1 International Finance Chapter 33 © 2006 Thomson/South-Western

2 Balance of Payments  A country’s balance of payments summarizes all economic transactions that occur during a given period between residents (people, firms, and governments) of that country and residents of other countries  Balance of payments measures a flow, or the balance of economic transactions

3 Balance of Payments  Balance-of-payments accounts are maintained according to the principles of double-entry bookkeeping, in which entries on one side of the ledger are called credits, and entries on the other side are called debits.

4 Merchandise Trade Balance  Equals the value of merchandise exports minus the value of merchandise imports  Reflects trade in goods, or tangible products, and is often referred to as the trade balance  If the value of merchandise exports exceeds the value of merchandise imports, there is a trade surplus  If the value of merchandise imports exceeds the value of merchandise exports, there is a trade deficit

5 Exhibit 1: Relative to GDP, U.S. Imports Have Topped Exports Since 1976, and the Trade Deficit Has Widened

6 Exhibit 2: U.S. Trade Deficits in 2003 by Country or Region

7 Balance on Goods and Services  Balance on goods and services: the portion of a country’s balance-of-payments account that measures the value of a country’s exports of goods and services minus the value of its imports of goods and services (net exports)  Merchandise trade balance focuses on the flow of goods, but services (intangibles) are also traded internationally

8 Unilateral Transfers  Unilateral transfers consist of government transfers to foreign residents: foreign aid, personal gifts to individuals abroad, etc.  Net unilateral transfers equal the unilateral transfers received from abroad by U.S. residents minus unilateral transfers sent to foreign residents by U.S. residents

9 Balance on Current Account  The portion of a country’s balance-of- payments account that measures that country’s balance on goods and services plus its net unilateral transfers  Can be negative = current account deficit  Can be positive = current account surplus

10 Capital Account  The record of a country’s international transactions involving purchases or sales of financial and real assets  Between 1917 and 1982, the United States ran a deficit in the capital account  U.S. residents purchased more foreign assets than foreigners purchased assets in the U.S.  This reversed itself in 1983, and since then foreigners have purchased more U.S. assets than the other way around

11 U.S. Balance of Payments 2003 (billions of dollars)

12 U.S. Balance of Payments 2003 (billions of dollars)  All transactions requiring payments from foreigners to U.S. residents are entered as credits, indicated by a plus sign (+), because they result in an inflow of funds from foreign residents to U.S. residents.  All transactions requiring payments to foreigners from U.S. residents are entered as debits, indicated by a minus sign (  ), because they result in an outflow of funds from U.S. residents to foreign residents. As you can see, a surplus in the capital account of $579.0 billion more than offsets a current account deficit of $541.8 billion.

13 U.S. Balance of Payments  The statistical discrepancy that balances payments is a negative $37.2 billion  Statistical discrepancy: the official “fudge factor” that:  measures the error in the balance-of-payments  satisfies the double-entry bookkeeping requirement that total debits equal total credits

14 Foreign Exchange and Exchange Rates  Foreign exchange: foreign money needed to carry out international transactions  Exchange rate: the price measured in the currency of one country that is needed to purchase one unit of another country’s currency

15 The Euro and Exchange Rates  The euro is now the common currency of the euro area  The price, or exchange rate, of the euro in terms of the dollar is the number of dollars required to purchase one euro

16 Foreign Exchange  Currency depreciation: with respect to the dollar, an increase in the number of dollars needed to purchase 1 unit of foreign exchange in a flexible rate system  Currency appreciation: With respect to the dollar, a decrease in the number of dollars needed to purchase 1 unit of foreign exchange in a flexible rate system

17 Demand for Foreign Exchange  U.S. residents need euros to pay for goods and services produced in the euro area  The demand curve for euros the inverse relationship between the dollar price of the euro and the quantity of euros demanded, other things constant  Incomes and preferences of U.S. consumers  The expected inflation rates in the U.S. and the euro area  The euro price of goods in the euro area  Interest rates in the U.S. and the euro area

18 Demand for Foreign Exchange  In the aggregate, the lower the dollar price of foreign exchange, other things constant, the greater the quantity demanded  A drop in the dollar price of foreign exchange, in this case the euro, means that fewer dollars are required to purchase each euro: prices of euro goods become cheaper

19 Supply of Foreign Exchange  The supply of foreign exchange is generated by the desire of foreign residents to acquire dollars  The positive relationship between the dollar- per-euro exchange rate and the quantity of euros supplied in the foreign exchange market implies an upward-sloping supply curve  Assumed constant are:  euro area incomes and preferences  expectations about the rates of inflation in the euro area and the United States  interest rates in the euro area and the United States

20 Exhibit 4: The Foreign Exchange Market D S Foreign exchange (millions of euros) Exchange rate (dollars per euro)  Initial equilibrium exchange rate is $1.10  If the exchange rate is allowed to adjust freely, or to float in response to market forces, the market will clear continually

