1. International Finance
Chapter 21

2. Exchange Rates: The Global Link
The exchange rate is the price of one country’s currency expressed in terms of another’s.
It is the domestic price of a foreign currency.
It is the price of one currency in terms of another.

3. Foreign-Exchange Markets
Money is a commodity to be bought and sold like any other.
An exchange rate is subject to the same influences that determine all market prices: demand and supply.
LO1

4. The Demand for Dollars
The market demand for U.S. dollars originates in:
Foreign demand for American exports.
Foreign demand for American investments.
Speculation.
LO1

5. The Supply of Dollars
The demand for foreign currency represents a supply of U.S. dollars.
The supply of dollars originates in:
American demand for imports.
American investments in foreign countries.
Speculation.
LO1

6. The Value of the Dollar
A higher dollar price for euros will raise the dollar costs of European goods.
LO3

7. The Supply Curve The supply of dollars is upward-sloping.
If the value of the dollar rises, Americans can buy more euros.
LO1

8. The Demand Curve
The demand for dollars arises from the foreign demand for U.S. exports and investments.
As dollars become cheaper, all American exports effectively fall in price.
LO1

9. Equilibrium
Just like any other commodity, the intersection of market demand and supply curves gives the equilibrium price of the dollar.
Equilibrium price – The price at which the quantity of a good demanded in a given time period equals the quantity supplied.
LO2

10. Foreign-Exchange Market
0.5
1.5
2.0
2.5
3.0
QUANTITY OF DOLLARS per time period
EURO PRICE OF DOLLAR
(euros per dollar)
Supply of dollars
0.90
Equilibrium
Demand for dollars
LO2

11. Foreign-Exchange Market
The value of the dollar can also be expressed in terms of other currencies.

12. Foreign-Exchange Market

13. The Balance of Payments
The balance of payments is a summary of a country’s international economic transactions in a given period of time.
It is an accounting statement of all international money flows in a given time period.

14. Trade balance = exports – imports
The trade balance is the difference between exports and imports of goods and services.
Trade balance = exports – imports

15. Trade Balance
A trade deficit represents a net outflow of dollars to the rest of the world.
Trade deficit – The amount by which the value of imports exceeds the value of exports in a given time period.

16. Current-Account Balance
The current-account balance is the most comprehensive summary of our trade relations.

17. Capital-Account Balance
The capital account balance takes into consideration assets bought and sold across international borders. – =
Capital account balance
Foreign purchase of U.S. assets
U.S. purchases of foreign assets

18. Capital-Account Balance
The capital-account surplus must equal the current-account deficit. – =
Net balance of payments
current-account balance
capital-account balance

20. Market Dynamics
Exchange rates are always changing in response to shifts in demand and supply.
LO2

21. Depreciation and Appreciation
Depreciation (currency) refers to a fall in the price of one currency relative to another.
Appreciation refers to a rise in the price of one currency relative to another.
LO2

22. Depreciation and Appreciation
Whenever one currency depreciates, another currency must appreciate.
LO2

23. Market Forces
Exchange rates change whenever the supply or demand (or both) has shifted.
Market forces are constantly changing – keeping foreign-exchange markets busy.
Foreign-exchange markets are places where foreign currencies are bought and sold.
LO2

24. Market Forces
Some of the more important reasons supply and/or demand may shift:
Relative income changes.
Relative price changes.
Changes in product availability.
Relative interest-rate changes.
Speculation.
LO2

25. Shifts in Foreign-Exchange Markets
Dollar-euro market
Dollar-yen market
Quantity of Dollars
Euro Price of Dollar
Quantity of Dollars
Yen Price of Dollar S2 S1 S1 S2 P2 P1 P1 P2 D D
LO2

26. Changing Values of U.S. Dollar

27. The Asian Crisis of
The Asian crisis of was caused by several market forces moving in the same direction at the same time.

28. The Asian Crisis of
In July 1997, the Thai government decided the baht was overvalued and let market forces find a new equilibrium.
Within days, the dollar price of the baht plunged 25 percent and the Thai price of the U.S. dollar increased.

29. The Asian Crisis of
The devaluation of the baht had a domino effect on other Asian currencies.
Holders of the Malaysian ringget, the Indonesian rupiah and the Korean won rushed to buy U.S. dollars.

30. The Asian Crisis of
The “Asian contagion” wasn’t confined to that area of the world.
Hog farmers in the U.S. saw foreign demand for their pork evaporate.
Koreans stopped taking vacations in Hawaii.
Thai Airways canceled orders for Boeing jets.

31. The Asian Crisis of
This loss of export markets slowed economic growth in the United States, Europe, Japan, and other nations.

32. Resistance to Exchange-Rate Changes
Resistance to exchange rate changes originates in various micro and macro economic interests.

33. Micro Interests
People who trade or invest in world markets want a solid basis for forecasting future costs, prices, and profits.
Fluctuating currency exchange rates are an unwanted burden on trade.
LO3

34. Micro Interests
A change in the price of a country’s money automatically alters the price of all of its exports and imports.
Import-competing industries suffer when currency depreciations make imports cheaper.
LO3

35. Macro Interests
A micro problem that becomes widespread enough can turn into a macro one.
The huge U.S. trade deficits of the 1980s effectively exported jobs to foreign nations.
LO3

36. U.S. a Net Debtor
From 1914 to 1984, the United States was a net creditor in the world economy.
Since 1985, the United States has been a net debtor.

37. U.S. a Net Debtor U.S. debtor status can complicate domestic policy.
A sudden flight from U.S. assets could severely weaken the dollar and disrupt the domestic economy.

