1. Unit 7: International Trade and Finance
Aka: Forex
Test: Friday May 1

2. Capital Flows and the Balance of Payments intro
Day 1
Capital Flows and the Balance of Payments intro
Learning Goals:
The meaning of the balance of payments accounts.
The determinants of international capital flows.

3. Capital Flows and the Balance of Payments
Every year Americans buy trillions of dollars of “stuff” from firms in foreign countries.
Consumers in foreign countries buy nearly the same amount of “stuff” from America.

4. Balance of Payments Accounts
The Santa Cruz family runs an auto repair and body shop. Over the course of the year, the shop earned $450,000 in sales.
The family spent $400,000 for living expenses and to run the shop, including purchasing equipment, supplies, materials and utilities.
The family earned $5000 in interest on savings and other investments.
The family paid $20,000 in interest on the mortgage for the building.
After paying all of the bills, the family took the remaining cash and deposited it into the bank.
Sources of Cash
Uses of Cash
Net 1
Purchases or
sales of goods
and services
Auto repair sales:
$450,000
Shop operations
and living
expenses:
$400,000
+$50,000 2
Interest income
and payments
Interest received from
investments: $5000
Interest paid on
mortgage:
$25,000
-$20,000 3
Loans and
deposits
Funds received from
new loans: $0
Funds deposited in
bank: $30,000
-$30,000
Total
$455,000 $0

5. On a micro level for one family…
Summarizes Goods and services to customers, and payments made to outside firms for the purchase of goods and services
Sources of Cash
Uses of Cash
Net 1
Purchases or
sales of goods
and services
Auto repair sales:
$450,000
Shop operations
and living
expenses:
$400,000
+$50,000 2
Interest income
and payments
Interest received from
investments: $5000
Interest paid on
mortgage:
$25,000
-$20,000 3
Loans and
deposits
Funds received from
new loans: $0
Funds deposited in
bank: $30,000
-$30,000
Total
$455,000 $0
Summarizes interest income received from past savings and interest paid for past borrowing
Summarizes money received from new borrowing and money used for new saving
All cash coming in and out is equal: every dollar has a source; and every dollar received gets used somewhere

6. On a macro level for the whole country

7. Payment from vs Payment to
Row 1: Shows payments that arise from the purchases of goods and services…payment is payment FROM foreign buyers, payment to is when we buy something from another country Row 2: Shows factor income – payments for the use of factors of production owned by residents of other countries. (Walmart makes profit in Europe_ Row 3 International transfers – funds sent by residents of one country to residents of another. Main element is that immigrants, send money home to their families. Row 4 shows transactions that involve governments or government agencies, mainly central banks. China will purchase a US bond, etc. Row 5: Shows private sales and purchases of assets. Eg if coca cola buys a factory in Mexico, this is an asset purchase and payment TO foreigners. I

8. Why 2 sets of info? (1,2, and 3 vs 4, and 5)
The difference is in whether or not purchases create liabilities (money owed later on)

9. Current account – do NOT create liabilities
Transactions that don’t create liabilities are considered part of the balance of payments on current account. Often referred to as simply ‘current account’ are the balance of payments on goods and services plus factor in come and net international transfer payments
Most important part of current account: balance of payments on goods and services, the difference between the value of exports and the value of imports during a given period
The merchandise trade balance (or just trade balance) is the difference between a country’s exports and imports of goods alone, not including services.

10. Financial account – (aka capital account) do create liabilities
Transactions that involve the sale or purchase of assets, and therefore do create future liabilities, are considered to be part of the balance of payments on financial account, or just ‘financial account’ or even (older) ‘capital account’

11. ‘Circular flow’ of balance of payments
Current account (CA) + Financial Account (FA) = 0 Or
CA = -FA
Why? Because sources of cash must equal uses of cash

12. Loanable funds comes back 
What determines whether money flows into a nation’s financial account? The financial account is used to measure capital inflows, or foreign savings that are available to finance domestic investment spending.
Oversimplified here because: we are assuming that all investment can be loaned, which isn’t always true – and – we are ignoring exchange rates at this point
Let’s use Japan and the US as examples
Say US interest rate is currently 3% and Japan’s is currently 7%

