1. TCO 9 Given a market for a specific currency, a specified exchange-rate system, a time horizon, and a change in one of the determinants of exchange rates, determine the effects of the change on the value of the currency and the country’s balance of payments. Explain how exchange rates make international trade in products and services possible. Explain the short, medium, and long-term factors determining exchange rates. Apply exchange rate principles to a supply and demand framework to illustrate the equilibrium exchange rate and the balance of payments. Interpret the meaning of differences between published exchange rates and the Economist magazine’s “Big Mac” index (optionally raising the issue of “quality of life”). Describe the difference between U.S. dependence on foreign oil to its dependence on foreign labor. Predict the long-term impact on U.S. wages of China joining the WTO.

2. The Mechanics of International Finance International trade and finance are an extension of our nation’s economic activities beyond our borders The balance of payments includes the “balance of trade” which has been negative since the mid- 1970s along with investment income, transfers of funds abroad, and capital inflows and outflows

3. The Balance of Payments The entire flow of U.S. dollars and foreign currencies into and out of the country constitutes the balance of payments The balance of payments has two parts –The current account – a summary of all the goods and services produced during the current year that we buy from or sell to foreigners –The capital account – records the long-term transactions that we conduct with foreigners –The total of both accounts will always be zero

4. What Does It Matter? We buy much more from foreigners than they buy form us –In effect, they lend or give us the money to make up the difference between our imports and our exports –We are essentially selling them a piece of the (American) rock consisting of corporate stock, real estate, corporate and government bonds and other debt instruments –Should this continue for another three or four decades, foreign investors will own most of America

5. Exchange Rate Systems The basis for international finance is the exchange of well over 100 national currencies A exchange rate is the price of a country’s currency in terms of another currency

6. Deterioration of the U.S. Balance of Payments The U.S. balances of payments deteriorated badly in the 50s and 60s. Reasons were –Renewed foreign competition after the war –Military and foreign aid spending –Increasing private investment abroad –Inflation –Oil price shocks –Productivity

7. The Freely Floating Exchange Rate System, 1973 to the Present The forces of supply and demand now set the exchange rates

8. The demand curve for marks represents the desire of Americans to exchange their dollars for marks –Americans would want marks to buy German goods and services, stocks, bonds, real estate, and other assets –Likewise, the supply curve of marks represents the desire of German citizens to purchase American goods, services, and financial assets We don’t have completely free floating exchange rates because governments do intervene, usually for a limited time The Free Floating Exchange Rate System, 1973 to the Present

9. The relative price levels between the two countries The relative growth of the two countries economies The relative level of interest rates in the two countries Factors Influencing Exchange Rates

10. How Well Do Freely Floating Exchange Rates Work? Until 1973 most countries had fixed exchange rates because they feared flexible rates would fluctuate wildly While there has certainly been some ups and downs, most notably with the dollar, we can still say so far so good While far from perfect, this may be the best system we have known

11. The Euro On January 1, 1999, most of Western Europe introduced a single currency, the euro –What the members of the euro area are doing is attempting to move toward a unified market with a single currency, just like the one we’ve long enjoyed in the United States –The euro was worth $1.17 in the beginning but now is in the $1.10 to $1.15 range

12. The Euro As the dollar has fallen in value, the euro has been replacing it as an international currency If the dollar continues to decline, the euro, and perhaps the Chinese yuan, will become more important players on the international financial stage

13. Hypothetical Supply and Demand for Dollars Relative to the Yen If the supply of dollars outside the United States were to go up, while the demand for dollars went down, what would happen to the price of the dollar relative to the yen? It would go down, in this case, from 100 yen to 80 yen

14. Running up a Tab in the Global Economy What should be pretty clear by now is that, as a nation, we have been living well beyond our means for more than 20 years It also should be clear that the party can’t last forever The United States quickly shifted from being the world’s largest creditor nation (which is good) to the largest debtor nation (which is not so good) What happened?

15. From Largest Creditor to Largest Debtor During the second half of the 19 th century our country was a classic debtor nation –We imported manufactured goods –We exported agricultural goods –We borrowed capital in order to industrialize On the eve of World War I with the process of industrialization largely completed (and during the war) we finally became the world’s leading creditor nation This position has now been turned around The United States is now the world’s largest debtor nation

16. From Largest Creditor to Largest Debtor How did we go from the largest creditor nation to the largest debtor so quickly? –The main reason is the mounting trade deficits –We continue to station hundreds of thousands of troops abroad and extend billions of dollars in military aid each year –The interest, rent, dividends, and profits we pay foreigners continues to grow as our debt mounts –As foreigners continue accumulating dollars they use them to buy up our assets

17. Living Beyond Our Means The U.S. Treasury depends on foreign savers to finance the deficit We are borrowing to pay for a massive spending spree and a war, not to finance capital expansion We are living for today and not worrying about tomorrow We are a nation of consumption junkies We are selling off the rock piece by piece –It seems as though everyone – the British, the Japanese, the Dutch, the Canadians, the Germans – owns a piece of the rock

18. Why We Need to Worry about the Current Account Deficit The Current Account Deficit is very high and will probably keep growing in the foreseeable future Foreigners will eventually stop accepting U.S. dollars The bottom line is we can bring our current account deficit under control or we can pay the consequences a few years from now