© 2005 Thomson C hapter 32 Exchange Rates, Balance of Payments, and International Debt

© 2005 Thomson 2 Gottheil - Principles of Economics, 4e Economic Principles Exchange rates Foreign exchange markets Appreciation and depreciation of currencies Floating and fixed exchange rates

© 2005 Thomson 3 Gottheil - Principles of Economics, 4e Economic Principles Arbitrage Devaluation Balance of payments International debt and debt service

© 2005 Thomson 4 Gottheil - Principles of Economics, 4e The Foreign Exchange Market: The Buying and Selling of Currencies Foreign exchange market A market in which currencies of different nations are bought and sold.

© 2005 Thomson 5 Gottheil - Principles of Economics, 4e The Foreign Exchange Market: The Buying and Selling of Currencies Exchange rate The number of units of foreign currency that can be purchased with one unit of domestic currency.

© 2005 Thomson 6 Gottheil - Principles of Economics, 4e The Foreign Exchange Market: The Buying and Selling of Currencies 1. Suppose that a kite costs 40 yaps, and the exchange rate is 10 yaps to the dollar. What is the dollar price of the kite? 40 yaps/10 = 4 dollars.

© 2005 Thomson 7 Gottheil - Principles of Economics, 4e EXHIBIT 1FOREIGN EXCHANGE MARKET

© 2005 Thomson 8 Gottheil - Principles of Economics, 4e Exhibit 1: Foreign Exchange Market At $2 per yap, is the foreign exchange market in Exhibit 1 in equilibrium, or is there an excess demand or excess supply of yaps? Since the equilibrium price is $3 per yap, at $2 per yap there would be an excess demand for yaps.

© 2005 Thomson 9 Gottheil - Principles of Economics, 4e Exhibit 1: Foreign Exchange Market At $4 per yap, is the foreign exchange market in Exhibit 1 in equilibrium, or is there an excess demand or excess supply of yaps? Since the equilibrium price is $3 per yap, at $4 per yap there would be an excess supply of yaps.

© 2005 Thomson 10 Gottheil - Principles of Economics, 4e The Foreign Exchange Market: The Buying and Selling of Currencies When the price of a foreign currency declines, the quantity of that foreign currency demanded increases. 2. Why is the demand curve for foreign currency downward-sloping?

© 2005 Thomson 11 Gottheil - Principles of Economics, 4e The Foreign Exchange Market: The Buying and Selling of Currencies For example, if a dollar can buy more yaps than before, then a dollar can also buy more yap-priced goods and services than before. 2. Why is the demand curve for foreign currency downward-sloping?

© 2005 Thomson 12 Gottheil - Principles of Economics, 4e The Foreign Exchange Market: The Buying and Selling of Currencies 2. Why is the demand curve for foreign currency downward-sloping? As a result, Americans wish to exchange dollars for more yaps in order to buy more yap-priced goods, increasing the quantity of yaps demanded in the foreign exchange market.

© 2005 Thomson 13 Gottheil - Principles of Economics, 4e The Foreign Exchange Market: The Buying and Selling of Currencies When the price of a foreign currency rises, then the purchasing power of the foreign currency rises when it comes to buying imported goods and services. 3. Why is the supply curve for foreign currency upward-sloping?

© 2005 Thomson 14 Gottheil - Principles of Economics, 4e The Foreign Exchange Market: The Buying and Selling of Currencies 3. Why is the supply curve for foreign currency upward-sloping? For example, if it takes more dollars to buy a yap, then it takes fewer yasps to buy a dollar, and so the price of American goods are cheaper for people who use the yap.

© 2005 Thomson 15 Gottheil - Principles of Economics, 4e The Foreign Exchange Market: The Buying and Selling of Currencies 3. Why is the supply curve for foreign currency upward-sloping? As a result, people who use yaps wish to exchange more yaps for dollars in order to buy more American goods, increasing the quantity of yaps supplied in the foreign exchange market.

© 2005 Thomson 16 Gottheil - Principles of Economics, 4e The Foreign Exchange Market: The Buying and Selling of Currencies 4. Which of the following will cause an increase in the demand for yaps? a. Decreasing American incomes b. Increasing yap-priced interest rates c. Increasing American interest rates

© 2005 Thomson 17 Gottheil - Principles of Economics, 4e The Foreign Exchange Market: The Buying and Selling of Currencies a. Decreasing American incomes b. Increasing yap-priced interest rates c. Increasing American interest rates 4. Which of the following will cause an increase in the demand for yaps?

