  money supply decreases or loss of official reserves. -- Fed might be forced into contractionary monetary policy to raise US interest rates and increase e* to the target fixed rate.

Exchange Rate Regimes -- Overall zIdeal system: floating exchange rates which do not exhibit much movement. zActual system (US): Managed Float -- floating exchange rates with occasional Federal Reserve intervention, to stop large movement in e*.