Unit 10 - Foreign Exchange Rates and Payment Balances Macroeconomics

Unit 10 - Foreign Exchange Rates and Payment Balances u Foreign Exchange Rates When countries trade, they exchange products for currencies. In a free market, the value of the currencies is determined by the demand and supply of the currencies. Macroeconomics

Unit 10 - Foreign Exchange Rates and Payment Balances u Exchange Rate Systems When currency values are allowed to fluctuate, we speak of a flexible rate system. When currency values are not allowed to fluctuate for a period of time, we speak of a fixed exchange rate system. Macroeconomics

Unit 10 - Foreign Exchange Rates and Payment Balances u Devaluation and Revaluation In a fixed exchange rate system, when the currency values change after a period of time, we speak of devaluation if there is a decrease in the currency’s value, and revaluation if there is an increase in the currency’s value. Macroeconomics

Unit 10 - Foreign Exchange Rates and Payment Balances u Devaluation and Revaluation Example 1 US Dollar = 3.64 Qatari Riyal After governments agree to a new “fixed” level: 1 US Dollar = 3.50 Qatari Riyal (hypothetical example) Macroeconomics Has the dollar revaluated or devaluated relative to the Qatari Riyal?

Unit 10 - Foreign Exchange Rates and Payment Balances u Devaluation and Revaluation If the dollar devaluates, it becomes cheaper for Qatar to buy U.S. products. US exports become cheaper, and Qatari exports to the U.S. become more expensive. Macroeconomics

Unit 10 - Foreign Exchange Rates and Payment Balances u Depreciation and Appreciation In a flexible exchange rate system, when the currency values change after a period of time, we speak of depreciation if there is a decrease in the currency’s value, and appreciation if there is an increase in the currency’s value. Macroeconomics

Unit 10 - Foreign Exchange Rates and Payment Balances u Depreciation and Appreciation Example $1 = 9.5 South African Rand After currency change: $1 = 10 South African Rand Has the dollar depreciated or appreciated? Macroeconomics

Unit 10 - Foreign Exchange Rates and Payment Balances u Depreciation and Appreciation If the dollar appreciates, it becomes more expensive for South Africa to purchase dollars. So if South Africa buys a U.S. car, it will have to pay more for the car (ceteris paribus). U.S. products become more expensive for South Africa. U.S. exports to South Africa become more expensive if the dollar appreciates. Macroeconomics

Unit 10 - Foreign Exchange Rates and Payment Balances u Flexible Exchange Rate Systems An advantage of a fixed exchange rate system between two currencies is that the exchange rates are constant for a period of time. Therefore, it creates more certainty in international trading. Macroeconomics

Unit 10 - Foreign Exchange Rates and Payment Balances u Variable Exchange Rate Systems Advantages of a variable exchange rate system are:  the currency always has its true (market) value.  no surpluses or shortages of a currency.  no government (central bank) interference necessary (and no central bank losses).  Modern day futures markets can fix the exchange rate via futures contracts. Macroeconomics

Unit 10 - Foreign Exchange Rates and Payment Balances u Balance of Payments The Balance of Payment (BOP) is an accounting record of a country’s inflows and outflows of money exchanged in international trade. Macroeconomics

Unit 10 - Foreign Exchange Rates and Payment Balances u Balance of Payments The BOP consists of two main accounts: 1.The current account 2.The capital account Macroeconomics

Unit 10 - Foreign Exchange Rates and Payment Balances u Balance of Payments The current account includes transactions related to international: 1.merchandise trade (cars, computers, food) 2.services trade (insurance, tourism, consulting) 3.investment income (earnings from stocks, bonds) 4.transfer payments (gifts, pensions) Macroeconomics

Unit 10 - Foreign Exchange Rates and Payment Balances u Balance of Payments The capital account includes transactions related to international: 5.purchases of financial assets (stocks, bonds) 6.purchases of real assets (land, buildings, businesses) 7.purchases of foreign currency (by banks or speculators) Macroeconomics

Unit 10 - Foreign Exchange Rates and Payment Balances u Balance of Payments By definition: the balance on the current account + the balance on the capital account + statistical discrepancy = 0. Macroeconomics

Unit 10 - Foreign Exchange Rates and Payment Balances u Balance of Payments For BOP statistics, visit: Macroeconomics

Unit 10 - Foreign Exchange Rates and Payment Balances u BOP Issues Controversial BOP issues include: 1.Is a trade deficit bad for the economy? 2.Should countries protect their domestic industries (through trade restrictions) to improve their balance of payments? 3.Should countries discourage domestic investments by foreigners? Macroeconomics

Unit 10 - Foreign Exchange Rates and Payment Balances u BOP Issues Is a trade deficit bad for the economy? Is a trade deficit bad for the economy?  A trade deficit can be a sign of strength. The more purchasing power a country has, the more it will import.  Imports adds to a country’s wealth.  Imports help foreign countries; this will eventually benefit the importing country. Macroeconomics

Unit 10 - Foreign Exchange Rates and Payment Balances u BOP Issues Should countries protect their domestic industries (through trade restrictions) to improve their balance of payments?  If a country protects its industries, other countries will protect theirs (retaliation).  Protectionism results in less specialization, less competition, less efficiency, lower production, and a lower standard of living. Macroeconomics

Unit 10 - Foreign Exchange Rates and Payment Balances u BOP Issues Should countries discourage domestic investments by foreigners?  Investments by foreign companies in our country results in more capital and more employment in our country.  It is a sign of a strong economy that other countries want to invest in our country.  Foreign investors invest for economic, not political reasons.  Economic interdependency strengthens, not weakens, political ties. Macroeconomics