Chapter 5: Foreign Exchange Markets and the Balance of Payments

Foreign exchange market Foreign exchange = money denominated in foreign currency Foreign exchange market = global market in which currencies are exchanged for each other Most foreign exchange transactions involve purchase and sale of bank deposits

Exchange rate Exchange rate = price of one currency in terms of another Reciprocal exchange rates – If $1 is worth 1/2 British pounds, each British pound is worth 2 of a dollar. Domestic currency price = foreign currency price x exchange rate

Appreciation and depreciation If the domestic currency appreciates, Imports become less expensive Imports rise Exports become more expensive in the rest of the world. Exports decline If the domestic currency depreciates, Imports become more expensive Imports decline Exports become less expensive in the rest of the world. Exports rise

Balance of payments Double-entry bookkeeping Credits Debits Two sides to each transaction Dollar value of money flowing into the country must equal the dollar value of the money flowing out (two sides of the same transaction) Credits activities that brings payments into the country Debits activities that involve payments to the rest of the world

Current and Financial accounts Current account = trade in goods and services Financial account = trade in financial assets Net balance on current account + net balance on capital account + statistical discrepancy = 0 (overall balance of payments = 0)

Current account Merchandise – trade in goods Services – trade in services Investment income = payment for capital services (interest payments) Unilateral transfers – payments for which no goods or services are provided in return

Balance of payment accounts – 2000 (in millions) Credit Debit Net balance Merchandise $183,728 $289,566 $-105,838 Services $71,309 $51,647 $19,662 Investment income $79,749 $83,949 -$4,200 Unilateral transfers -$11,925 Current Account -$102,301 Capital Account $215,008 $143,283 $71,725 Statistical discrepancy -$30,410 Overall BOP $0