Exchange Rates and the Balance of Payments Chapter 34 Exchange Rates and the Balance of Payments

Introduction The price of one currency in terms of another is set by the interaction of supply and demand in international financial markets. Among the participants in these markets are governments seeking to change or maintain exchange rates.

Learning Objectives Distinguish between the balance of trade and the balance of payments Identify the key accounts within the balance of payments Outline how exchange rates are determined in the markets for foreign exchange

Learning Objectives Discuss factors that can induce changes in equilibrium exchange rates Understand how policymakers can go about attempting to fix exchange rates Explain alternative approaches to limiting exchange rate variability

Chapter Outline The Balance of Payments and International Capital Movements Determining Foreign Exchange Rates The Gold Standard and the International Monetary Fund Fixed Exchange Rates

Did You Know That... Exchange rates between currencies are a factor in determining the location of vehicle production? The recent decline in the value of the dollar against the yen and the euro led foreign automakers to locate more vehicle assembly in the U.S.?

The Balance of Payments and International Capital Movements Balance of Trade The value of goods and services bought and sold in the world market The difference between exports and imports of goods Balance of Payments A summary record of a country’s economic transactions with foreign residents and governments over a year

Surplus (+) and Deficit (-) Items on the International Accounts Surplus Items (+) Deficit Items (-) Exports of merchandise Imports of merchandise Private and government gifts from Private and governmental gifts to foreigners foreigners Foreign use of domestically owned Use of foreign-owned transportation transportation Foreign tourists’ expenditures in this country Tourism expenditures abroad Foreign military spending in this country Military spending abroad Interest and dividend receipts from foreigners Interest and dividends paid to foreigners Sales of domestic assets to foreigners Purchases of foreign assets Funds deposited in this country by foreigners Funds placed in foreign depository institutions Sales of gold to foreigners Purchases of gold from foreigners Sales of domestic currency to foreigners Purchases of foreign currency Table 34-1

The Balance of Payments and International Capital Movements Accounting Identities Statements that certain numerical measurements are equivalent by accepted definition

The Balance of Payments and International Capital Movements When family expenditures exceed income, the family must do one of the following: Reduce its money holdings, or sell stocks, bonds, or other assets Borrow Receive gifts from friends or relatives Receive a public transfer from a government Cannot continue indefinitely

The Balance of Payments and International Capital Movements Accounting identities Net lending by households must equal net borrowing by businesses and governments Disequilibrium When a situation cannot continue indefinitely

The Balance of Payments and International Capital Movements Households, businesses, and governments must reach equilibrium. When nations trade or interact, certain identities or constraints must hold.

The Balance of Payments and International Capital Movements Three categories of balance of payments transactions Current account transactions Capital account transactions Official reserve account transactions

The Balance of Payments and International Capital Movements Current account transactions Merchandise trade transactions Importing and exporting of merchandise Balance = merchandise exports - merchandise imports

The Balance of Payments and International Capital Movements Current account transactions Service exports and imports Invisible or intangible items Shipping Insurance Tourism Banking Income from investments

The Balance of Payments and International Capital Movements Current account transactions Unilateral transfers Gifts by citizens Gifts by governments

Example: Multinational Firms in Trade Statistics When economic activities are conducted by multinational firms, there are different trade statistics that will be calculated depending on whether the activities are measured according to the ownership of resources or according to the location of productive activities.

Example: Multinational Firms in Trade Statistics When the U.S. Commerce Department reports trade statistics on an ownership basis, exports and imports are adjusted to reflect purchases and sales involving foreign affiliates of U.S. firms.

