21 The Balance of Payments, Exchange Rates, and Trade Deficits McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

International Transactions International trade Buy/sell current goods or services Imports and exports International asset transactions Buy/sell real or financial assets Buy stock Sell your house to a foreigner Requires currency exchange LO1 21-2

Balance of Payments Sum of international financial transactions Current account Balance on goods and services Net investment income Net transfers Balance on current account LO2 21-3

Balance of Payments Capital and financial account Capital account Financial account Balance of payments accounts sum to zero Current account deficits generate asset transfers to foreigners Official reserves LO2 21-4

Balance of Payments LO2 21-5

Official Reserves Foreign currencies, certain reserves with the IMF, and stocks of gold Owned by government or central bank Used as balancing mechanism in balance of payments LO2 21-6

U.S. Trade Balances LO2 21-7

Flexible Exchange Rates Demand for pounds Supply of pounds Market equilibrium Increase in dollar price of pounds Dollar depreciates Pound appreciates Decrease in dollar price of pounds Dollar appreciates Pound depreciates LO3 21-8

Q 0 Dollar Price of 1 Pound Quantity of Pounds P Flexible Exchange Rates The Market for Foreign Currency (Pounds) D1D1 S1S1 Dollar Appreciates (Pound Depreciates) Dollar Depreciates (Pound Appreciates) Exchange Rate: $2 = £1 $2 $3 $1 Q1Q1 LO3 21-9

Flexible Exchange Rates Determinants of exchange rates Factors that shift demand/supply Changes in tastes Relative income changes Relative price-level changes Purchasing-power-parity theory Relative interest rates Relative expected returns on assets Speculation LO

Q 0 Dollar Price of 1 Pound Quantity of Pounds P Flexible Exchange Rates The Market for Foreign Currency (Pounds) D1D1 S1S1 Exchange Rate: $2 = £1 $2 $3 $1 Q1Q1 D2D2 Exchange Rate: $3 = £1 Balance Of Payments Deficit Q2Q2 x a b c LO

Flexible Exchange Rates Eliminate balance of payments deficit or surplus Disadvantages of flexible exchange rates Volatility Uncertainty and diminished trade Terms-of-trade changes Instability LO

Flexible Exchange Rates LO

Fixed Exchange Rates Government intervention Use of reserves Trade policies Exchange controls and rationing Distorted trade Favoritism Restricted choice Black markets Macroeconomic adjustments LO

The Managed Float Gold standard Fixed exchange rate system Bretton Woods Fixed exchange rate system indirectly tied to gold Managed float 1971-present LO

The Managed Float Dependence on foreign exchange markets Occasional intervention In support of managed float Concerns with managed float LO

U.S. Trade Deficit Large and persistent Causes of trade deficits High U.S. growth (relatively) China Price of oil Low U.S. saving rate Implications of trade deficits Increased current consumption Increased indebtedness LO

Goods and Services Goods Billions of Dollars Balance of Trade Balance on Current Account U.S. Trade Deficits LO

Speculation in Currency Markets Positive or negative influence? Contributes to currency market fluctuations Self-fulfilling expectations Smoothing short-term fluctuations Absorbing risk Futures market at work Positive role played overall LO