CHAPTER 20 International Finance Chapter 37 in Economics Michael Parkin ECONOMICS 5e

Slide 20-2 Copyright © 2000 Addison Wesley Longman, Inc. Learning Objectives Explain how international trade is financed Describe a country’s balance of payments accounts Explain what determines the amount of international borrowing and lending

Slide 20-3 Copyright © 2000 Addison Wesley Longman, Inc. Learning Objectives (cont.) Explain why the United States changed from being a lender to being a borrower in the mid-1980s Explain how the foreign exchange value of the dollar is determined Explain why the foreign exchange value of the dollar fluctuates

Slide 20-4 Copyright © 2000 Addison Wesley Longman, Inc. Learning Objectives Explain how international trade is financed Describe a country’s balance of payments accounts Explain what determines the amount of international borrowing and lending We will address all three objectives simultaneously.

Slide 20-5 Copyright © 2000 Addison Wesley Longman, Inc. Financing International Trade Balance of Payments Accounts Balance of payments accounts record a country’s international trading, borrowing, and lending.

Slide 20-6 Copyright © 2000 Addison Wesley Longman, Inc. Financing International Trade The balance of payments accounts include: 1) Current account Records payments for imports of goods and service from abroad, receipts from exports of goods and services sold abroad, net interest paid abroad, and net transfers (e.g. foreign aid). Current account balance equals exports minus imports, net interest, and net transfers.

Slide 20-7 Copyright © 2000 Addison Wesley Longman, Inc. Financing International Trade The balance of payments accounts include: 2) Capital account Records foreign investment in the United States minus U.S. investment abroad.

Slide 20-8 Copyright © 2000 Addison Wesley Longman, Inc. Financing International Trade The balance of payments accounts include: 3) Official settlements account Records the change in official U.S. reserves. Official U.S reserves are the government’s holdings of foreign currency. If official reserves increase, the official settlements accounts balance is negative.

Slide 20-9 Copyright © 2000 Addison Wesley Longman, Inc. U.S. Balance of Payments Accounts in 1996 Current account Import of goods and services-940 Exports of goods and services+830 Net interest income–10 Net transfers –40 Current account balance –160 Capital account Foreign investment in the United States+430 U.S. investment abroad-240 Statistical discrepancy –40 Capital account balance+150 Official settlements account Decrease in official U.S. reserves-10

Slide Copyright © 2000 Addison Wesley Longman, Inc. The Balance of Payments:

Slide Copyright © 2000 Addison Wesley Longman, Inc. Financing International Trade Borrowers and Lenders, Debtors and Creditors A net borrower is a country that is borrowing more from the rest of the world than it is lending. A net lender is a country that is lending more than it is borrowing.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Financing International Trade Borrowers and Lenders, Debtors and Creditors Debtor nations are countries that during their entire history have borrowed more from the rest of the world than they have lent to it. Creditor nations are countries that have invested more in the rest of the world than other countries have invested in it.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Learning Objectives (cont.) Explain why the United States changed from being a lender to being a borrower in the mid-1980s Explain how the foreign exchange value of the dollar is determined Explain why the foreign exchange value of the dollar fluctuates

Slide Copyright © 2000 Addison Wesley Longman, Inc. Financing International Trade Borrowers and Lenders, Debtors and Creditors The United States is both a net borrower and a debtor nation. We became a borrower as a result of a string of current account deficits. Is there any reason to be concerned?

Slide Copyright © 2000 Addison Wesley Longman, Inc. Financing International Trade No — if the borrowing is financing investment that is generating economic growth and higher income. Yes — if the money is being used to finance consumption. This will result in higher interest payments and consumption will eventually have to be reduced.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Financing International Trade Current Account Balance The current account balance (CAB) equals:

Slide Copyright © 2000 Addison Wesley Longman, Inc. Financing International Trade Net Exports Net exports have the largest impact on the current account balance. They are determined by the government budget and private saving and investment.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Financing International Trade Net Exports Net exports is exports of goods and services minus imports of goods and services. A government sector surplus or deficit is net taxes minus government purchases of goods and services. A private sector surplus or deficit is saving minus investment.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Net Exports, the Government Budget, Saving, and Investment Variables ExportsX855 ImportsM954 Government purchasesG1,407 Net TaxesT1,340 InvestmentI1,116 SavingS1,084 Symbols and equations United States in 1996 (billions of dollars)

Slide Copyright © 2000 Addison Wesley Longman, Inc. Net Exports, the Government Budget, Saving, and Investment Net ExportsX - M 855 – 954 = -99 Government sectorT - G 1,340 – 1,407 = –67 Private sectorS - I 1,084 – 1,116 = –32 Surpluses and deficits

Slide Copyright © 2000 Addison Wesley Longman, Inc. Net Exports, the Government Budget, Saving, and Investment National accountsY = C + I + G + X – M = C + S + T RearrangingX – M = S – I + T – G Net exportsX – M –99 equals: Government sector T – G –67 plus Private sectorS – I –32 Relationship among surpluses and deficits

Slide Copyright © 2000 Addison Wesley Longman, Inc. Financing International Trade The Twin Deficits Since there is a tendency for the government sector deficit and the net exports deficit to move in the same direction, they are sometimes referred to as the twin deficits.

