1. International Trade and Foreign Exchange Markets
I. The Balance of Payments – The sum of all the transactions that take place between a country and foreign countries. For our purposes, they are recorded in two accounts:
A. The Current Account - the sum of a country’s exports (+) and imports (-).
1. Goods
2. Services
3. Investment income
4. Net transfers.

2. International Trade and Foreign Exchange Markets
B. The Financial Account (used to be Capital Account) – Purchase or sale of assets from and to foreigners.
1. Foreigners buy U.S. assets (+)
2. U.S. citizen buys foreign assets (-)
3. Real assets
a. Factories
b. Office buildings
c. etc.
4. Financial assets
a. Government bonds
b. Corporate bonds
c. Stocks
d. etc.

3. International Trade and Foreign Exchange Markets
C. The current account and the financial account must always balance.
1. There is some discrepancy about this. Different textbooks say different things.
2. Your textbook includes a separate “official reserves account,” but this seems to have disappeared in recent texts and on the AP exam. It has become part of the financial account (which your book calls the capital account).
3. Suffice it to say: Any credit in the current account must be matched by a debit in the financial account and vice versa.

5. International Trade and Foreign Exchange Markets
Problem Set #1:
Which of these is a current account transaction?
(A) India buys $10 billion of new U.S. treasury bonds.
(B) A U.S. firm buys 5% of the stock of another US. Firm.
(C) A U.S. firm builds a new factory in Kenya.
(D) A U.S. firm sells $500 million worth of candles to an Australian importer.
(E) The U.S. buys $8 billion worth of euros.

6. International Trade and Foreign Exchange Markets
Problem Set #2:
What does it mean to say that a country has a current account deficit?
If a country does have a current account deficit, what must be true of its financial account (née capital account)?

7. International Trade and Foreign Exchange Markets
II. Foreign Currency exchange rates and the foreign currency market.
A. To buy imports, you need the currency of the country your importing from. For example, when Best Buy imports Korean televisions, it needs won, not dollars.
B. To do so, Best Buy would buy Korean won on the foreign exchange market (from a bank or currency dealer).
C. Foreign exchange rates are flexible, meaning the value of one currency against another can fluctuate.
D. The price of a foreign currency is set by supply and demand in the foreign exchange market, just like anything else.

8. International Trade and Foreign Exchange Markets
E. So what determines the value of one currency versus another? Supply and demand. If demand for a nation’s currency increases, the currency will appreciate. If demand decreases, the currency will depreciate.
appreciate – When a currency goes up in value.
depreciate – When a currency goes down in value.

9. Flexible Exchange Rates
The Market for Foreign Currency
(Pounds) Q
Dollar Price of 1 Pound
Quantity of Pounds P S1
Exchange
Rate: $2 = £1
(Dollar/Euro) $2 $3 $1 Q1
Dollar
Depreciates
(Pound
Appreciates)
Dollar
Appreciates
(Pound
Depreciates)
The demand for pounds is downward sloping, meaning that as the pound becomes less expensive in terms of dollars, more British goods and services will be purchased since they will be cheaper. The supply for pounds curve is upsloping because the British will purchase more U.S. goods when the dollar price of pounds rises. When that happens, the British will buy more U.S. goods and services because they will become less expensive. D1
LO3
38-9

10. 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
There are many factors that can cause a nation’s currency to appreciate or depreciate but the basic laws of supply-demand apply. If the demand for a nation’s currency increases, that nation’s currency will appreciate and vice versa if the demand drops. If the supply of currency increases, it will depreciate and if one country’s currency appreciates, some other country’s currency will depreciate relative to it. So, what causes supply or demand to shift? Any change in consumer’s tastes will, of course, cause the demand for the currency to change. The change in income relative to the income in other nations will also shift demand, as will relative inflation rate changes. Under the purchasing-power-parity theory, exchange rates should eventually adjust such that they equate the purchasing power of various currencies. Many people use the “Big Mac” example. Since McDonald’s is located in almost every country, we can look at how much a Big Mac costs in each nation and then convert that to an exchange rate. Inflation can skew the numbers if one nation’s rate is different than the other’s. Interest rates and expected returns on assets can also affect demand if their relative rates are different between the nations. Another factor is speculation. Speculators are people who buy and sell currency solely to make money in the classic “buy low, sell high” process. These speculators can cause shifts in supply and demand.
LO3
38-10

11. 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
(Dollar/Euro) $2 $3 $1 a x b D2
Exchange
Rate:
$2 = £1
Under flexible exchange rates, a shift in the demand for pounds, all other things equal, would cause a U.S. balance of payments deficit. This deficit would be corrected by a change in the exchange rate. Under fixed exchange rates, the US would have to cover the shortage by selling official reserves, restricting trade, implementing exchange controls, or enacting a contractionary stabilization policy. D1 Q1 Q2
LO3
38-11

12. International Trade and Foreign Exchange Markets
Problem Set #3:
If interest rates in the U.S. increase compared to those in Mexico, how will that affect Mexican investment in the U.S.?
(b) How will your answer to part (a) affect the demand for dollars in the foreign exchange market? Draw a diagram below.
Peso/U.S. dollar
Quantity of U.S. dollars

13. International Trade and Foreign Exchange Markets
Problem Set #3:
(c) How will your answer to part (b) affect the supply of pesos in the foreign exchange market? Draw a diagram below? What will happen to the dollar price of pesos? Show this on your diagram.

