1. International Finance
CHAPTER 33
© 2003 South-Western/Thomson Learning

2. Balance of Payments
A country’s balance of payments summarizes all economic transactions that occur during a given period between residents of that country and residents of other countries
Balance of payments measures a flow
More descriptive phrase would be the balance of economic transactions

3. Balance of Payments
Balance of payments accounts are maintained according to the principles of double-entry bookkeeping
Entries on one side of the ledger are called credits
Entries on the other side are called debits
Consists of several individual accounts
Deficit in one or more accounts must be offset by a surplus in the other accounts

4. Merchandise Trade Balance
Merchandise trade balance equals the value of merchandise exports minus the value of merchandise imports
Reflects trade in goods, or tangible products and is often referred to as the trade balance
If the value of merchandise exports exceeds the value of merchandise imports, there is a trade surplus

5. Merchandise Trade Balance
If the value of merchandise imports exceeds the value of merchandise exports, there is a trade deficit
The trade balance depends on a variety of factors
Relative strength and competitiveness of the domestic economy compared to other economies
Relative value of the domestic currency compared to other currencies

6. Merchandise Trade Balance
Since 1976 U.S. imports have exceeded U.S. exports every year
Trade deficits as a percent of GDP have increased steadily during the last decade, growing from 1.3% in 1991 to 4.6% in 2000

7. Balance on Goods and Services
Merchandise trade balance focuses on the flow of goods, but services, intangibles, are also traded internationally
These services are often called invisibles
The balance on goods and services is the value of exports of goods and services minus the value of imports of goods and services
Common to refer to exports minus imports  net exports

8. Unilateral Transfers
Unilateral transfers consist of government transfers to foreign residents, foreign aid, personal gifts to individuals abroad, etc.
Net unilateral transfers equal the unilateral transfers received from abroad by U.S. residents minus unilateral transfers sent to foreign residents by U.S. residents

9. Balance on Current Account
The current account includes all transactions in currently produced goods and services plus net unilateral transfers
Can be negative  current account deficit
Can be positive  current account surplus
Zero

10. Capital Account
The capital account records transactions involving foreign assets and liabilities
Between 1917 and 1982, the United States ran a deficit in the capital account  U.S. residents purchased more foreign assets than foreigners purchased assets in the U.S.
This reversed itself in 1983 and since 1983, U.S. imports of capital have exceeded exports  surplus in capital account

11. Foreign Exchange
Foreign exchange is the currency of another country that is needed to carry out international transactions
A country runs a deficit in its current account when the amount of foreign exchange that country gets from exporting goods and services and from receipts of unilateral transfers falls short of the amount needed to pay for its imports and to make unilateral transfers

12. Foreign Exchange
The additional foreign exchange required must come from a net capital inflow
If a country runs a current account surplus, the foreign exchange received from selling exports and from unilateral transfers received exceeds the amount required to pay for imports and to make unilateral transfers
The deficit in the U.S. current account in recent years has been offset by a surplus in the capital account

13. Exchange Rate
The exchange rate is the price of a unit of one currency required to purchase a unit of another currency
Determined by the interaction of the households, firms, private financial institutions, governments, and central banks that buy and sell foreign exchange
Fluctuates to equate the quantity of foreign exchange demanded with the quantity supplied
Foreign exchange market incorporates all the arrangements used to buy and sell foreign exchange

14. Exchange Rate
We will consider the market for the euro in terms of the dollar
Euro is the common currency of 12 European countries
Big advantage of a common currency is that Europeans no longer have to change money every time they cross a border or trade with other countries in the group

15. Exchange Rate
The price, or exchange rate, of the euro in terms of the dollar is the number of dollars required to purchase one euro
An increase in the number of dollars needed to purchase a euro indicates a weakening, or a depreciation, of the dollar
A decrease in the number of dollars needed to purchase a euro indicates a strengthening, or an appreciation of the dollar

16. Demand for Foreign Exchange
U.S. residents need euros to pay for goods and services produced in Euroland
The demand curve for euros the inverse relationship between the dollar price of the euro and the quantity of euros demanded, other things constant
Incomes and preferences of U.S. consumers
The expected inflation rates in the U.S. and Euroland
The euro price of goods in Euroland
Interest rates in the U.S. and Euroland

17. Demand for Foreign Exchange
In the aggregate, the lower the dollar price of foreign exchange, other things constant, the greater the quantity demanded
A drop in the dollar price of foreign exchange, in this case the euro, means that fewer dollars are required to purchase each euro  prices of euro goods become cheaper

18. Supply of Foreign Exchange
The supply of foreign exchange is generated by the desire of foreign residents to acquire dollars
The positive relationship between the dollar-per-euro exchange rate and the quantity of euros supplied in the foreign exchange market implies an upward-sloping supply curve

19. Supply of Foreign Exchange
The supply curve is drawn assuming other things constant
Euroland incomes and preferences
Expectations about the rates of inflation in Euroland and the United States
Interest rates in Euroland and the United States

20. Arbitrageurs
Exchange rates between specific currencies are nearly identical at any given time in markets around the world
Arbitrageurs are dealers who take advantage of any difference in exchange rates between markets by buying low and selling high ensure this equality  their actions help to equalize exchange rates across markets