Slide Copyright © 2000 Addison Wesley Longman, Inc. The Twin Deficits

Slide Copyright © 2000 Addison Wesley Longman, Inc. Financing International Trade Is U.S. Borrowing for Consumption or Investment Net exports were –$99 billion in 1996 The government buys structures (e.g. highways, dams) that exceed $200 billion/year. The government spends on education and health care—increases human capital.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Financing International Trade Is U.S. Borrowing for Consumption or Investment Our borrowing is financing investment

Slide Copyright © 2000 Addison Wesley Longman, Inc. Learning Objectives (cont.) Explain why the United States changed from being a lender to being a borrower in the mid-1980s Explain how the foreign exchange value of the dollar is determined Explain why the foreign exchange value of the dollar fluctuates

Slide Copyright © 2000 Addison Wesley Longman, Inc. The Exchange Rate The foreign exchange market is the market in which the currency of one country is exchanged for the currency of another. The foreign exchange rate is the price at which one currency exchanges for another. In April 1997==>$1 = 123 Japanese yen

Slide Copyright © 2000 Addison Wesley Longman, Inc. The Exchange Rate

Slide Copyright © 2000 Addison Wesley Longman, Inc. The Exchange Rate Currency depreciation is the fall in the value of one currency in terms of another. The dollar depreciates if in later months it will buy less yen than before (e.g. 90 yen as compared to 114). Currency appreciation is the rise in the value of one currency in terms of another currency.

Slide Copyright © 2000 Addison Wesley Longman, Inc. The Exchange Rate Demand in the Foreign Exchange Market The quantity of dollars demanded in the foreign exchange market depends upon: 1) The exchange rate 2) Interest rates in the United States and other countries 3) The expected future exchange rate

Slide Copyright © 2000 Addison Wesley Longman, Inc. The Exchange Rate The Law of Demand for Foreign Exchange The demand for dollars is aderived demand. They buy dollars in order to buy U.S.-made goods and services. Holding other things the same, the higher the exchange rate, the less is the quantity of dollars demanded.

Slide Copyright © 2000 Addison Wesley Longman, Inc. D The Demand for Dollars Quantity (trillions of dollars per day) Exchange rate (yen per dollar) Other things remaining the same, a rise in the exchange rate decreases the quantity of dollars demanded... …and a fall in the exchange rate increases the quantity of dollars demanded

Slide Copyright © 2000 Addison Wesley Longman, Inc. The Exchange Rate Why do exchange rates influence the quantity of dollars demanded? 1) Exports Effect 2) Expected Profit Effect

Slide Copyright © 2000 Addison Wesley Longman, Inc. The Exchange Rate Changes in the Demand for Dollars A change in any other influence on the dollars that people plan to buy in the foreign exchange market: Changes the demand for dollars Shifts the demand curve for dollars

Slide Copyright © 2000 Addison Wesley Longman, Inc. The Exchange Rate The other factors that change the demand for dollars are: 1) Interest rates in the United States and other countries 2)The expected future exchange rate

Slide Copyright © 2000 Addison Wesley Longman, Inc. D2D2 D1D1 Changes in the Demand for Dollars Quantity (trillions of dollars per day) Exchange rate (yen per dollar) D0D0 Increase in the demand for dollars Decrease in the demand for dollars

Slide Copyright © 2000 Addison Wesley Longman, Inc. The demand for dollars increases if: The demand for dollars decreases if: Changes in the Demand for Dollars The U.S interest rate differential increases The expected future exchange rate rises The U.S. interest rate differential decreases The expected future exchange rate falls

Slide Copyright © 2000 Addison Wesley Longman, Inc. The Exchange Rate Supply in the Foreign Exchange Market The quantity of dollars supplied in the foreign exchange market depends upon: 1) The exchange rate 2) Interest rates in the United States and other countries 3) The expected future exchange rate

Slide Copyright © 2000 Addison Wesley Longman, Inc. The Exchange Rate The Law of Demand for Foreign Exchange People supply dollars in the foreign exchange market when they buy U.S. imports. Holding other things the same, the higher the exchange rate, the higher is the quantity of dollars supplied.

