3. The World of International Finance
Today, the world currency markets are always open. When foreign exchange traders in New York City are sound asleep at 3:00 A.M., their counterparts in London are already on their phones and computers at 8:00 A.M.
Macroeconomics: Principles, Applications, and Tools O’Sullivan, Sheffrin, Perez 6/e.
P R E P A R E D B Y
FERNANDO QUIJANO, YVONN QUIJANO, AND XIAO XUAN XU

4. A P P L Y I N G T H E C O N C E P T S
Can the price of hamburgers around the world give us a clue to the proper value for exchange rates?
Big Macs and Purchasing Power Parity
What factors may allow the United States to continue running large trade deficits with the rest of the world?
World Savings and U.S. Current Account Deficits
How well has the new European central bank managed monetary policy?
Managing the Euro: The European Central Bank
What are the causes of financial collapses that occur throughout the globe?
The Argentine Financial Crisis 1 2 3 4

5. 19.1 What Are Exchange Rates? HOW EXCHANGE RATES ARE DETERMINED
The price at which currencies trade for one another in the market.
euro
The common currency in Europe.
An increase in the value of a currency relative to the currency of another nation is called an appreciation of a currency.
A decrease in the value of a currency relative to the currency of another nation is called a depreciation of a currency.

6. 19.1 How Demand and Supply Determine Exchange Rates
HOW EXCHANGE RATES ARE DETERMINED
19.1
How Demand and Supply Determine Exchange Rates
FIGURE 19.1 The Demand for and Supply of U.S. Dollars
Market equilibrium occurs where the demand for U.S. dollars equals the supply.

7. 19.1 Changes in Demand or Supply HOW EXCHANGE RATES ARE DETERMINED
FIGURE 19.2 Shifts in the Demand for U.S. Dollars
An increase in the demand for dollars will increase (appreciate) the dollar’s exchange rate. Higher U.S. interest rates or lower U.S. prices will increase the demand for dollars.

8. 19.1 Changes in Demand or Supply HOW EXCHANGE RATES ARE DETERMINED
FIGURE 19.3 Shifts in the Supply of U.S. Dollars
An increase in the supply of dollars will decrease (depreciate) the dollar exchange rate. Higher European interest rates or lower European prices will increase the supply of dollars.

9. 19.1 Changes in Demand or Supply HOW EXCHANGE RATES ARE DETERMINED
Let’s summarize the key facts about the foreign exchange market, using euros as our example:
1 The demand curve for dollars represents the demand for dollars in exchange for euros. The curve slopes downward. As the dollar depreciates, there will be an increase in the quantity of dollars demanded in exchange for euros.
2 The supply curve for dollars is the supply of dollars in exchange for euros. The curve slopes upward. As the dollar appreciates, there will be an increase in the quantity of dollars supplied in exchange for euros.
3 Increases in U.S. interest rates and decreases in U.S. prices will increase the demand for dollars, leading to an appreciation of the dollar.
4 Increases in European interest rates and decreases in European prices will increase the supply of dollars in exchange for euros, leading to a depreciation of the dollar.

10. 19.2 REAL EXCHANGE RATES AND PURCHASING POWER PARITY
R E A L - N O M I N A L P R I N C I P L E
What matters to people is the real value of money or income—its purchasing power—not the face value of money or income..
real exchange rate
The price of U.S. goods and services relative to foreign goods and services, expressed in a common currency.

11. 19.2 REAL EXCHANGE RATES AND PURCHASING POWER PARITY
FIGURE 19.4 Real Exchange Rate and Net Exports as Percent of GDP, 1980–2007
The figure shows the real exchange rate for the United States compared to its net exports as a share of GDP.
Notice that, in general, when the real (multilateral) exchange rate increased, U.S. net exports fell.

12. 19.2 REAL EXCHANGE RATES AND PURCHASING POWER PARITY law of one price
The theory that goods easily tradable across countries should sell at the same price expressed in a common currency.
purchasing power parity
A theory of exchange rates whereby a
unit of any given currency should be
able to buy the same quantity of
goods in all countries.