The Balance of Payments and International Capital Movements Balancing the current account Net exports plus unilateral transfers plus net investment income exceeds zero Current account surplus Net exports plus unilateral transfers plus net investment income is negative Current account deficit

The Balance of Payments and International Capital Movements A current account surplus means the import of money or money equivalent which means a capital account deficit A current account deficit must be paid by the export of money or money equivalent which means a capital account surplus

The Balance of Payments and International Capital Movements Capital account transactions Deals with the buying and selling of real and financial assets

The Balance of Payments and International Capital Movements The current account and capital account must sum to zero, in the absence of interventions by finance ministries or central banks. Capital Account  Current Account  0

The Balance of Payments and International Capital Movements Official reserve account transactions Foreign currencies Gold Special Drawing Rights (SDRs) Reserve assets created by the International Monetary Fund that countries can use to settle international payments

The Balance of Payments and International Capital Movements Official reserve account transactions The reserve position in the International Monetary Fund Financial assets held by an official agency such as the U.S. Treasury Department

The Balance of Payments and International Capital Movements What affects the balance of payments? Relative rate of inflation Political stability

The Balance of Payments and International Capital Movements What affects the balance of payments? Inflation among trading partners Political stability

Determining Foreign Exchange Rates Foreign Exchange Market The market for buying and selling foreign currencies Exchange Rates The price of one currency in terms of another

Determining Foreign Exchange Rates Demand for and supply of foreign currency U.S. transactions involving imports constitute a supply of dollars and demand for some foreign currency The opposite is true for export transactions

Determining Foreign Exchange Rates The equilibrium foreign exchange rate Appreciation An increase in the value of a currency in terms of other currencies Depreciation A decrease in the value of a currency in terms of other currencies

Deriving the Demand for Japanese Yen Panel (b) U.S. Demand Curve for Japanese Laptop Computers D 100 1,500 300 1,250 500 1,000 Price per Unit ($) 700 750 Quantity of Japanese Laptops per Week Figure 34-2, Panels (a) and (b)

Deriving the Demand for Japanese Yen Panel (b) U.S. Demand Curve for Japanese Laptop Computers D 100 1,500 300 1,250 500 1,000 Price per Unit ($) 700 750 Quantity of Japanese Laptops per Week Figure 34-2, Panels (c) and (b)

Deriving the Demand for Japanese Yen Panel (e) U.S. Derived Demand for Yen D1 10 .0150 30 .0125 Price per Franc ($) 50 .0100 70 .0075 Quantity of Yen Demanded per Week (millions) Figure 34-2, Panels (d) and (e)

Determining Foreign Exchange Rates Supply of Japanese Yen Price of U.S. microprocessor = $200 Exchange rate = $0.01 for 1 yen 200,000 yen ($200@$0.01/yen) = 1 microprocessor Exchange rate = $0.0125 16,000 Yen ($200@ $0.0125/Yen) = 1 microprocessor

Determining Foreign Exchange Rates 60 0.0125 50 0.0100 Price per Yen ($) 40 0.0075 Quantity of Yen Supplied per Week (millions) Figure 34-3

Total Demand for and Supply of Japanese Yen 2 0.0125 3 0.0100 E Price per Yen($) Trillions of Yen per Year Figure 34-4

A Shift in the Demand Schedule 2 S D 1 4 0.0120 E 2 3 0.0100 E 1 Price per Yen ($) Trillions of Yen per Year Figure 34-5

A Shift in the Supply of Japanese Yen D 3 0.0100 E Price per Yen ($) S 1 E 1 5 0.0050 Trillions of Yen per Year Figure 34-6

International Example: South Africa’s Currency Appreciation Gold and platinum are key South African exports. The increased demand for these commodities has also increased the demand for South African rand. As interest rates in South Africa became relatively higher, the demand for South African financial assets also increased.

International Example: South Africa’s Currency Appreciation The result of these changes has been an appreciation of the rand. The dollar price of the rand has doubled since the end of 2001.