Slide Copyright © 2000 Addison Wesley Longman, Inc. The Exchange Rate Why do exchange rates influence the quantity of dollars supplied? 1) Imports Effect 2) Expected Profit Effect

Slide Copyright © 2000 Addison Wesley Longman, Inc. S The Supply of Dollars Quantity (trillions of dollars per day) Exchange rate (yen per dollar) Other things remaining the same, a rise in the exchange rate increases the quantity of dollars supplied... …and a fall in the exchange rate decreases the quantity of dollars supplied

Slide Copyright © 2000 Addison Wesley Longman, Inc. The Exchange Rate Changes in the Supply of Dollars A change in any other influence on the dollars that people plan to sell in the foreign exchange market: Changes the supply of dollars Shifts the supply curve of dollars

Slide Copyright © 2000 Addison Wesley Longman, Inc. The Exchange Rate The other factors that change the supply of dollars are: 1) Interest rates in the United States and other countries 2)The expected future exchange rate

Slide Copyright © 2000 Addison Wesley Longman, Inc. S2S2 S1S1 The Supply of Dollars Quantity (trillions of dollars per day) Exchange rate (yen per dollar) S0S0 Decrease in the supply of dollars Increase in the supply of dollars

Slide Copyright © 2000 Addison Wesley Longman, Inc. The supply of dollars increases if: The demand for dollars decreases if: Changes in the Supply of Dollars The U.S interest rate differential decreases The expected future exchange rate falls The U.S. interest rate differential increases The expected future exchange rate rises

Slide Copyright © 2000 Addison Wesley Longman, Inc. The Exchange Rate Market Equilibrium If the exchange rate is too high, there is a surplus of dollars. If the exchange rate is too low, there is a shortage of dollars.

Slide Copyright © 2000 Addison Wesley Longman, Inc. The Exchange Rate Market Equilibrium At the equilibrium exchange rate, there is neither a shortage nor a surplus.

Slide Copyright © 2000 Addison Wesley Longman, Inc. Equilibrium Exchange Rate Quantity (trillions of dollars per day) Exchange rate (yen per dollar) S D Surplus at 150 yen per dollar Shortage at 50 yen per dollar Equilibrium at 100 yen per dollar

Slide Copyright © 2000 Addison Wesley Longman, Inc. Learning Objectives (cont.) Explain why the United States changed from being a lender to being a borrower in the mid-1980s Explain how the foreign exchange value of the dollar is determined Explain why the foreign exchange value of the dollar fluctuates

Slide Copyright © 2000 Addison Wesley Longman, Inc. The Exchange Rate Changes in the Exchange Rate Why the Exchange Rate is Volatile Supply and demand are not independent of each other. A change in the expected future changes or U.S. interest rate differential changes both supply and demand.

Slide Copyright © 2000 Addison Wesley Longman, Inc. S 94 Exchange Rate Fluctuations Quantity (trillions of dollars per day) Exchange rate (yen per dollar) Q0Q0 D 94 S 95 D to 1995

Slide Copyright © 2000 Addison Wesley Longman, Inc. S 97 D 97 Exchange Rate Fluctuations Quantity (trillions of dollars per day) Exchange rate (yen per dollar) 84 0Q0Q0 S 95 D to 1997

Slide Copyright © 2000 Addison Wesley Longman, Inc. The Exchange Rate Exchange Rate Expectations Two expectations that effect the value of money are: 1) Purchasing power parity 2) Interest rate parity

Slide Copyright © 2000 Addison Wesley Longman, Inc. The Exchange Rate Purchasing Power Parity Money is worth what it will buy. Purchasing power parity means equal value of money.

Slide Copyright © 2000 Addison Wesley Longman, Inc. The Exchange Rate Purchasing Power Parity If prices increase in Canada (for example) and other countries but remain constant in the United States, people will generally expect that the value of the U.S. dollar is too low and will expect it to rise. Supply of and demand for dollars change The exchange rate changes

Slide Copyright © 2000 Addison Wesley Longman, Inc. The Exchange Rate Interest Rate Parity Money is worth what it can earn. Interest rate parity means equal interest rates.

Slide Copyright © 2000 Addison Wesley Longman, Inc. The Exchange Rate Interest Rate Parity If the rate of return on the dollar is higher in the United States than another, the demand for U.S. dollars rise and the exchange rate rises until expected interest rates are equal.

Slide Copyright © 2000 Addison Wesley Longman, Inc. The Exchange Rate The Fed in the Foreign Exchange Market Since the Fed influences the supply of money, it also has an impact on the exchange rate. The Fed can intervene in the foreign exchange market and smooth out fluctuations in the exchange rate.

Slide Copyright © 2000 Addison Wesley Longman, Inc. D2D2 Foreign Exchange Market Intervention Quantity (trillions of dollars per day) Exchange rate (yen per dollar) S D1D1 130 Target exchange rate D0D0

Slide Copyright © 2000 Addison Wesley Longman, Inc. The End