13. When two nations have differing real interest rates in their domestic loanable funds markets, savers in the U.S. begin to look for countries like Japan where the return on a financial asset is higher. Individuals and firms in the U.S. begin to purchase financial assets in Japan, sending dollars as payment to Japan.
Another way to think about it is that the U.S. is exporting dollars and importing financial assets. Japan is exporting the financial assets and importing dollars.
Note: recent AP Macro exams have been very strict on this point. It is important to understand that U.S. investors are seeking financial assets in Japan, not physical assets (like factories) in Japan

14. Other factors for investments
International differences in the demand for funds reflect underlying differences in investment opportunities.
A country with a rapidly growing economy, other things equal, tends to offer more investment opportunities than a country with a slowly growing economy. So a rapidly growing economy typically—though not always—has a higher demand for capital and offers higher returns to investors than a slowly growing economy in the absence of capital flows. As a result, capital tends to flow from slowly growing to rapidly growing economies.
International differences in the supply of funds reflect differences in savings across countries. These may be the result of differences in private savings rates, which vary widely among countries.
They may also reflect differences in savings by governments. In particular, government budget deficits, which reduce overall national savings, can lead to capital inflows.

15. Two way capital inflow
The flow of financial capital is a two-way street.
Financial investors in the U.S. are sending money to Japan because interest rates might be higher, but Japanese investors are sending money to the U.S. stock market because they believe the U.S. economy has a brighter future.
Corporations diversify financial risk by both selling shares of their own stock to foreign investors, but also by purchasing foreign shares of stocks or foreign bonds

16. According to the world bank
So, in very general terms at this point, what does this mean if this is the US’ balance of payments?

17. practice See first couple of pages in your Activity Packet
Then we will listen to the learning prep clip for LP #1

18. The Foreign Exchange market
Day 2-3
Learning Goals
The role of the foreign exchange market and the exchange rate
The importance of real exchange rates and their role in the current account (part of BOP)

19. Some keys to understand…
Foreign currencies are exchanged because foreign goods and services are exchanged. The market for a currency (like the U.S. dollar) operates with the forces of supply and demand.
When the dollar can buy more of a foreign currency (like the euro), it is said that the dollar has appreciated in value, or it has become “stronger” against the euro.
When the dollar can buy less of a foreign currency (like the euro), it is said that the dollar has depreciated in value, or it has become “weaker” against the euro.
Movements in the exchange rate ensure that changes in the financial account and in the current account offset each other.
The real exchange rate is the nominal exchange rate adjusted for international differences in aggregate price levels.

20. Foreign exchange in the Balance of Payments
Financial account – reflects movement of capital
Current account reflects movement of goods and services
In order for these two things to remain equal (same amount going in and coming out) and actually balanced, we need to look at the exchange rate.
The exchange rate is the prices at which currencies trade
The foreign exchange market is the market place in which currencies are traded

21. Let’s say we’re in Cancun and we want to buy a t-shirt…
Cost = pesos; you only have US dollars
You need to go to a foreign exchange market and exchange your dollars for pesos
Let’s say the exchange rate is 1$ to 12.5 pesos
187.5pesos/12.5 pesos per dollar = $15

22. What if later in the month…
The exchange rate is now 1 dollar to 12.1 pesos
Has the US dollar appreciated or depreciated?
Is the shirt now more or less expensive?
It takes more of your dollars to purchase pesos…or your same dollar buys you fewer pesos.
The dollar was more expensive (measured in pesos per dollar) now than it was on the last slide…
So the dollar has APPRECIATED in value against the peso because it has become more expensive
See pages 225 and 226 in your activity packet…DO THEM ALL!!!

