International Trade and Foreign Exchange Markets I. The Balance of Payments – The sum of all the transactions that take place between a country and foreign countries. For our purposes, they are recorded in two accounts: A. The Current Account - the sum of a country’s exports (+) and imports (-). 1. Goods 2. Services 3. Investment income 4. Net transfers.

International Trade and Foreign Exchange Markets B. The Financial Account (used to be Capital Account) – Purchase or sale of assets from and to foreigners. 1. Foreigners buy U.S. assets (+) 2. U.S. citizen buys foreign assets (-) 3. Real assets a. Factories b. Office buildings c. etc. 4. Financial assets a. Government bonds b. Corporate bonds c. Stocks d. etc.

International Trade and Foreign Exchange Markets C. The current account and the financial account must always balance. 1. There is some discrepancy about this. Different textbooks say different things. 2. Your textbook includes a separate “official reserves account,” but this seems to have disappeared in recent texts and on the AP exam. It has become part of the financial account (which your book calls the capital account). 3. Suffice it to say: Any credit in the current account must be matched by a debit in the financial account and vice versa.

International Trade and Foreign Exchange Markets Problem Set #1: Which of these is a current account transaction? (A) India buys $10 billion of new U.S. treasury bonds. (B) A U.S. firm buys 5% of the stock of another US. Firm. (C) A U.S. firm builds a new factory in Kenya. (D) A U.S. firm sells $500 million worth of candles to an Australian importer. (E) The U.S. buys $8 billion worth of euros.

International Trade and Foreign Exchange Markets Problem Set #2: What does it mean to say that a country has a current account deficit? If a country does have a current account deficit, what must be true of its financial account (née capital account)?

International Trade and Foreign Exchange Markets II. Foreign Currency exchange rates and the foreign currency market. A. To buy imports, you need the currency of the country your importing from. For example, when Best Buy imports Korean televisions, it needs won, not dollars. B. To do so, Best Buy would buy Korean won on the foreign exchange market (from a bank or currency dealer). C. Foreign exchange rates are flexible, meaning the value of one currency against another can fluctuate. D. The price of a foreign currency is set by supply and demand in the foreign exchange market, just like anything else. http://www.xe.com/currencycharts/?from=KRW}&to=USD&view=1Y

International Trade and Foreign Exchange Markets E. So what determines the value of one currency versus another? Supply and demand. If demand for a nation’s currency increases, the currency will appreciate. If demand decreases, the currency will depreciate. appreciate – When a currency goes up in value. depreciate – When a currency goes down in value.

Flexible Exchange Rates The Market for Foreign Currency (Pounds) Q Dollar Price of 1 Pound Quantity of Pounds P S1 Exchange Rate: $2 = £1 (Dollar/Pound) $2 $3 $1 Q1 Dollar Depreciates (Pound Appreciates) Dollar Appreciates (Pound Depreciates) The demand for pounds is downward sloping, meaning that as the pound becomes less expensive in terms of dollars, more British goods and services will be purchased since they will be cheaper. The supply for pounds curve is upsloping because the British will purchase more U.S. goods when the dollar price of pounds rises. When that happens, the British will buy more U.S. goods and services because they will become less expensive. D1 LO3 38-9

Flexible Exchange Rates Determinants of exchange rates Factors that shift demand/supply Changes in tastes Relative income changes Relative price-level changes Relative interest rates There are many factors that can cause a nation’s currency to appreciate or depreciate but the basic laws of supply-demand apply. If the demand for a nation’s currency increases, that nation’s currency will appreciate and vice versa if the demand drops. If the supply of currency increases, it will depreciate and if one country’s currency appreciates, some other country’s currency will depreciate relative to it. So, what causes supply or demand to shift? Any change in consumer’s tastes will, of course, cause the demand for the currency to change. The change in income relative to the income in other nations will also shift demand, as will relative inflation rate changes. Under the purchasing-power-parity theory, exchange rates should eventually adjust such that they equate the purchasing power of various currencies. Many people use the “Big Mac” example. Since McDonald’s is located in almost every country, we can look at how much a Big Mac costs in each nation and then convert that to an exchange rate. Inflation can skew the numbers if one nation’s rate is different than the other’s. Interest rates and expected returns on assets can also affect demand if their relative rates are different between the nations. Another factor is speculation. Speculators are people who buy and sell currency solely to make money in the classic “buy low, sell high” process. These speculators can cause shifts in supply and demand. LO3 38-10

Flexible Exchange Rates The Market for Foreign Currency (Pounds) Q Dollar Price of 1 Pound Quantity of Pounds P S1 Exchange Rate: $3 = £1 c (Dollar/Pound) $2 $3 $1 a x b D2 Exchange Rate: $2 = £1 Under flexible exchange rates, a shift in the demand for pounds, all other things equal, would cause a U.S. balance of payments deficit. This deficit would be corrected by a change in the exchange rate. Under fixed exchange rates, the US would have to cover the shortage by selling official reserves, restricting trade, implementing exchange controls, or enacting a contractionary stabilization policy. D1 Q1 Q2 LO3 38-11

International Trade and Foreign Exchange Markets Problem Set #3: If interest rates in the U.S. increase compared to those in Mexico, how will that affect Mexican investment in the U.S.? (b) How will your answer to part (a) affect the demand for dollars in the foreign exchange market? Draw a diagram below. Peso/U.S. dollar Quantity of U.S. dollars

International Trade and Foreign Exchange Markets Problem Set #3: (c) How will your answer to part (b) affect the supply of pesos in the foreign exchange market? Draw a diagram below? What will happen to the dollar price of pesos? Show this on your diagram.

International Trade and Foreign Exchange Markets Problem Set #4: Assume the real interest rate in Canada increases relative to the real interest rate in the U.S. Draw a graph of the value of the Canadian dollar in terms of the U.S. dollar that demonstrates this change. Quantity of Canadian dollars /Canadian Dollars U.S. dollars

International Trade and Foreign Exchange Markets Problem Set #4: (b) Given your answer to part (a), what will happen to the level of Canadian exports? Explain.

International Trade and Foreign Exchange Markets Problem Set #4: (c) Will there be an inflow or an outflow of capital into Canada as a result of the change in interest rates in part (a)? Explain.

International Trade and Foreign Exchange Markets Problem Set #4: (d) Allright, now let’s put it all together. Reconcile the Canadian balance of payments as a result of these changes? (How will it balance?) - The current account will be in deficit due to decreased exports, but the financial (ne’e capital) account will be in surplus due to greater foreign investment in Canada. This will balance Canada’s balance of payments.

International Trade and Foreign Exchange Markets Problem Set #5: Assume there is an increase in investment demand in the U.S. (a) What will happen to the real interest rate? (b) What will happen to the international value of the dollar?

International Trade and Foreign Exchange Markets Problem Set #5: Assume there is an increase in investment demand in the U.S. (c) Choose a graph to demonstrate your answers to parts (a) and (b) (one graph for each part: 2 graphs total) (a) (b)

International Trade and Foreign Exchange Markets Problem Set #6: If the inflation rate in Kerseyland is much higher than that of its neighbors, what will be the effect on (a) The demand for its products? (b) The value of its currency?

International Trade and Foreign Exchange Markets Problem Set #7: If the dollar appreciates compared to the rest of the world’s currencies, what will be the effect on (a) The volume of U.S. exports? Explain. (b) The volume of U.S. imports? Explain.

International Trade and Foreign Exchange Markets Problem Set #8: Assume a French company buys computers from a U.S. firm. Draw side by side graphs of the dollar and the Euro on the Foreign Exchange market. Demonstrate the effect of this transaction on both currencies.