13. A P P L I C A T I O N 1
BIG MACS AND PURCHASING POWER PARITY
APPLYING THE CONCEPTS #1: Can the price of hamburgers around the world give us a clue to the proper value for exchange rates?
For several years, the Economist measured the price of a Big Mac throughout the world and checked to see whether the law of one price held. Table 19.1 contains the results for selected countries and the market-exchange rate predicted by the theory of purchasing power parity. To obtain the exchange rate, divide the price of Big Macs in the foreign country by the dollar price.
TABLE 19.1
BIG MAC PRICING AROUND THE WORLD VERSUS ACTUAL EXCHANGE RATES
Country
Price of a Big Mac in Local Currency
Price of a Big Mac in Dollars
Predicted Purchasing Power Exchange Rate Based on Big Mac Pricing (Foreign Currency per U.S. Dollar)
Actual Exchange Rate (Foreign Currency per U.S. Dollar)
United States
3.41 dollars
$3.41
____
United Kingdom
1.99 pounds
4.01
0.58
0.50
Hong Kong
12.0 HK dollars
1.54
3.52
7.82
Switzerland
6.30 Swiss francs
5.20
1.85
1.21
Mexico
29.0 pesos
2.69
8.50
10.80
Japan
250 yen
2.29
73.30
109.20

14. THE CURRENT ACCOUNT, THE FINANCIAL ACCOUNT, AND THE CAPITAL ACCOUNT
19.3
balance of payments
A system of accounts that measures
transactions of goods, services, income, and financial assets between domestic households, businesses, and governments and residents of the rest of the world during a specific time period.
current account
The sum of net exports (exports
minus imports) plus net income received
from abroad plus net transfers from
abroad.

15. THE CURRENT ACCOUNT, THE FINANCIAL ACCOUNT, AND THE CAPITAL ACCOUNT
19.3
financial account
The value of a country’s net sales
(sales minus purchases) of assets.
capital account
The value of capital transfer and
transaction in nonproduced,
nonfinancial assets in the
international accounts.

16. current account + financial account + capital account = 0
THE CURRENT ACCOUNT, THE FINANCIAL ACCOUNT, AND THE CAPITAL ACCOUNT
19.3
Rules for Calculating the Current, Financial, and Capital Accounts
Here is a simple rule for understanding transactions on the current, financial, and capital accounts: Any action that gives rise to a demand for foreign currency is a deficit item. Any action that gives rise to a supply of foreign currency is a surplus item.
The current, financial, and capital accounts of a country are linked by a very important relationship:
current account + financial account + capital account = 0

17. THE CURRENT ACCOUNT, THE FINANCIAL ACCOUNT, AND THE CAPITAL ACCOUNT
19.3
Rules for Calculating the Current, Financial, and Capital Accounts

18. THE CURRENT ACCOUNT, THE FINANCIAL ACCOUNT, AND THE CAPITAL ACCOUNT
19.3
Rules for Calculating the Current, Financial, and Capital Accounts
net international investment position Domestic holding of foreign assets minus foreign holdings of domestic assets.
sovereign investment fund Assets accumulated by foreign governments that are invested abroad.

19. A P P L I C A T I O N 2
WORLD SAVINGS AND U.S. CURRENT ACCOUNT DEFICITS
APPLYING THE CONCEPTS #2: What factors may allow the United States to continue running large trade deficits with the rest of the world?
The 2006 Economic Report of the President directly addressed whether the United States can continue to run large current account deficits and, of course, financial account surpluses. In the report, the government recognized that the current account deficits would eventually be reduced. However, it also highlighted a number of factors suggesting the deficits could continue for a long period of time.
For the United States to continue to run a current account deficit, other countries in the world need to continue to purchase U.S. assets.
In recent years, four major countries experienced circumstances that encouraged them to save by purchasing assets from abroad: Japan, Germany, Russia, and China.
For the United States to continue to run trade deficits in the future, these or other countries must want to continue to save more than they want to invest domestically.

20. 19.4 FIXED AND FLEXIBLE EXCHANGE RATES
To set the stage for understanding exchange rate systems, let’s recall what happens when a country’s exchange rate appreciates—increases in value. There are two distinct effects:
1 The increased value of the exchange rate makes imports less expensive for the residents of the country where the exchange rate appreciated.
2 The increased value of the exchange rate makes U.S. goods more expensive on world markets.

21. 19.4 Fixing the Exchange Rate FIXED AND FLEXIBLE EXCHANGE RATES
foreign exchange market intervention The purchase or sale of currencies by government to influence the market exchange rate.
FIGURE 19.5 Government Intervention to Raise the Price of the Dollar
To increase the price of dollars, the U.S. government sells euros in exchange for dollars.
This shifts the demand curve for dollars to the right.