23. Equilibrium exchange rate
Market for the US dollar
The price of a currency, or exchange rate, is determined in the market with the forces of supply and demand. If I want pesos, I demand them. And in order to acquire pesos, I must supply dollars to the exchange market. So when Americans demand more pesos, they must supply more dollars.
The graph below shows the market for the U.S. dollar.
The unit on the x-axis is the quantity of U.S. dollars supplied and demanded.
The unit on the y-axis is the price of U.S. dollars, measured in pesos per dollar.
Note: If you are graphing the market for the U.S. dollar, an easy way to remember how to label the y-axis is to think of the notation typically used: (foreign currency)/dollar. The dollar goes in the denominator. The dollars are also the unit on the x-axis.
“what goes below goes below”. If it’s the market for dollars, dollars are on the x-axis and in the denominator.

24. What happens in the foreign exchange graphs?
Why does the Demand for dollars slope downward?
As the price of a dollar falls (its value depreciates) it takes fewer pesos to buy one dollar.
Consumers in Mexico will find U.S. goods to be less expensive.
U.S. exports to Mexico will rise, and more dollars will be demanded to pay for those goods.
Why does the Supply of Dollars slope upward?
As the price of a dollar rises (its value appreciates) one dollar buys more pesos.
Consumers in the U.S. will find Mexican-made goods to be less expensive.
U.S. imports from Mexico will rise, and more dollars will be supplied to pay for those goods.
Market for the US dollar

25. What if demand for the US dollar increases?
Let’s say more Mexicans demand dollars…they are investing in US assets As the demand for dollars shifts to the right, the equilibrium price of dollars rises and the dollar appreciates. It will now cost more than 12.5 pesos to buy one U.S. dollar. Because the U.S. dollar has appreciated against the peso, American consumers will increase purchases of goods and services from Mexico. More U.S. dollars will be supplied and will flow out of the U.S. current account. Because the quantity of dollars demanded and supplied is the same at the equilibrium exchange rate, the increased quantity of dollars demanded must be equal to the increased quantity of dollars supplied.

26. How does this keep the BOP at zero?
This tells us that any increase in the U.S. balance of payments on the financial account is exactly offset by a decrease in the U.S. balance of payments on the current account.
An increase in capital flows into the U.S. leads to a stronger dollar, which then creates a decrease in U.S. net exports.
A decrease in capital flows into the U.S. leads to a weaker dollar, which then creates an increase in U.S. net exports.

27. Inflation and real exchange rates
Real exchange rates – are exchange rates adjusted for international differences in aggregate price level.
Real exchange rate = Foreign currency per U.S. dollar *(Price level in US/Price level in Mex)
Nominal exchange rate – would be the unadjusted for aggregate price levels
Example 1: There is no difference in aggregate price levels between the U.S. and Mexico in the base year.
Real exchange rate = 12.5*(100/100) = 12.5 pesos per dollar
Example 2: Suppose the Mexican economy has suffered 10% aggregate inflation and PMex=110.
Real exchange rate = 12.5*(100/110) = 11.4 pesos per dollar.
So in real terms, even though the exchange rate hasn’t changed, inflation in Mexico means that each U.S. dollar will buy fewer pesos and thus fewer Mexican goods.

28. Purchasing power parity
purchasing power parity between two countries’ currencies is the nominal exchange rate at which a given basket of goods and services would cost the same amount in each country.
Suppose, for example, that a basket of goods and services that costs $100 in the United States costs 1,000 pesos in Mexico. Then the purchasing power parity is 10 pesos per U.S. dollar: at that exchange rate,1,000 pesos = $100, so the market basket costs the same amount in both countries.

29. Quick review see Activity packet 227-228

30. Exchange rate policy
What we Know Already…
Learning Goals:
The nominal exchange rate is a price that is determined by supply and demand in a market.
However, a nation can deliberately manipulate the exchange rate of its own currency to achieve certain economy goals.
Why? Because exchange rate has a great deal of influence on net exports!
The difference between fixed exchange rates and floating exchange rates
Considerations that lead countries to choose different exchange rate regimes

31. Exchange rate regimes
Exchange rate regime – a rule governing policy toward the exchange rate.
There are two kinds of exchange rates: fixed and floating:
Fixed Exchange rate – when the government keeps the exchange rate against some other currency at or near a particular target (eg: Hong Kong has an official policy of setting an exchange rate of HK$7.80 per US$1.
Floating Exchange rate – when the government lets the exchange rate go wherever the market takes it. This is the policy used by the US, Britain, and Canada

32. How can an exchange rate be fixed or held
Let’s say there is a country named Genovia that for some reason decided to fix the value of its currency, the geno, at US$1.50
The obvious problem is that $1.50 may not be the market price for the geno. The natural equilibrium may be higher or lower.
Graph on left shows that the fixed value is above equilibrium creating a surplus.
Graph on the right shows equilibrium above fixed value creating a shortage.