© 2005 Thomson 18 EXHIBIT 2EFFECT OF AN INCREASE IN THE DEMAND FOR YAPS ON THE DOLLARS-FOR-YAPS RATE OF EXCHANGE

© 2005 Thomson 19 Gottheil - Principles of Economics, 4e Exhibit 2: Effect of an Increase in the Demand for Yaps on the Dollars-for-Yaps Rate of Exchange 1. After the increase in demand from D 1 to D 2, Is there excess supply, excess demand, or equilibrium at an exchange rate of $3 per yap? There is excess demand of ( ) = 40 thousand yaps.

© 2005 Thomson 20 Gottheil - Principles of Economics, 4e Exhibit 2: Effect of an Increase in the Demand for Yaps on the Dollars-for-Yaps Rate of Exchange 2. After the increase in demand from D 1 to D 2, what is the new equilibrium exchange rate? The new equilibrium exchange rate is $5 per yap.

© 2005 Thomson 21 Gottheil - Principles of Economics, 4e The Foreign Exchange Market: The Buying and Selling of Currencies 5. Which of the following will cause a decrease in the supply of yaps? a. Decreasing American tastes for yap- priced goods b. Decreasing yap-priced interest rates c. Decreasing yap-priced incomes

© 2005 Thomson 22 Gottheil - Principles of Economics, 4e The Foreign Exchange Market: The Buying and Selling of Currencies 5. Which of the following will cause a decrease in the supply of yaps? a. Decreasing American tastes for yap- priced goods b. Decreasing yap-priced interest rates c. Decreasing yap-priced incomes

© 2005 Thomson 23 EXHIBIT 3EFFECT OF AN INCREASE IN THE SUPPLY OF YAPS ON THE DOLLARS-FOR-YAPS RATE OF EXCHANGE

© 2005 Thomson 24 Gottheil - Principles of Economics, 4e Exhibit 3: Effect of an Increase in the Supply of Yaps on the Dollars-for-Yaps Rate of Exchange 1. After the increase in supply from S 1 to S 2, is there excess supply, excess demand, or equilibrium at an exchange rate of $3 per yap? There is an excess supply of ( ) = 20 thousand yaps.

© 2005 Thomson 25 Gottheil - Principles of Economics, 4e Exhibit 3: Effect of an Increase in the Supply of Yaps on the Dollars-for-Yaps Rate of Exchange 2. After the increase in supply from S 1 to S 2, what is the new equilibrium exchange rate? The new equilibrium exchange rate is $2 per yap.

© 2005 Thomson 26 Gottheil - Principles of Economics, 4e Floating Exchange Rates Floating exchange rate An exchange rate determined strictly by the demands and supplies for a nation’s currency.

© 2005 Thomson 27 Gottheil - Principles of Economics, 4e Floating Exchange Rates Appreciation A rise in the price of a nation’s currency relative to foreign currencies.

© 2005 Thomson 28 Gottheil - Principles of Economics, 4e Floating Exchange Rates Depreciation A fall in the price of a nation’s currency relative to foreign currencies.

© 2005 Thomson 29 Gottheil - Principles of Economics, 4e Floating Exchange Rates 1. Complete the sentence: When journalists say that the dollar has “weakened,” they mean that the dollar has _____ in value.

© 2005 Thomson 30 Gottheil - Principles of Economics, 4e Floating Exchange Rates 1. Complete the sentence: When journalists say that the dollar has “weakened,” they mean that the dollar has depreciated in value.

© 2005 Thomson 31 Gottheil - Principles of Economics, 4e Floating Exchange Rates 2. If the dollar has appreciated in value relative to the yap, then which of the following is true: a. The exchange rate has more yaps per dollar than before. b. The exchange rate has fewer yaps per dollar than before.

© 2005 Thomson 32 Gottheil - Principles of Economics, 4e Floating Exchange Rates 2. If the dollar has appreciated in value relative to the yap, then which of the following is true: a. The exchange rate has more yaps per dollar than before. b. The exchange rate has fewer yaps per dollar than before.

© 2005 Thomson 33 Gottheil - Principles of Economics, 4e Tourists at the Mall Has the U.S. dollar appreciated or depreciated in value relative to the Japanese yen between 1960 and 1996? Depreciated in value.

© 2005 Thomson 34 Gottheil - Principles of Economics, 4e Tourists at the Mall Has the U.S. dollar appreciated or depreciated in value relative to the Japanese yen between 1960 and 1996? In 1960 the exchange rate was 358 yen per dollar. By 1996 there were only 131 yen per dollar.

© 2005 Thomson 35 Gottheil - Principles of Economics, 4e Floating Exchange Rates Arbitrage The practice of buying a foreign currency in one market at a low price and selling it in another at a higher price.

