Exchange Rates, Balance of Payments, and International Debt

Exchange Rates, Balance of Payments, and International Debt
Chapter 32 Exchange Rates, Balance of Payments, and International Debt Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

Gottheil — Principles of Economics, 7e
Economic Principles Exchange rates Foreign exchange markets Appreciation and depreciation of currencies Floating and fixed exchange rates Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

The Foreign Exchange Market: The Buying and Selling of Currencies
A market in which currencies of different nations are bought and sold. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

1. Suppose that a kite costs 40 yaps, and the exchange rate is 10 yaps to the dollar. What is the dollar price of the kite? 40 yaps/10 = 4 dollars Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

Exhibit 1: Foreign Exchange Market
At $2 per yap, is the foreign exchange market in Exhibit 1 in equilibrium, or is there an excess demand or excess supply of yaps? Since the equilibrium price is $3 per yap, at $2 per yap there would be an excess demand for yaps. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

Exhibit 1: Foreign Exchange Market
At $4 per yap, is the foreign exchange market in Exhibit 1 in equilibrium, or is there an excess demand or excess supply of yaps? Since the equilibrium price is $3 per yap, at $4 per yap there would be an excess supply of yaps. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

2. Why is the demand curve for foreign currency downward-sloping? When the price of a foreign currency declines, the quantity of that foreign currency demanded increases. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

2. Why is the demand curve for foreign currency downward-sloping? For example, if a dollar can buy more yaps than before, then a dollar can also buy more yap-priced goods and services than before. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

2. Why is the demand curve for foreign currency downward-sloping? As a result, Americans wish to exchange dollars for more yaps in order to buy more yap-priced goods, increasing the quantity of yaps demanded in the foreign exchange market. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

3. Why is the supply curve for foreign currency upward-sloping? When the price of a foreign currency rises, then the purchasing power of the foreign currency rises when it comes to buying imported goods and services. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

3. Why is the supply curve for foreign currency upward-sloping? For example, if it takes more dollars to buy a yap, then it takes fewer yaps to buy a dollar, and so the price of American goods are cheaper for people who use the yap. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

3. Why is the supply curve for foreign currency upward-sloping? As a result, people who use yaps wish to exchange more yaps for dollars in order to buy more American goods, increasing the quantity of yaps supplied in the foreign exchange market. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

4. Which of the following will cause an increase in the demand for yaps? a. Decreasing American incomes b. Increasing yap-priced interest rates c. Increasing American interest rates Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

Exhibit 2: Effect of an Increase in the Demand for Yaps on the Dollars-for-Yaps Rate of Exchange 1. After the increase in demand from D1 to D2, Is there excess supply, excess demand, or equilibrium at an exchange rate of $3 per yap? There is excess demand of (70 – 30) = 4,000 yaps. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

Exhibit 2: Effect of an Increase in the Demand for Yaps on the Dollars-for-Yaps Rate of Exchange 2. After the increase in demand from D1 to D2, what is the new equilibrium exchange rate? The new equilibrium exchange rate is $5 per yap. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

5. Which of the following will cause a decrease in the supply of yaps? a. Decreasing American tastes for yap-priced goods b. Decreasing yap-priced interest rates c. Decreasing yap-priced incomes Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

5. Which of the following will cause a decrease in the supply of yaps? a. Decreasing American tastes for yap-priced goods. b. Decreasing yap-priced interest rates. c. Decreasing yap-priced incomes. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

Exhibit 3: Effect of an Increase in the Supply of Yaps on the Dollars-for-Yaps Rate of Exchange 1. After the increase in supply from S1 to S2, is there excess supply, excess demand, or equilibrium at an exchange rate of $3 per yap? There is an excess supply of (50 – 30) = 20,000 yaps. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

Exhibit 3: Effect of an Increase in the Supply of Yaps on the Dollars-for-Yaps Rate of Exchange 2. After the increase in supply from S1 to S2, what is the new equilibrium exchange rate? The new equilibrium exchange rate is $2 per yap. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

Floating Exchange Rates
An exchange rate determined strictly by the demands and supplies for a nation’s currency. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

2. If the dollar has appreciated in value relative to the yap, then which of the following is true: a. The exchange rate has more yaps per dollar than before. b. The exchange rate has fewer yaps per dollar than before. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

Tourists at the Mall Has the U.S. dollar appreciated or depreciated in value relative to the Japanese yen between 1960 and 1996? Depreciated in value Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

Tourists at the Mall Has the U.S. dollar appreciated or depreciated in value relative to the Japanese yen between 1960 and 1996? In 1960 the exchange rate was 358 yen per dollar. By 1996 there were only 131 yen per dollar. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

