Chapter 15 International and Balance of Payments Issues

Exchange Rates High exchange rates make exports expensive and imports cheaper and result in larger trade deficit Exchange rate (R) is defined  No. of units of foreign currency per one unit of domestic currency  1/r shows number of dollars per unit of foreign currency

Exchange Rates Currency Appreciation – when R goes up, domestic currency appreciates When $ appreciates against Euro, it implies that $ will buy more Euros Similarly, currency depreciation implies that $ will buy less Euros Real Exchange Rate is defined as  Nominal Exchange Rate X domestic price level foreign price level R e = Rx P d P f

Importance of Exchange Rates For the managers, exchange rates influence prices of firm’s inputs as well as outputs. Firms also hedge against currency risk. Details of currency risk exposure are included in the annual reports of the firms

Balance of Trade Balance of trade is the relation between exports and imports  If exports > Imports  Trade Surplus  If exports < Imports  Trade Deficit Appreciation of $ makes trade balance more negative as exports and imports

Determinants of Exports and Imports Imports = f [level of income, R] (+) (+) Exports = f [Y d, Y f, R] (+) (+) (-) Y d = domestic level of income Y f = foreign level of income

Capital Flows Capital Outflows: occur when a country has a trade surplus and its citizens purchase real and financial assets from abroad Capital Inflows occur when a country has a trade deficit and its citizens sell real and financial assets abroad Net capital flow = capital inflows – capital outflow  Net capital flow matches trade balance (x-m) in an accounting sense

Balance of Payments Accounting Balance of Payments records all transactions between residents of the country and the rest of the world It consists of Current Account and Capital Account (refer to Table 15.4 pg 460) Current Account includes Exports (+) and Imports (-), Receipts on U.S. assets abroad (+), Payments on foreign assets in the US(-)

Unilateral Transfers Unilateral Transfers include flow of goods and services and financial assets in which nothing of significant economic value is received in return  Examples: foreign aid, military transfers, pensions, gifts

Capital Account Capital Account includes  Change in U.S. holdings of foreign assets – capital outflow  Change in foreign holdings of U.S. assets statistical discrepancy – capital inflow  The difference represents Net Capital Flow

Foreign Exchange Market Demand for $ =  f [R, Y f Relative interest rates] (-) (+) Supply of $ =  f [R, YD, Relative interest rates] (+) (+) If interest rate in the US increases relative to foreign interest rate, there are higher capital inflows to the U.S. D for $ and S for $ increase E D S Q* Q d, Q s R* R 0

Exchange Rate Systems Flexible Exchange Rate System – exchange rates are determined by the forces of D and S. There is no intervention by the Central Bank Fixed Exchange Rate System – a system where central banks intervene to maintain or stabilize exchange rates at a fixed value Managed Float – A system where central banks intervene in the foreign exchange markets to maintain or stability of exchange rates within a range

Policy Analysis US Economy ( )  US Income  D for imports  S of $  R  Interest rate  Capital Inflows  D for $  R This was a period of ‘strong dollar’ (Try using IS-LM Curves!)

Euro Market After its introduction in 1999, value of Euro declined  Higher interest rates in the US led to capital inflows in the US S of Euros Value of Euros  Relatively faster growth in the US income led to increase in the European investment. This led to an increase in the capital inflows in the US

Euro Market European Central Bank intervened to increase the value of Euro.  Why? What are th consequences of “weak euro”?  How does it affect US companies?  In 2002, Euro appreciated and dollar depreciated. How would you analyze these trends?

Asian Financial Crisis 1997 Initially, Thailand and South Korea experienced a decline in their exchange rates The crisis spread to other economies such as Malaysia, Indonesia, Hong Kong, and Philippines, IMF provided ‘rescue packages’ and recommended ‘macro economic policy packages’

Chinese Yuan China maintains an undervalued currency to increase imports and lower imports China is under US pressure to revalue its currency Recently, Yuan was revalued slightly and was tied to a basket of currencies instead of dollar The ‘slight’ revaluation is not enough High trade deficit with China and high investment in China are the causes of concern