38. Exchange-Rate Intervention
Governments often intervene in foreign-exchange markets to achieve greater exchange-rate stability.
LO2

39. Fixed Exchange Rates
Under a gold standard, each country determines that its currency is worth so much gold.
Gold Standard - An agreement by countries to fix the price of their currencies in terms of gold; a mechanism for fixing exchange rates.
LO2

40. Balance of Payment Problems
Market supply and demand of currency naturally shift.
This moves the equilibrium exchange rate away from the fixed exchange rate.
LO2

41. Balance of Payment Problems
Excess demand for a foreign currency implies:
A balance-of-payments deficit for the domestic nation, and
A balance-of-payments surplus for the foreign nation.
LO2

42. Balance of Payment Problems
A balance-of-payments deficit results from an excess demand for foreign currency at current exchange rates.
A balance-of-payments surplus results from an excess demand for domestic currency at current exchange rates.
LO2

43. Balance of Payment Problems
There are only two ways to deal with balance-of-payments problems when there are fixed exchange rates:
Allow exchange rates to change.
Alter market supply or demand so that they intersect at the established exchange rate.
LO2

44. Fixed Rates and Market Imbalance
Quantity of Pounds
Dollar Price of Pounds D2 D1 S1
Excess demand for pounds e2 e1 qS qD
LO2

45. The Need for Reserves
The Treasury could help maintain the officially established exchange rate by selling some of its foreign exchange reserves.
Foreign-Exchange Reserves - Holdings of foreign exchange by official government agencies, usually the central bank or treasury.
LO2

46. The Need for Reserves
Foreign exchange reserves may not be adequate to maintain fixed exchange rates.
The long-term string of U.S. balance-of-payments deficits overwhelmed its stock of foreign exchange reserves.
LO2

47. The Impact of Monetary Intervention
Quantity of Pounds
Dollar Price of Pounds D2 S1 S2 e1
Excess demand qS qD
LO2

48. The U.S. Balance of Payments: 1950 – 1973
+$4 +2 –2 –4 –6 –8
–10
1950
1955
1960
1965
1970
1973
1975
Balance (billions of dollars)
Surplus
Deficit

49. The Role of Gold
Gold reserves are a potential substitute for foreign-exchange reserves.
Gold Reserves - Stocks of gold held by a government to purchase foreign exchange.
LO2

50. The Role of Gold
Continuing U.S. balance-of-payments deficits exceeded the holdings in Fort Knox.
As a result, U.S. gold reserves lost their credibility as a potential guarantee of fixed exchange rates.
LO2

51. Domestic Adjustments
Trade protection can be used to prop up fixed exchange rates.
Deflationary (or restrictive) policies help correct a balance-of-payments deficit by lowering domestic incomes and thus the demand for imports.
LO2

52. Domestic Adjustments
Domestic adjustments require a deficit country to give up full employment and a surplus country to give up price stability.
LO2

53. The Euro Fix
The 12 nations of the European Monetary Union (EMU) fixed their exchange rates in 1999.
They eliminated their national currencies, making the euro the common currency of Euroland.

54. Flexible Exchange Rates
Flexible exchange rates is a system in which exchange rates are permitted to vary with market supply and demand conditions.
Also called floating exchange rates.
With flexible exchange rates, the quantity of foreign exchange demand always equals the quantity supplied.
LO2

55. Flexible Exchange Rates
Someone is always hurt (and others are helped) by exchange-rate movements.
Currency depreciation may cause domestic cost-push inflation by pushing up input prices.
Currency appreciation reduces exports by raising the price of domestically produced goods to foreigners.
LO2

56. Speculation
Speculators often counteract short-term changes in foreign-exchange supply and demand.
Sometimes, speculators move “with the market” and make swings in the exchange rate even more extreme.
LO2

57. Managed Exchange Rates
Governments may buy and sell foreign exchange for the purpose of narrowing exchange-rate movements.
Such limited intervention in foreign-exchange markets is referred to as managed exchange rates.
LO2

58. Managed Exchange Rates
Managed exchange rates is a system in which governments intervene in foreign-exchange markets to limit but not eliminate exchange rate fluctuations.
Sometimes called “dirty floats.”
LO2

59. Managed Exchange Rates
The basic objective of exchange-rate management is to provide a stabilizing force.
LO2

60. Currency Bailouts The world has witnessed a string of currency crises:
The Asian crisis of
The Brazilian crisis of 1999.
The Argentine crisis of
The recurrent ruble crises in Russia.
Periodic panics in Mexico and South America.

61. Currency Bailouts
In most cases a currency “bailout” was arranged by the International Monetary fund, joined by the central banks of the strongest economies.

62. The Case for Bailouts
The case for currency bailouts typically rests on the domino theory.
Weakness in one currency can undermine another.
Industrial countries often offer currency bailout as a form of self-defense.

63. The Case Against Bailout
Critics of bailouts argue that such interventions are ultimately self-defeating.
Once a country knows that currency bailouts will occur, it may not pursue domestic policy adjustments to stabilize its currency.

64. The Case Against Bailout
A nation can avoid politically unpopular options such as high interest rates, tax hikes, or cutbacks in government spending.

65. The Case Against Bailout
It can also turn a blind eye to trade barriers, monopoly power, lax lending policies, and other constraints on productive growth.

66. Future Bailouts?
To minimize the ill effects of bailouts, the IMF and other institutions typically require the crisis nation to pledge more prudent monetary, fiscal, and trade policies.

67. Future Bailouts?
As long as the crisis nation is confident of an eventual bailout, however, it has a lot of bargaining power to resist policy changes.

68. International Finance
End of Chapter 21