3. How might floating exchange rates make international trade riskier? Suppose that the price of an internationally traded good changes during the time between when a purchase is negotiated and the product is delivered. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

Exhibit 4: Trade under Free and Fixed Exchange Rates
2. If there is a system of fixed exchange rates, then what happens if the demand for a foreign currency increases? Since the exchange rate cannot change, an increase in demand will create excess demand for the foreign currency. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

3. If there is excess demand for yaps under a system of fixed exchange rates, what will the yap government need to do to eliminate the excess demand for the yap? The yap government will need to exchange some of its own yaps for dollars on the foreign exchange market. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

3. If there is excess demand for yaps under a system of fixed exchange rates, what will the yap government need to do to eliminate the excess demand for the yap? This will increase the supply of yaps on the foreign exchange market and eliminate the excess demand. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

3. If there is excess demand for yaps under a system of fixed exchange rates, what will the yap government need to do to eliminate the excess demand for the yap? In order for the yap government to do this, it must have sufficient stock of yaps to exchange for dollars. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

Exhibit 4: Trade Under Free and Fixed Exchange Rates
4. Continuing the yap example, what might the yap government be forced to do if it did not have a sufficient quantity of yaps on reserve to eliminate the excess demand? The yap government might be forced to borrow yaps from another country, or even agree to increase the exchange rate ($ per yap). Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

Devaluation Government policy that lowers the nation’s exchange rate; its currency instantly is worth less in the foreign exchange market. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

4. In which of the following would a country most likely be forced into a devaluation of its currency: a. The excess supply of its currency in the foreign exchange market exceeds its foreign exchange reserves. b. The excess demand for its currency in the foreign exchange market exceeds its foreign exchange reserves. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

Exchange controls A system in which government, as the sole depository of foreign currencies, exercises complete control over how these currencies can be used. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

International Monetary Fund (IMF) An international organization formed to make loans of foreign currencies to countries facing balance of payments problems. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

Balance of Payments Balance on current account A category that itemizes a nation’s imports and exports of goods and services, income receipts and payments on investment, and unilateral transfers. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

EXHIBIT 5 THE U.S. BALANCE OF PAYMENTS ACCOUNT: ($ billions) Source: Survey of Current Business (Washington, D.C.: U.S. Department of Commerce, June 2011). Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

Exhibit 5: The U.S. Balance of Payments Account: 2010
In which of the following categories of the U.S. balance of payments did the U.S. run a surplus in 2010? a. Balance of trade b. Balance on current account c. Balance on capital account Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

Exhibit 6: U.S. Balance of Trade: 1960–2007
Until the mid-1990s, the balance deficit was often less than $100 billion. Note the sharp plunge in the balance of trade from the late 1990s through to 2007, reaching $819 billion by 2007. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

Exhibit 6: U.S. Balance of Trade: 1960–2007
That said, what has been the overall trend in the U.S. balance of trade since the mid-1970s? Since the mid-1970s, the U.S. balance of trade has been in deficit. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

Balance of Payments What is an example of an export of services? When a U.S. engineering firm provides engineering design services for a project in another country. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

Balance of Payments Unilateral transfers Transfers of currency made by individuals, businesses, or government of one nation to individuals, businesses, or governments in other nations, with no designated return. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

Balance of Payments Balance on capital account A category that itemizes changes in the foreign asset holdings of a nation and that nation’s asset holdings abroad. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

What is a Balance of Payments Problem?
Do trade imbalances always create problems? No. For example, a country may have a balance of trade deficit because it is importing capital equipment necessary for it to produce valuable exports in the future. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

How Deficits on Current Account Develop
If foreigners make huge investments in U.S. stocks and bonds, how might this affect the current account? Foreign purchases of U.S. stocks and bonds increases the demand for U.S. dollars. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

If foreigners make huge investments in U.S. stocks and bonds, how might this affect the current account? Increased demand for the U.S. dollar increases the value of the dollar relative to other currencies. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

If foreigners make huge investments in U.S. stocks and bonds, how might this affect the current account? A high-valued dollar makes imports cheap for Americans, but makes American exports expensive for foreigners in other countries. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

If foreigners make huge investments in U.S. stocks and bonds, how might this affect the current account? Consequently imports increase and exports decline, causing a current account deficit. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

International Debt International debt The total amount of outstanding IOUs a nation is obligated to repay other nations and international organizations. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

Exhibit 7: Debt Service of Selected Countries, as a Percentage of Exports: 2010 What causes countries such as Angola to have such high debt service as a percentage of their exports? The amount of international debt held by these countries is quite large relative to the value of their exports, making repayment difficult. Gottheil — Principles of Economics, 7e © 2013 Cengage Learning

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