McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 18 International Finance and Exchange Rates

1- 2 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin 18-2 Chapter Outline International Financial Transactions Foreign Exchange Markets Alternative Foreign Exchange Systems Determinants of Exchange Rates

1- 3 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin 18-3 Balance of Payments Balance of Payments: the accounting system for how money moves between countries to facilitate the purchase of goods, services, financial instruments, and physical investments. Current Account: The portion of the Balance of Payments accounting that represents that impacts of trade, short-term investment payments, and American payments of foreign taxes, foreign payments of American taxes, and the net transfer of private money. The Capital Account represents the changes in holding of longer term financial and physical assets by citizens of one country in another country.

1- 4 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin 18-4 Balance of Payments United States, 2009 ($ millions) Major Accounting Item Sub Accounting Item Sub Acct component Component Amount Sub Acct BalanceBalance Current Account Balance of TradeExports 1, Imports 2,329 Balance of Short- term Investment Income Income to the US Payments from the US 499 Net Transfers (taxes, private payments) -137 Capital Account Change in the Ownership of Assets US owned assets abroad 1, Foreign owned assets in the US 1,245 Financial Derivatives Net Statistical Discrepancy & Net Derivatives

1- 5 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin 18-5 Current Account Mirrors the Balance of Trade

1- 6 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin 18-6 Foreign Purchases of US Assets & US Purchases of Foreign Assets

1- 7 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin 18-7 Trade Requires Currency Trade between countries is beneficial. International trade requires that the currency of the trading partners be exchanged. The market where people come to trade currencies is called the foreign exchange market. E.g. the production and export of a radio can require several currency transactions.

1- 8 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin 18-8 Foreign Exchange Markets The demand for a currency (say the dollar) is also the supply of the other currency (say the yen). The supply for a currency (say the dollar) is also the demand of the other currency (say the yen).

1- 9 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin 18-9 Modeling Foreign Exchange A curve which represents the willingness of those who have Yuan to trade them for U.S. dollars A curve which represents the willingness of those who have Yuan to trade them for U.S. dollars Quantity of Yuan Price of Yuan in U.S. dollars equilibrium exchange rate

1- 10 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin Various Exchange Rates Foreign Currency Amount of Currency needed to get $1 Amount of US Dollars needed to get one unit of the Currency British Pound Canadian Dollar Chinese Yuan Euro Hong Kong Dollar Japanese Yen Mexican Peso Russian Ruble South Korean Won

1- 11 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin Various Exchange Rates

1- 12 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin Alternative Foreign Exchange Systems Floating exchange rate system: a system whereby markets determine the value of a currency relative to all other currencies. Fixed exchange rate system : a system whereby a government sets the value of a currency relative to all other currencies and uses its reserve of foreign currencies or gold to maintain the exchange rate. Gold standard: one means by which a country can execute a fixed exchange rate. Managed Float exchange rate system: a system whereby governments decide the range of exchange rates they will allow the market to create, and act only when either the top end or the bottom end of that range is breached.

1- 13 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin Fixed Exchange Rates Price of Yuan in Dollars Yuan S1S1 D1D1 ER fixed Yuan* D2D2 S2S2

1- 14 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin Managed Float Price of Yuan in Dollars Yuan S1S1 D1D1 ER target Yuan* D2D2 S2S2 ER ceiling ER floor

1- 15 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin Determinants of Exchange Rates Desire to hold one currency or another to Facilitate trade Facilitate the purchase of financial assets Interest Rates Projected Inflation Rates Relative safety of the currency