21. Arbitrageurs
Because they buy and sell simultaneously, relatively little risk is involved
For example, if one euro costs $0.89 in New York but $0.90 in Frankfurt, the arbitrageur would buy euros in New York and the same time selling them in Frankfurt
the demand for euros in New York would increase and the supply of euros in Frankfurt would increase
price differential would be eliminated

22. Speculators
Speculators buy or sell foreign exchange in hopes of profiting by trading the currency at a more favorable exchange rate later
By taking risks, speculators aim to profit from market fluctuations by trying to buy low now and selling high later

23. Purchasing Power Parity
As long as trade across borders is unrestricted and as long as exchange rates are allowed to adjust freely, the purchasing power parity theory (PPP) predicts that the exchange rate between two currencies will adjust in the long run to reflect price-level differences between the two currency regions
A given basket of internationally traded goods should therefore sell for about the same around the world after adjusting for transportation costs and the like

24. Purchasing Power Parity
The PPP theory is more of a long-run predictor than a day-to-day indicator of the relationship between changes in the price level and the exchange rate
Because of trade barriers, central bank intervention in exchange markets, and the fact that many of the products are not traded, the PPP theory usually does not explain exchange rates at a particular point in time

25. Flexible Exchange Rates
In our preceding examples, we have been discussing a system of flexible exchange rates  exchange rates are determined by supply and demand
Flexible, or floating, exchange rates adjust continually to the myriad forces that buffet the foreign exchange market
Government officials usually have little direct role in foreign exchange markets

26. Fixed Exchange Rates
If government officials try to set exchange rates, acting and ongoing central bank intervention is necessary to establish and maintain these fixed exchange rates
Suppose, for example, the European Central Bank selects what it thinks is an appropriate rate of exchange between the dollar and the euro it attempts to fix or peg the exchange rate within a narrow band around the particular value selected

27. Fixed Exchange Rates
If the value of the euro threatens to climb above the maximum acceptable exchange rate, monetary authorities
must sell euros and buy dollars
thereby keeping the dollar price of the euro down
Conversely, if the value of the euro threatens to drop below the minimum acceptable exchange rate, monetary authorities
must sell dollars and buy euros in foreign exchange markets

28. Fixed Exchange Rates
If monetary officials must keep selling foreign exchange to maintain the pegged rate, they risk running out of foreign exchange reserves
The government has several options
The pegged exchange rate can be increased: devaluation of the domestic currency
The pegged exchange rate can be decreased: revaluation of the domestic currency
The government can attempt to reduce the domestic demand for foreign exchange directly by imposing restrictions on imports or capital flows

29. Fixed Exchange Rates
The government can adopt contractionary fiscal or monetary policies to reduce the country’s income level, increase interest rates, or reduce inflation relative to that of the country’s trading partners
Finally, the government can allow the disequilibrium to persist and ration the available foreign reserves through some form of foreign exchange control

30. Gold Standard
From 1879 to 1914, the international financial system operated under a gold standard  the major currencies were convertible into gold at a fixed rate
The gold standard provided a predictable exchange rate, one that did not vary as long as currencies could be redeemed for gold at the announced rate

31. Gold Standard
However, the money supply in each country was determined in part by the flow of gold between countries  each country’s monetary policy was influenced by the supply of gold
A balance-of-payments deficit resulted in a loss of gold, which theoretically caused a country’s money supply to drop

32. Gold Standard
Conversely, a balance-of-payments surplus resulted in an increase in gold  a country’s money supply would increase
The supply of money throughout the world also depended on the vagaries of gold discoveries

33. Bretton Woods Agreement
During World War I, many countries could no longer convert their currencies into gold with the result that the gold standard eventually collapsed
At the end of World War II, the Allies met to formulate a new international monetary system
Because the U.S. had a strong economy, the dollar was selected as the key reserve currency

34. Bretton Woods Agreement
All exchange rates were fixed in terms of the dollar and the U.S. stood ready to convert foreign holdings of dollars into gold at a rate of $35 an ounce
Even though exchange rates were fixed by the Bretton Woods accord, other countries could adjust their exchange rates relative to the U.S. dollar if they found a chronic disequilibrium in their balance of payments

35. International Monetary Fund
The Bretton Woods agreement also created the International Monetary Fund (IMF) to
Set rules for maintaining the international monetary system
Standardize financial reporting for international trade
Make loans to countries with temporary balance of payments problems
Establish a revolving fund to lend money to troubled economies

36. Demise of the Bretton Woods System
During the latter part of the 1960s, inflation in the U.S. caused the dollar to become overvalued at the official exchange rate
the gold value of the dollar exceeded the exchange value of the dollar
The result was that in August 1971, the U.S. stopped exchanging gold for Dollars

37. Demise of the Bretton Woods System
The dollar was devalued with the hope that this would put the dollar on firmer footing and would save the dollar standard
With prices rising at different rates, an international monetary system based on fixed exchanged rates was doomed
The Bretton Woods system collapsed

38. Managed Float
Managed float system combines features of a freely floating exchange rate with sporadic intervention by central banks as a way of moderating exchange rate fluctuations among the world’s major currencies
Most smaller countries still peg their currencies to one of the major currencies or to a basket of major currencies

39. Managed Float Major criticisms of flexible exchange rates
They are inflationary since they free monetary authorities to pursue expansionary policies
They have often been volatile, especially since the late 1970s
This volatility creates uncertainty and risks for importers and exporters and can lead to wrenching changes in the competitiveness of a country’s export sector