© 2005 Thomson 36 Gottheil - Principles of Economics, 4e Floating Exchange Rates 3. How might floating exchange rates make international trade riskier? Suppose that the price of an internationally traded good changes during the time between when a purchase is negotiated and the product is delivered.

© 2005 Thomson 37 Gottheil - Principles of Economics, 4e Floating Exchange Rates 3. How might floating exchange rates make international trade riskier? Then the change in exchange rates is like an unforeseen change in the price of the good, which redistributes the gains from trade in an unforeseen way.

© 2005 Thomson 38 Gottheil - Principles of Economics, 4e Floating Exchange Rates Fixed exchange rate A rate determined by government and then maintained through the process of buying and selling quantities of its own currency on the foreign exchange market.

© 2005 Thomson 39 EXHIBIT 4ATRADE UNDER FREE AND FIXED EXCHANGE RATES

© 2005 Thomson 40 EXHIBIT 4BTRADE UNDER FREE AND FIXED EXCHANGE RATES

© 2005 Thomson 41 Gottheil - Principles of Economics, 4e Exhibit 4: Trade Under Free and Fixed Exchange Rates 1. If there is a system of free or floating exchange rates, then what happens if the demand for a foreign currency increases? The exchange rate (dollars per unit of foreign currency) increases and there is neither excess demand nor excess supply of the foreign currency.

© 2005 Thomson 42 Gottheil - Principles of Economics, 4e Exhibit 4: Trade Under Free and Fixed Exchange Rates 2. If there is a system of fixed exchange rates, then what happens if the demand for a foreign currency increases? Since the exchange rate cannot change, an increase in demand will create excess demand for the foreign currency.

© 2005 Thomson 43 Gottheil - Principles of Economics, 4e Exhibit 4: Trade Under Free and Fixed Exchange Rates The yap government will need to exchange some of its own yaps for dollars on the foreign exchange market. 3. If there is excess demand for yaps under a system of fixed exchange rates, what will the yap government need to do to eliminate the excess demand for the yap?

© 2005 Thomson 44 Gottheil - Principles of Economics, 4e Exhibit 4: Trade Under Free and Fixed Exchange Rates This will increase the supply of yaps on the foreign exchange market and eliminate the excess demand. 3. If there is excess demand for yaps under a system of fixed exchange rates, what will the yap government need to do to eliminate the excess demand for the yap?

© 2005 Thomson 45 Gottheil - Principles of Economics, 4e Exhibit 4: Trade Under Free and Fixed Exchange Rates In order for the yap government to do this, it must have sufficient stock of yaps to exchange for dollars. 3. If there is excess demand for yaps under a system of fixed exchange rates, what will the yap government need to do to eliminate the excess demand for the yap?

© 2005 Thomson 46 Gottheil - Principles of Economics, 4e Exhibit 4: Trade Under Free and Fixed Exchange Rates 4. Continuing the yap example, what might the yap government be forced to do if it did not have a sufficient quantity of yaps on reserve to eliminate the excess demand? The yap government might be forced to borrow yaps from another country, or even agree to increase the exchange rate ($ per yap).

© 2005 Thomson 47 Gottheil - Principles of Economics, 4e Floating Exchange Rates Foreign exchange reserves The stock of foreign currencies a government holds.

© 2005 Thomson 48 Gottheil - Principles of Economics, 4e Floating Exchange Rates Devaluation Government policy that lowers the nation’s exchange rate; its currency instantly is worth less in the foreign exchange market.

© 2005 Thomson 49 Gottheil - Principles of Economics, 4e Floating Exchange Rates 4. In which of the following circumstances would a country most likely be forced into a devaluation of its currency: a. The excess supply of its currency in the foreign exchange market exceeds its foreign exchange reserves. b. The excess demand for its currency in the foreign exchange market exceeds its foreign exchange reserves.

© 2005 Thomson 50 Gottheil - Principles of Economics, 4e Floating Exchange Rates 4. In which of the following circumstances would a country most likely be forced into a devaluation of its currency: a. The excess supply of its currency in the foreign exchange market exceeds its foreign exchange reserves. b. The excess demand for its currency in the foreign exchange market exceeds its foreign exchange reserves.

© 2005 Thomson 51 Gottheil - Principles of Economics, 4e Floating Exchange Rates Import controls Tariffs and quotas used by government to limit a nation’s imports.

© 2005 Thomson 52 Gottheil - Principles of Economics, 4e Floating Exchange Rates Exchange controls A system in which government, as the sole depository of foreign currencies, exercises complete control over how these currencies can be used.

© 2005 Thomson 53 Gottheil - Principles of Economics, 4e Floating Exchange Rates International Monetary Fund (IMF) An international organization formed to make loans of foreign currencies to countries facing balance of payments problems.