33. How can genovia keep their currency at a point that is not equilibrium?
There are 3 ways a government may intervene when fixing a currency.
Exchange Market Intervention – buying up the surplus of its OWN currency. This is why some countries keep foreign exchange reserves (or stocks in foreign countries) so that they can practice this type of price support.
The government can try to shift either the demand or supply curves so that the price hits equilibrium at the fixed price. Maybe the central bank manipulates interest rates. This could attract foreign capital…or vice versa.
The government could limit the right of individuals to buy foreign currency. The government may require a license to purchase dollars, reducing the supply of the geno so prices could rise.

34. The exchange rate dilemma Is it a good idea to fix the exchange rate?
Advantages
Disadvantages
A fixed exchange rate provides stability in foreign transactions in much the same way we experience transactions across state lines. If you take your dollars from Indiana to Kentucky, you know that the value of your dollars is unchanged. But if you take your dollars from Indiana to Europe, the value of those dollars can change daily. A fixed exchange rate avoids this uncertainty.
The fixed exchange rate also commits the central bank to monetary policies that would not upset the exchange rate. For example, if the bank adhered to the exchange rate regime, the bank could not dramatically increase the money supply. This would cause inflation and reduce the value of the currency. More stability.
To stabilize an exchange rate through intervention, a country must keep large quantities of foreign currency on hand, and that currency is usually a low-return investment. Even large reserves can be quickly exhausted when there are large capital flows out of a country. If a country chooses to stabilize an exchange rate by adjusting monetary policy rather than through intervention, it must divert monetary policy from other goals, notably stabilizing the economy and managing the inflation rate.
Finally, foreign exchange controls, like import quotas and tariffs, distort incentives for importing and exporting goods and services. They can also create substantial costs in terms of red tape and corruption.

35. Review see activity packet 229-233

36. Formative assessment #1 #2
The college student is essentially buying a service from Australia. This would be an import of services into the U.S., so this is recorded as a payment to foreigners, and the current account balance would decrease.
The German firm is buying products from America. This is an American export, so this is recorded as a payment from foreigners, and the current account balance in the U.S. would increase.
The American bank has purchased a foreign asset so dollars are sent to foreigners. Thus the balance on the financial account would decrease.
The increased purchase of Mexican oil would cause US individuals and businesses to increase their demand for the peso. To purchase pesos, individuals would increase their supply of US dollars to the foreign exchange market, causing a rightward shift in the supply curve of US dollars. This would cause the peso price of the dollar to fall (the amount of pesos per dollar would fall). The peso would appreciate and the US dollar would depreciate as a result.

37. Formative assessment #3 #4
The real exchange rate equals pesos per US dollar x aggregate price level in the US/aggregate price level in Mexico. Today, the aggregate price level in both countries is The real exchange rate today is: 10 x (100/100) = 10. The aggregate price level in five years in the US will be 100 x (120/100) = 120, and in Mexico it will be 100 x (1,200/800) = Thus, the real exchange rate in five years, assuming the nominal exchange rate does not change, will be 10 (120/150) = 8
Today, a basket of goods and services cost $100 costs 800 pesos, so the purchasing power parity is 8 pesos per US dollar. In five years, a basket that costs $120 will cost 1,200 pesos, so the purchasing power parity will be 10 pesos per US dollar
1 point: The vertical axis is labeled “Exchange rate (Chinese yuan per U.S. dollar)” and the horizontal axis is labeled “Quantity of U.S. dollars.”
1 point: Demand is downward sloping and labeled, supply is upward sloping and labeled.
1 point: The equilibrium exchange rate and the quantity of dollars are labeled on the axes at the point where the supply and demand curves intersect.
1 point: The fixed exchange rate level is depicted below the equilibrium exchange rate.
1 point: Shortage
1 point: The quantity demanded exceeds the quantity supplied at the higher fixed exchange rate.
1 point: The shortage is labeled as the horizontal distance between the supply and demand curves at the fixed exchange rate.

