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The Balance of Payments, Exchange Rates, and Trade Deficits

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1 The Balance of Payments, Exchange Rates, and Trade Deficits
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

2 International Transactions
International trade Buy/sell current goods or services Imports and exports International asset transactions Buy/sell real or financial assets Buy stock Sell your house to a foreigner Requires currency exchange LO1 38-2

3 Sum of international financial transactions Current account
Balance of Payments Sum of international financial transactions Current account Balance on goods and services Net investment income Net transfers Balance on current account LO2 38-3

4 Capital and financial account Capital account Financial account
Balance of Payments Capital and financial account Capital account Financial account Balance of payments accounts sum to zero Current account deficits generate asset transfers to foreigners Official reserves LO2 38-4

5 Balance of Payments LO2 38-5

6 Foreign currencies, certain reserves with the IMF, and stocks of gold
Official Reserves Foreign currencies, certain reserves with the IMF, and stocks of gold Owned by government or central bank Used as balancing mechanism in balance of payments LO2 38-6

7 Flexible Exchange Rates
Demand for pounds Supply of pounds Market equilibrium Increase in dollar price of pounds Dollar depreciates Pound appreciates Decrease in dollar price of pounds Dollar appreciates Pound depreciates LO3 38-7

8 Flexible Exchange Rates
The Market for Foreign Currency (Pounds) Q Dollar Price of 1 Pound Quantity of Pounds P S1 Exchange Rate: $2 = £1 $2 $3 $1 Q1 Dollar Depreciates (Pound Appreciates) Dollar Appreciates (Pound Depreciates) D1 LO3 38-8

9 Flexible Exchange Rates
Determinants of exchange rates Factors that shift demand/supply Changes in tastes Relative income changes Relative price-level changes Purchasing-power-parity theory Relative interest rates Relative expected returns on assets Speculation LO3 38-9

10 Flexible Exchange Rates
The Market for Foreign Currency (Pounds) Q Dollar Price of 1 Pound Quantity of Pounds P S1 Exchange Rate: $3 = £1 c $2 $3 $1 Balance Of Payments Deficit a x b D2 Exchange Rate: $2 = £1 D1 Q1 Q2 LO3 38-10

11 Flexible Exchange Rates
Eliminate balance of payments deficit or surplus Disadvantages of flexible exchange rates Volatility Uncertainty and diminished trade Terms-of-trade changes Instability LO4 38-11

12 Government intervention Use of reserves Trade policies
Fixed Exchange Rates Government intervention Use of reserves Trade policies Exchange controls and rationing Distorted trade Favoritism Restricted choice Black markets Macroeconomic adjustments LO4 38-12

13 Fixed exchange rate system Bretton Woods: 1944-1971
The Managed Float Gold standard: Fixed exchange rate system Bretton Woods: Fixed exchange rate system indirectly tied to gold Managed float: 1971-present LO4 38-13

14 Dependence on foreign exchange markets Occasional intervention
The Managed Float Dependence on foreign exchange markets Occasional intervention In support of managed float Concerns with managed float LO4 38-14

15 Causes of trade deficits High U.S. growth (relatively) China
U.S. Trade Deficit Large and persistent Causes of trade deficits High U.S. growth (relatively) China Price of oil Low U.S. saving rate Implications of trade deficits Increased current consumption Increased indebtedness LO5 38-15

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