1. Chapter 38 The Balance of Payments, Exchange Rates, and Trade Deficits
McGraw-Hill/Irwin
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Chapter Objectives How currencies are exchanged
Balance sheet for recording international payments
How exchange rates are determined
Flexible vs. fixed exchange rates
Causes and consequences of trade deficits
38-2

3. International Transactions
International trade
Buy/sell current goods or services
Imports and exports
International asset transactions
Buy/sell real or financial assets
Buy stock
Sell your house to a foreigner
Requires currency exchange
38-3

4. Balance of Payments Sum of international financial transactions
Current account
Balance on goods and services
Net investment income - interest
Net transfers
Balance on current account
38-4

6. Balance of Payments Capital and financial account
Capital account – Debt forgiveness
Financial account - Assets
Balance of payments accounts sum to zero
Current account deficits generate asset transfers to foreigners
Official reserves
38-6

9. U.S. Trade Balances Goods and Services, Select Nations, 2007 Australia
Deficit
Surplus
Australia
+10.0
Belgium
+9.8
Canada
-67.0
China
-256.6
Germany
-45.3
Japan
-85.0
Mexico
-77.3
Netherlands
+14.3
-10
-20
-30
-40
-50
-60
-70
-250 10 20
Source: Bureau of Economic Analysis
38-9

10. Flexible Exchange Rates
Demand for pounds
Supply of pounds
Market equilibrium
Increase in dollar price of pounds
Dollar depreciates
Pound appreciates
Decrease in dollar price of pounds
Dollar appreciates
Pound depreciates
38-10

11. Flexible Exchange Rates
The Market for Foreign Currency (Pounds) Q
Dollar Price of 1 Pound
Quantity of Pounds P S1
Exchange
Rate: $2 = £1 $2 $3 $1
Dollar
Depreciates
(Pound
Appreciates)
Dollar
Appreciates
(Pound
Depreciates) D1 Q1
38-11

12. 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
38-12

13. Change in Tastes
Vs.

14. Change in Relative Income

15. Change in Relative Price Level

16. Change in Relative Interest Rates
Change in Relative Expected Returns on Investment

17. Currency Speculation
Self-fulfilling prophecy

18. 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 $2 $3 $1
Balance
Of Payments
Deficit a x b D2
Exchange
Rate:
$2 = £1 D1 Q1 Q2
38-18

19. Flexible Exchange Rates
Eliminate balance of payments deficit or surplus
Disadvantages of flexible exchange rates
Volatility
Uncertainty and diminished trade
Terms-of-trade changes
Instability
Depreciation of dollar = more exports = higher prices (inflation)
Appreciation of dollar = more imports/less exports = more unemployment
38-19

20. Fixed Exchange Rates Government intervention
Alter Supply/Demand
Use of reserves (show on graph)
Selling pounds = transfer of assets
Trade policies – tariffs, subsidies
Exchange controls and rationing
Distorted trade lessens advantages
Favoritism to certain importers
Restricted choice for consumers
Black markets – LEVIS!
38-20

21. Macroeconomic Adjustments
Monetary/Fiscal Policy
Trade deficit with Britain
Reduce demand for British Pounds by undertaking contractionary policy, reducing American incomes and thus imports of British goods
The cost?
Recession.

22. Exchange Rate Systems Gold standard 1879-1934 Bretton Woods 1944-1971
Fixed exchange rate system
Bretton Woods
Fixed exchange rate system indirectly tied to gold
International Monetary Fund
Managed float 1971-present
38-22

23. Managed Float In support of managed float
Dependence on foreign exchange markets
Occasional intervention (IMF)
Tsunami
In support of managed float
Track Record
Concerns with managed float
Volatility
Manipulation
38-23

24. U.S. Trade Deficit Large and persistent Causes of trade deficits
High U.S. growth (relatively)
China
Price oil
Low U.S. saving rate
Implications of trade deficits
Increased current consumption
Increased indebtedness
38-24

25. Speculation in Currency Markets
Positive or negative influence?
Contributes to currency market fluctuations
Self-fulfilling expectations
Smoothing short-term fluctuations
Absorbing risk
Futures market at work
Positive role played overall
38-25

26. Key Terms balance of payments current account
balance on goods and services
trade deficit
trade surplus
balance on current account
capital and financial account
balance on capital and financial
balance-of-payments deficits and surpluses
official reserves
flexible- or floating- exchange-rate system
fixed-exchange-rate system
purchasing-power-parity theory
currency interventions
managed floating exchange rate
38-26