1. Exchange Rates, The Balance of Payments, and Trade Deficits
Chapter 38

2. Money Market Graph
If the supply of money decreases interest rates increase
This causes a chain reaction
i↑=
foreign investors buy USA bonds and assets↑=
D$↑=
$ appreciates=
X↓, M↑=
AD↓=
RGDP↓, PL↓
Interest Rate M2 M1
10% 5% Dm
Quantity of Money

3. Interest Rate’s affect on Trade
foreign investors buy USA bonds and assets↑=
D$↑ (demand for $)
because foreigners need US$ to buy bonds
$ appreciates
because the exchange rate will increase
X↓ (exports), M↑ (surplus of $)
We will not be able to sell goods over seas because the dollar is more expensive so X decrease. Since the dollar is more expensive, we too will buy stuff from places with cheaper currencies
AD↓
Because we are buying more than we are selling (Xn)
RGDP↓, PL↓ (price level)

4. Interest Rate’s affect on Trade
QUS$
SUS$
DUS$
ERe
ER1 Qe Q1
DUS$1
Exchange Rate (ER)
(Foreign Currency price per dollar) M2
Interest Rate M1
10% 5% Dm
Quantity of Money
**The increase in the interest rate causes in increase in demand for the U.S. dollar

5. Interest Rate’s affect on Trade
QUS$
SUS$
DUS$
ERe
ER1 Qe Q1
DUS$1
Exchange Rate (ER)
(Dollar price per foreign currency) AS PL
PLe
PL1 AD
AD2 Y1 Ye
RGDP
When the dollar appreciates it causes exports (and AD) to decrease and therefore RGDP decreases which drops PL too

6. Financing International Trade
Best Buy wants to buy $1 million of Sony TVs
Japan, who produces the TVs, wants to be paid in Yen—how does Best Buy pay them?
Best Buy will have to purchase Yen from a foreign exchange market (these markets are found in larger cities or areas with large tourism populations)
Once completed they can purchase the TVs using Yen

7. Current exchange rates are:
Money that is MORE valuable than the U.S. Dollar
Money that is LESS valuable than the U.S. Dollar
British Pound (£)= $1.42
Euro (€)= $1.23
Swiss Franc = $1.02
Canadian Dollar (C$) = $0.79 Chinese Yuan (¥) = $0.16
Australian Dollar (AUD$) = $0.77
Mexican Peso ($) = $0.054
Japanese Yen (¥) = $
($1 = Yen)
As of Apr 26, 2018

8. And the worst is…
1 Vietnamese Dong (đ) = $

9. Financing International Trade
Let’s look at the example again…
Best Buy wants to buy $1,000,000 worth of product from Japan’s Sony division
How many Yen will it take to make the purchase?
$1,000,000 = 1,093,200,000 Yen

10. Financing International Trade
Business transactions are not the only reason that currencies need to be exchanged
Vacations
Purchasing stocks/investments
Loan payments

11. Flexible Exchange Rates
There are two types of exchange rates:
Flexible (floating): demand and supply of currency determines the exchange rate (no government involvement)
Fixed: government sets the exchange rate and makes changes to the economy to insure those rates stay accurate/consistent

12. Flexible Exchange Rates
The exchange rate would be wherever the supply curve intersects the demand curve
Here it would be $1.57 dollars = 1 £
When using the Flexible Exchange Rate system the price is subject to change based on the demand or supply of the product
Dollar price per £
Quantity of £
$1.57
S £
D £
$4.00
$0.25 Qe

13. Flexible Exchange Rates
Exchange Rate (ER)
(Dollar price per £)
Quantity of £
$1.57
S £
D £
$4.00
$0.25 Qe
What could cause the supply or demand of a currency to change?
Change in taste: British tea declines in popularity in the US
What happens to the British Pound? U.S. dollar?
It now takes less U.S. dollar to purchase a British pound
Dollar appreciates, Pound depreciates
$0.90
D £2 Q2

14. Flexible Exchange Rates
Exchange Rate (ER)
(Dollar price per £)
Quantity of £
$1.57
S £
D £
$4.00
$0.25 Qe
If ER goes down then
Dollar appreciates, Pound depreciates
If ER goes up
Dollar depreciates, Pound appreciates
$0.90
D £2 Q2

15. Pitfalls of Flexible Exchange Rates
Uncertainty and Diminished Trade
Because you don’t know what is going to happen, you might be discouraged to engage in trade
Terms-of-Trade Changes
An increase in the dollar price per British pound could mean that the US has to export more to get the same amount of pounds
Instability
Wild fluctuations can depress industries and cause a nightmare for making decisions with fiscal and monetary policy

16. Fixed Exchange Rates
In a fixed system two countries agree on a fixed rate between them
Britain and the US agree that the ration will be 2 US dollars = 1 British pound
Problem: What if demand for the pound goes up?
If demand goes up (meaning the pound should be more valuable) but the price doesn’t change a SHORTAGE of British pound will occur

17. Fixed Exchange Rates How do you adjust for this scenario?
There are 4 possible solutions:
Use of Reserves—if you need to meet the demand without changing the price, take some of the money that was in reserve (not in circulation) and put it in circulation
Trade Policies—If the US is facing a shortage of British pound they can discourage imports from Britain (in other words, put a tariff on British goods to prevent trade)

18. Fixed Exchange Rates Other techniques for controlling shortages:
Exchange controls and rationing—the US government could require that all pounds being brought into circulation in the US have to go through the Federal Government first. Therefore, we can control how much is allowed in the nation
There are 4 issues that come with this option

19. Fixed Exchange Rates Four objections to exchange controls:
Distorted trade—would disrupt the natural flow of trade and thus interrupt comparative advantage
Favoritism—in other words, nations who support certain candidates could get “favored nation” status
Restricted choice—Freedom of choice would be limited since the government is blocking access to certain goods/countries
Black markets—duh…

20. Fixed Exchange Rates A final attempt to deal with concerns is:
Domestic macroeconomic adjustments
In other words use monetary and fiscal policy to adjust the inflation value of your money

21. Monetary Exchange Video

22. Balance of Payments
A balance of payments is the sum of all transactions that take place between its residents and foreigners
This balance sheet is divided into three categories:
Current Account—U.S. trade in currently produced goods/services
Capital Account—purchase/sell of assets (stocks, factories, equipment)
Official Reserves Account—The nation’s stock of foreign currencies that are held in the Federal Reserve system

23. 2010 Balance of Payments Goods and services exported = $1.837T
Goods and services imported = $2.337T
Balance on goods/services = - $ 500B
Capital accounts transaction = -$152M
Official Reserves Account
US owned assets in foreign countries are the same as imports when balancing the books (a hotel in Japan owned by an American)
Likewise foreign owned assets in the US are considered exports (a Canadian owning a business in the US)

24. 2010 Balance of Payments US owned assets abroad = -$1.005T
Foreign owned assets in US = $1.246T
Official Reserves Balance = $241B
Balance on goods/services = -$ 500B
Capital accounts transaction = -$152M
Official Reserves Balance = $241B
Basic Balance of Payments = -$499B
All BOPs have to equal $0 so how does this $499B turn into $0 (where does the money come from)?

25. And now…a video