24 McGraw-Hill/IrwinCopyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. The Balance of Payments, Exchange Rates, and Trade Deficits

International Transactions International trade Trade goods and services or assets for money When using different currencies, currencies must be converted for trade to occur LO1

Balance of Payments Sum of all of a nation’s international financial transactions Balance of payments accounts sum to zero Current account deficits generate asset transfers to foreigners Can use official reserves to balance payments if necessary like a savings account LO2

Balance of Payments LO2

U.S. Trade Balances LO2

Flexible Exchange Rates Flexible or floating exchange rates Exchange rates are determined in the free market Fixed exchange rates Government determines exchange rates and makes adjustments to maintain them LO3

Flexible Exchange Rates Determinants of exchange rates Factors that shift demand/supply Changes in tastes Relative income changes Relative price-level changes Purchasing-power-parity theory Relative interest rates Relative expected returns on assets Speculation LO3

Flexible Exchange Rates Eliminate balance of payments deficit or surplus Disadvantages of flexible exchange rates Uncertainty and diminished trade Terms-of-trade changes Instability LO4

Flexible Exchange Rates LO4

Fixed Exchange Rates Government intervention Use of reserves Trade policies Exchange controls and rationing Distorted trade Favoritism Restricted choice Black markets Macroeconomic adjustments LO4

The Managed Float Occasional intervention In support of managed float More successful than expected even during severe financial crises Concerns with managed float Too volatile Guidelines are too vague LO4

U.S. Trade Deficit Large and persistent Causes of trade deficits High U.S. growth (relatively) China Price of oil Low U.S. saving rate Implications of trade deficits Increased current consumption Increased indebtedness LO5

U.S. Trade Deficits U.S. Trade Deficits, LO5