Principles & Policies I: Macroeconomics Chapter 18: International Financial Policy Maclachlan, Macroeconomics Fall 2004

Chapter 18 Learning Objectives. You should be able to: Describe the balance of payments and the trade balance, and relate them to the supply and demand for currencies. List four important fundamental determinants of exchange rates. Explain how a country fixes an exchange rate. Define purchasing power parity and explain its relevance to the debate about whether to have a fixed or flexible exchange rate. Differentiate fixed, flexible, and partially flexible exchange rates, and discuss the advantages and disadvantages of each. Discuss advantages and disadvantages of a common currency. Maclachlan, Macroeconomics Fall 2004

Maclachlan, Macroeconomics Fall 2004 Balance of Payments Current account (receipts from exports, payments from imports) Capital account (receipts from investments in U.S., payments from investment by Americans in foreign countries) Official transaction account (receipts from sale of U.S. $, payments from purchase of U.S. $ Maclachlan, Macroeconomics Fall 2004

Fundamental Forces Determining Exchange Rates Changes in a country’s income. Changes in country’s prices. Changes in interest rates. Changes in trade policy. Maclachlan, Macroeconomics Fall 2004

Purchasing Power Parity A method of calculating exchange rates that attempts to value currencies at rates such that each currency will buy an equal basket of goods. Creates a balance in trade. When a country has an inflation, its currency depreciates. Maclachlan, Macroeconomics Fall 2004

Fixing the exchange rate Standing ready to buy and sell the currency at a given price. Maclachlan, Macroeconomics Fall 2004

Maclachlan, Macroeconomics Fall 2004 Fixed Exchange Rates Advantages International monetary stability. Forces governments to keep inflation down. Disadvantages Imbalances create potential of a speculative attack. Governments lose freedom in conducting macroeconomic policy. Maclachlan, Macroeconomics Fall 2004

George Soros vs. Bank of England Plus $1.1 billion Minus $1.1 billion Maclachlan, Macroeconomics Fall 2004

Flexible Exchange Rates Advantages Orderly, incremental adjustments of exchange rates. Freedom in conducting macroeconomic policy. Disadvantages Speculation in currencies causes volatility. Allows governments to inflate the currency. Maclachlan, Macroeconomics Fall 2004

Maclachlan, Macroeconomics Fall 2004 Common Currency Advantages Eliminates costs of exchanging currencies. Facilitates price comparisons. Creates a larger market. Disadvantage Loss of control over monetary policy Maclachlan, Macroeconomics Fall 2004

Maclachlan, Macroeconomics Fall 2004 Euroland 12 Member States of the European Union are participating in the single currency: Belgium Germany Greece Spain France Ireland Italy Luxembourg The Netherlands Austria Portugal Finland Maclachlan, Macroeconomics Fall 2004