22. 19.4 Fixed versus Flexible Exchange Rates
FIXED AND FLEXIBLE EXCHANGE RATES
19.4
Fixed versus Flexible Exchange Rates
FLEXIBLE EXCHANGE RATE SYSTEM
flexible exchange rate system A currency system in which exchange rates are determined by free markets.
FIXED EXCHANGE RATES
fixed exchange rate system A system in which governments peg exchange rates to prevent their currencies from fluctuating.

23. 19.4 Fixed versus Flexible Exchange Rates
FIXED AND FLEXIBLE EXCHANGE RATES
19.4
Fixed versus Flexible Exchange Rates
BALANCE OF PAYMENTS DEFICITS AND SURPLUSES
balance of payments deficit Under a fixed exchange rate system, a situation in which the supply of a country’s currency exceeds the demand for the currency at the current exchange rate.
balance of payments surplus Under a fixed exchange rate system, a situation in which the demand of a country’s currency exceeds the supply for the currency at the current exchange rate.
devaluation A decrease in the exchange rate to which a currency is pegged under a fixed exchange rate system.
revaluation An increase in the exchange rate to which a currency is pegged under a fixed exchange rate system.

24. 19.4 The U.S. Experience with Fixed and Flexible Exchange Rates
Fixed exchange rate systems provide benefits, but they require countries to maintain similar economic policies—especially to maintain similar inflation rates and interest rates.
Higher prices in the United States cause the U.S. real exchange rate to rise. This increase in the real exchange rate over time causes a trade deficit to emerge.
Exchange Rate Systems Today
The flexible exchange rate system has worked well enough since the breakdown of Bretton Woods.
Some economists believe that the world will eventually settle into three large currency blocs: the euro, the dollar, and the yen.

25. A P P L I C A T I O N 3
MANAGING THE EURO: THE EUROPEAN CENTRAL BANK
APPLYING THE CONCEPTS #3: How well has the new European central bank managed monetary policy?
The European Central Bank (ECB) was founded in 1998, one year before the euro was launched. The bank was charged with managing monetary policy—the money supply, interest rates, and the exchange rate.
Monetary policy at the ECB is set by six members of an executive board plus 13 heads of the euro-zones national banks. Inflation is their primary focus. Decisions are made by consensus.
How well has the ECB performed? In its early days, the ECB was viewed as somewhat clumsy at managing its communications, and the euro initially fell in value. But in recent years, its reputation has increased. The euro has appreciated against the U.S. dollar. The ECB also demonstrated considerable financial skill as it responded decisively to the global mortgage-related financial crisis in the summer of It had carefully prepared for a financial crisis several years in advance, and its actions to provide liquidity to banks even spurred the Fed to take similar steps to combat the crisis.
The ECB has now earned the respect of global financial market participants.

26. 19.5 MANAGING FINANCIAL CRISES
Hardly a year goes by without some international financial crisis.
Even when a country takes strong, institutional steps to peg its currency, a collapse is still possible.

27. A P P L I C A T I O N 4
THE ARGENTINE FINANCIAL CRISIS
APPLYING THE CONCEPTS #4: What are the causes of financial collapses that occur throughout the globe?
During the late 1980s, Argentina suffered from hyperinflation. As part of its financial reforms, it pegged its currency to the U.S. dollar, making pesos “convertible” into dollars. To issue pesos, the central bank had to have an equal amount of dollars, or its equivalent in other hard currencies, on hand. Some economists believed this reform would bring stability to the financial system. Unfortunately, they were proved wrong.
Several problems developed:
As the dollar appreciated, Argentina began to suffer from a large trade deficit.
Wage increases also pushed up the real exchange rate.
Argentina had to borrow extensively in dollar-denominated loans.
Eventually, Argentina was forced to default on its international debt in 2002 and freeze bank accounts. The hopes of the reforms in the early 1990s had become a bitter memory.

28. K E Y T E R M S balance of payments balance of payments deficit
balance of payments surplus
capital account
current account
devaluation
euro
exchange rate
financial account
fixed exchange rate system
flexible exchange rate system
foreign exchange market intervention
law of one price
net international investment position
purchasing power parity
real exchange rate
revaluation
sovereign investment funds