© 2005 Thomson 54 Gottheil - Principles of Economics, 4e Balance of Payments Balance of payments An itemized account of a nation’s foreign economic transactions.

© 2005 Thomson 55 Gottheil - Principles of Economics, 4e Balance of Payments Balance on current account A category that itemizes a nation’s imports and exports of goods and services, income receipts and payments on investment, and unilateral transfers.

© 2005 Thomson 56 Gottheil - Principles of Economics, 4e EXHIBIT 5THE U.S. BALANCE OF PAYMENTS ACCOUNT: 2002 ($ BILLIONS) Source: Survey of Current Business (Washington, D.C.: U.S. Department of Commerce, February 2003).

© 2005 Thomson 57 Gottheil - Principles of Economics, 4e Exhibit 5: The U.S. Balance of Payments Account: 2002 ($ billions) In which of the following categories of the U.S. balance of payments did the U.S. run a surplus in 2002? a. Balance of trade b. Balance on current account c. Balance on capital account

© 2005 Thomson 58 Gottheil - Principles of Economics, 4e Exhibit 5: The U.S. Balance of Payments Account: 2002 ($ billions) In which of the following categories of the U.S. balance of payments did the U.S. run a surplus in 2002? a. Balance of trade b. Balance on current account c. Balance on capital account

© 2005 Thomson 59 Gottheil - Principles of Economics, 4e EXHIBIT 6U.S. BALANCE OF TRADE: 1950–2002

© 2005 Thomson 60 Gottheil - Principles of Economics, 4e Exhibit 6: U.S. Balance of Trade: What has been the overall trend in the U.S. balance of trade since the mid-1970s? Since the mid-1970s the U.S. balance of trade has been in deficit.

© 2005 Thomson 61 Gottheil - Principles of Economics, 4e Balance of Payments What is an example of an export of services? When a U.S. engineering firm provides engineering design services for a project in another country.

© 2005 Thomson 62 Gottheil - Principles of Economics, 4e Balance of Payments Unilateral transfers Transfers of currency made by individuals, businesses, or government of one nation to individuals, businesses, or governments in other nations, with no designated return.

© 2005 Thomson 63 Gottheil - Principles of Economics, 4e Balance of Payments Balance on capital account A category that itemizes changes in the foreign asset holdings of a nation and that nation’s asset holdings abroad.

© 2005 Thomson 64 Gottheil - Principles of Economics, 4e What is a Balance of Payments Problem? Do trade imbalances always create problems? No. For example, a country may have a balance of trade deficit because it is importing capital equipment necessary for it to produce valuable exports in the future.

© 2005 Thomson 65 Gottheil - Principles of Economics, 4e How Deficits on Current Account Develop Foreign purchases of U.S. stocks and bonds increases the demand for U.S. dollars. If foreigners make huge investments in U.S. stocks and bonds, how might this affect the current account?

© 2005 Thomson 66 Gottheil - Principles of Economics, 4e How Deficits on Current Account Develop Increased demand for the U.S. dollar increases the value of the dollar relative to other currencies. If foreigners make huge investments in U.S. stocks and bonds, how might this affect the current account?

© 2005 Thomson 67 Gottheil - Principles of Economics, 4e How Deficits on Current Account Develop If foreigners make huge investments in U.S. stocks and bonds, how might this affect the current account? A high-valued dollar makes imports cheap for Americans, but makes American exports expensive for foreigners in other countries.

© 2005 Thomson 68 Gottheil - Principles of Economics, 4e How Deficits on Current Account Develop If foreigners make huge investments in U.S. stocks and bonds, how might this affect the current account? Consequently imports increase and exports decline, causing a current account deficit.

© 2005 Thomson 69 Gottheil - Principles of Economics, 4e International Debt International debt The total amount of outstanding IOUs a nation is obligated to repay other nations and international organizations.

© 2005 Thomson 70 Gottheil - Principles of Economics, 4e International Debt Debt service Interest payments on international debt as a percentage of a nation’s merchandise exports.

© 2005 Thomson 71 Gottheil - Principles of Economics, 4e EXHIBIT 7DEBT SERVICE OF SELECTED COUNTRIES, AS A PERCENTAGE OF EXPORTS: 2001 Source: United Nations Development Programme, Human Development Report 2003 (New York: Oxford University Press, 2003).

© 2005 Thomson 72 Gottheil - Principles of Economics, 4e Exhibit 7: Debt Service of Selected Countries, as a Percentage of Exports What causes countries such as Argentina to have such high debt service as a percentage of their exports? The amount of international debt held by these countries is quite large relative to the value of their exports, making repayment difficult.