Determining Foreign Exchange Rates Market determinants of exchange rates Changes in real interest rates Changes in productivity Changes in product preferences Perceptions of economic stability

The Gold Standard and the International Monetary Fund An international monetary system in which nations fix their exchange rates in terms of gold All currencies are fixed in terms of all others, and any balance of payments deficits or surpluses can be made up by shipments of gold

The Gold Standard and the International Monetary Fund A balance of payments deficit More gold flowed out than flowed in Equivalent to an restrictive monetary policy A balance of payments surplus More gold flowed in than out Equivalent to an expansionary monetary policy

The Gold Standard and the International Monetary Fund Problems with the gold standard A nation gives up control of its monetary policy New gold discoveries often caused inflation

The Gold Standard and the International Monetary Fund Bretton Woods and the International Monetary Fund 1944—representatives of capitalist countries met in Bretton Woods, New Hampshire Created a new international payment system to replace the gold standard Members could change the par value once by 10 percent and after that par value changes needed IMF approval

The Gold Standard and the International Monetary Fund End of the old IMF On August 15, 1971, President Richard Nixon suspended the convertibility of the dollar into gold. On December 18, 1971, the United States devalued the dollar relative to the currencies of 14 major industrial nations.

Current Foreign Exchange Rate Arrangements Figure 34-7

Fixed versus Floating Exchange Rates To maintain a fixed exchange rate, the central bank of a country can buy and sell currencies. It must use its own foreign exchange reserves to engage in these financial market transactions.

A Fixed Exchange Rate Figure 34-8 • The supply of ringgit shifts to the right as Thai residents demand more U.S. goods • The value of the ringgit will fall The Bank of Malaysia buys ringgit with dollars shifting the demand for ringgit to the right Figure 34-8

International Example: Central Banks’ Currencies of Choice A central bank allocates foreign exchange reserves based on its perception of which currencies will be needed most frequently to alter the demand for its own currency. The U.S. dollar is the currency most commonly held in foreign exchange reserves; but the euro, the Japanese yen, and the British pound also comprise a measurable portion of these accounts.

Fixed Exchange Rates Pros and cons of fixed exchange rates Pros Limiting foreign exchange risk The possibility that changes in the value of a nation’s currency will result in variations in market value of assets

Fixed Exchange Rates Pros and cons of fixed exchange rates Cons A country’s residents can avoid foreign exchange risk by hedging A financial strategy that reduces the chance of suffering losses arising from foreign exchange risk A nation’s output and employment can fall in the short run if demand for its products decreases and its labor is relatively immobile

The Dirty Float and Managed Exchange Rates A system between flexible and fixed exchange rates in which central banks occasionally enter foreign exchange markets to influence rates

Managed Exchange Rates What do you think? Is it possible to “manage” foreign exchange rates? One study concludes that neither the Fed nor the central banks of the other G7 can successfully influence exchange rates in the long run.

Managed Exchange Rates Crawling Pegs An automatically adjusting target for the value of a nation’s currency The exchange rate gradually adjusts the upward or downward by a country’s central bank buying or selling its currency as needed to keep it consistent with long-run forces.

Managed Exchange Rates Target Zones Upper and lower limits or bands for values of an exchange rate are established and maintained by central banks

Issues and Applications: Japan’s Finance Ministry Learns a New Currency Trick As the value of the dollar has declined against the Japanese yen in recent years, American consumers must pay more for Japanese-made goods. In response, the Japanese government began buying dollars on the foreign exchange market. Of late, the government has been using private banks to implement the foreign exchange transactions needed to arrest the yen appreciation.

Summary Discussion of Learning Objectives The balance of trade versus the balance of payments Balance of trade Exports of goods-imports Balance of payments A system of account for all transactions between a nation’s residents and the rest of the world

Summary Discussion of Learning Objectives The key accounts within the balance of payments Current account Capital account Official reserve transactions account

Summary Discussion of Learning Objectives Exchange rate determination in the market for foreign exchange The equilibrium exchange rate is the exchange rate at which the quantity of a country’s currency is equal to the quantity supplied

Summary Discussion of Learning Objectives Factors that can induce changes in equilibrium exchange rates Changes in desired imports or exports Changes in real interest rates Changes in relative productivity Tastes and preferences of consumers Perceptions of stability

Summary Discussion of Learning Objectives How policymakers can attempt to keep exchange rates fixed A country’s central bank increases the demand for its country’s currency if the exchange rate begins to fall Alternative approaches to limiting exchange rate variability Dirty floats Crawling pegs Target zones

Exchange Rates and the Balance of Payments End of Chapter 34 Exchange Rates and the Balance of Payments