21 Exhibit 5: Effect on the Foreign Exchange Market of an Increased Demand for Euros D S Foreign exchange (millions of euros) 800 $  Suppose an increase in U.S. incomes causes Americans to increase their demand for all normal goods, including those from the euro area: demand curve shifts from D to D'  The shift of the demand curve leads to an increase in the exchange rate from $1.10 to $1.12 per euro  The euro appreciates and the dollar depreciates: euro area people purchase more American products Exchange rate (dollars per euro) D'

22 Arbitrageurs  Dealers who take advantage of temporary geographic differences in exchange rates by simultaneously buying a currency in one market and selling it in another  If one euro costs $0.89 in New York and $0.90 in Frankfurt, the arbitrageur would buy euros in New York and at the same time sell them in Frankfurt  Demand for euros in New York would increase  Supply of euros in Frankfurt would increase  Price differential would be eliminated

23 Speculators  Speculators buy or sell foreign exchange in hopes of profiting from fluctuations in the exchange rate over time  trading the currency at a more favorable exchange rate later  By taking risks, speculators aim to profit from market fluctuations by trying to buy low now and sell high later

24 Purchasing Power Parity  Purchasing power parity theory (PPP): predicts the exchange rate between two currencies will adjust in the long run to reflect price-level differences between the two currency regions  This is true as long as trade across borders is unrestricted and exchange rates are allowed to adjust freely  PPP is generally a long-run indicator

25 Purchasing Power Parity  A given basket of internationally traded goods should therefore sell for about the same around the world after adjusting for transportation costs and the like  Big Mac Index

26 Exhibit 6: In May 2004, the U.S. Price of a Big Mac Exceeded Prices in Most Other Countries

27 Flexible Exchange Rates  Exchange rate determined by the forces of demand and supply without government intervention

28 Fixed Exchange Rates  Fixed exchange rates: rate of exchange between currencies pegged within a narrow range and maintained by the central bank’s ongoing purchases and sales of currencies  Suppose the European Central Bank selects what it thinks is an appropriate rate of exchange between the dollar and the euro: it attempts to fix, or peg, the exchange rate within a narrow band around the particular value selected

29 Fixed Exchange Rates  If the value of the euro threatens to climb above the maximum acceptable exchange rate, monetary authorities  Sell euros and buy dollars keeping the dollar price of the euro down  If the value of the euro threatens to drop below the minimum acceptable exchange rate, monetary authorities  Sell dollars and buy euros in foreign exchange markets

30 Fixed Exchange Rates  If monetary officials must keep selling foreign exchange to maintain the pegged rate, they risk running out of foreign exchange reserves  The government has several options  The pegged exchange rate can be increased: devaluation of the domestic currency  The pegged exchange rate can be decreased: revaluation of the domestic currency  The government can attempt to reduce the domestic demand for foreign exchange directly by imposing restrictions on imports or capital flows

31 Fixed Exchange Rates  The government can adopt contractionary fiscal or monetary policies to reduce the country’s income level, increase interest rates, or reduce inflation relative to that of the country’s trading partners  Finally, the government can allow the disequilibrium to persist and ration the available foreign reserves through some form of foreign exchange control

32 Development of the International Monetary System  From 1879 to 1914, the international financial system operated under a gold standard  The gold standard provided a fixed, predictable exchange rate that did not vary as long as currencies could be redeemed for gold at the announced rate

33 Bretton Woods Agreement  Because the U.S. had a strong economy, the dollar was selected as the key reserve currency  Created the International Monetary Fund (IMF) to  Set rules for maintaining the international monetary system  Standardize financial reporting for international trade  Make loans to countries with temporary balance of payments problems  Establish a revolving fund to lend money to troubled economies

34 Demise of the Bretton Woods System  During the latter part of the 1960s, inflation in the U.S. caused the dollar to become overvalued at the official exchange rate  The gold value of the dollar exceeded the exchange value of the dollar  The result was that in August 1971, the U.S. stopped exchanging gold for dollars

35 Demise of the Bretton Woods System  The dollar was devalued with the hope that this would put the dollar on firmer footing and would save the dollar standard  With prices rising at different rates, an international monetary system based on fixed exchanged rates was doomed and the Bretton Woods system collapsed

36 Current System: Managed Float  Managed float system: combines features of a freely floating exchange rate with sporadic intervention by central banks as a way of moderating exchange rate fluctuations among the world’s major currencies  Most smaller countries still peg their currencies to one of the major currencies or to a basket of major currencies

37 Managed Float  Major criticisms of flexible exchange rates:  They are inflationary because they free monetary authorities to pursue expansionary policies  They have often been volatile, especially since the late 1970s  This volatility creates uncertainty and risks for importers and exporters and can lead to wrenching changes in the competitiveness of a country’s export sector  Policymakers’ ideal is a system that will foster international trade, lower inflation, and promote a more stable world economy