38. Exchange rates and macroeconomic policy (part 2)
Key Ideas
Learning Goals
A nation can intentionally devalue or revalue currency through monetary policy.
The meaning and purpose of devaluation and revaluation of a currency under a fixed exchange rate regime
Why open-economy considerations affect macroeconomic policy under floating exchange rates

39. Exchange rates and macro policy
Why would Britain choose NOT to join the Euro Zone?
Arguments for: if we use the same currency as our neighbors, our trade will increase!
Arguments against: Takes away from Britain’s ability to have an independent monetary policy and could lead to other macroeconomic problems!

40. Devaluation and Revaluation of Fixed exchange rates
What if a country who had a fixed exchange rate at 1* = $2 suddenly changed to 1* = $1.50?
This intentional depreciation of their currency is known as devaluation.
Why would a country do this?
It takes fewer dollars to buy their currency, so their goods are less expensive to Americans
The devaluation would also make American goods more expensive, thus reducing imports from America
The home country would experience an increase in net exports to America; aggregate demand would shift to the right and that boosts GDP!
What if the country switched currency from a fixed rate of 1* = $2 to 1* = $3?
This is known as revaluation
Why would a country do this?
It now takes more US dollars to buy a * so goods produced there are more expensive to Americans.
This revaluation makes American goods less expensive to consumers of the home country, thus increasing imports from America.
The * would experience a decrease in net exports to America; aggregate demand would shift to the left reducing inflation!
Bottom line: may be used as tools of monetary policy if the government practices a fixed exchange rate

41. Monetary policy under a floating exchange rate regime
Monetary policy is used to stabilize the economy, but it can also have an impact on the foreign exchange market.
Suppose the market for * is competitive and the exchange rate with the dollar is floating. What would happen if the central bank of that country increased the money supply?
Interest rates would fall with expansionary monetary policy, domestic investment would increase, and aggregate demand would increase.
Foreign investors would seek alternative nations in which to invest in financial assets, so the demand for the * would decrease.
Citizens of the home country would also seek nations with higher returns on financial investments so the supply of * would increase.
With both an increased supply and decreased demand, the value of the * will depreciate against the dollar.
A depreciated currency will make products made in the home country less expensive to American consumers, thus there would be an increase in net exports and another increase in aggregate demand.

42. International business cycle
Canada is the US’ biggest trading partner. What would happen if Canada went into a recession?
Will typically cause a decrease in real GDP in the US…
WHY?
Canadians buy many goods made in America, so a recession in Canada means American firms will shift fewer products to Canadian customers. Exports will fall, and AD falls with it. But, this seemingly straightforward chain of events is also affect by the exchange rate regime in the US.
A recession hits the Canadian economy
Canadians decrease demand for goods made in America
This amounts to a decrease in demand for the US dollar, and the US dollar depreciates
A depreciating US dollar means goods made in America become more affordable to Canadian consumers
Thus the depreciating US dollar puts the brakes on the diminished exports to Canada and the negative impact on the US economy is lessened
So in theory a free-floating exchange rate allows a nation some insulation from recessions that begin in other nations

43. Can you think your way through this?
Central Bank Action
Interest Rates
Domestic Invest-ment
Aggregate Demand
Value of Domestic Currency
Why?
Net Exp-orts
Real GDP
Price Level
Increases Money Supply
Decrease Money Supply
depreciates
fall
Everyone leaves…tons less demand from both at home and abroad
rises
Rise
rise
rises
rise
appreciates
falls
falls
rise
fall
fall
fall

44. Barriers to trade capital flow activity packet pages 221-224 and 235-240