14. International Trade and Foreign Exchange Markets
Problem Set #4:
Assume the real interest rate in Canada increases relative to the real interest rate in the U.S. Draw a graph of the value of the Canadian dollar in terms of the U.S. dollar that demonstrates this change.
Quantity of Canadian dollars
/Canadian Dollars
U.S. dollars

15. International Trade and Foreign Exchange Markets
Problem Set #4:
(b) Given your answer to part (a), what will happen to the level of Canadian exports? Explain.
- Canadian exports will decrease because the appreciation of the Canadian dollar makes Canadian products more expensive for American consumers.

16. International Trade and Foreign Exchange Markets
Problem Set #4:
(c) Will there be an inflow or an outflow of capital into Canada as a result of the change in interest rates in part (a)? Explain.
- There will be an inflow of capital into Canada because the higher relative interest rate in Canada will attract foreign investment.

17. International Trade and Foreign Exchange Markets
Problem Set #4:
(d) Allright, now let’s put it all together. Reconcile the Canadian balance of payments as a result of these changes? (How will it balance?)
- The current account will be in deficit due to decreased exports, but the financial (ne’e capital) account will be in surplus due to greater foreign investment in Canada. This will balance Canada’s balance of payments.

18. International Trade and Foreign Exchange Markets
Problem Set #5:
Assume there is an increase in investment demand in the U.S.
(a) What will happen to the real interest rate?
(b) What will happen to the capital stock?
(c) What will happen to the international value of the dollar?

19. International Trade and Foreign Exchange Markets
Problem Set #5:
Assume there is an increase in investment demand in the U.S.
(d) Choose a graph to demonstrate your answers to parts (a) and (c) (one graph for each part: 2 graphs total)
(a)
(c)

20. International Trade and Foreign Exchange Markets
Problem Set #6:
If the inflation rate in Kerseyland is much higher than that of its neighbors, what will be the effect on
(a) The demand for its products?
(b) The value of its currency?

21. International Trade and Foreign Exchange Markets
Problem Set #7:
If the dollar appreciates compared to the rest of the world’s currencies, what will be the effect on
(a) The volume of U.S. exports? Explain.
U.S. exports will decrease because the appreciation of the dollar makes U.S. products more expensive to foreigners.
(b) The volume of U.S. imports? Explain.
U.S. imports will increase because the dollar will have more purchasing power in foreign countries due to the increase in its value compared to foreign currencies.

22. International Trade and Foreign Exchange Markets
Problem Set #8:
Assume a French company buys computers from a U.S. firm. Draw side by side graphs of the dollar and the Euro on the Foreign Exchange market. Demonstrate the effect of this transactions on both currencies.

23. FRQ #1
1. Japan, the European Union, Canada, and Mexico have flexible exchange rates.
(a) Suppose the real interest rate in Canada increases relative to that in Mexico.
(i) Using a correctly labeled graph of the foreign exchange market for the Canadian dollar, show the effect of the change in real interest rate in Canada on the international value of the Canadian dollar (expressed as Mexican pesos per Canadian dollar).

24. FRQ #1
1. Japan, the European Union, Canada, and Mexico have flexible exchange rates.
(ii) How will the change in the international value of the Canadian dollar that you identified in part (a)(i) affect Canadian exports to Mexico? Explain.
Canadian exports to Mexico will decrease because the appreciation of the Canadian dollar makes Canadian products more expensive for Mexican consumers.

25. FRQ #1
1. Japan, the European Union, Canada, and Mexico have flexible exchange rates.
(b) Suppose Japan attracts an increased amount of investment from the European Union.
(i) Using a correctly labeled graph of the loanable funds market in Japan, show the effect of the increase in foreign investment on the real interest rate in Japan.

26. FRQ #1
1. Japan, the European Union, Canada, and Mexico have flexible exchange rates.
(b) Suppose Japan attracts an increased amount of investment from the European Union.
(ii) How will the real interest rate change in Japan that you identified in part (b)(i) affect the employment level in Japan in the short run? Explain.
Lower real interest rates in Japan will lead to increased investment* spending, which will increase aggregate demand and output, leading to an increase in the employment level.
*Note on AP scoring guidelines, I’m seeing the term “interest-sensitive spending” a lot. I think you would get credit for “investment spending,” but if you can remember, use “interest-sensitive.” It includes consumer spending financed by loans.

27. FRQ #2
1. Assume that yesterday the exchange rate between the euro and the Singaporean dollar was 1 euro = 0.58 Singaporean dollars. Assume that today the euro is trading at 1 euro = 0.60 Singaporean dollars.
(a) How will the change in the exchange rate affect each of the following in Singapore in the short run?
(i) Aggregate demand. Explain.
Aggregate demand will increase because the depreciation of the Singaporean dollar makes Singapore’s exports less expensive in Europe. Therefore, net exports will increase in Singapore, increasing aggregate demand.

28. FRQ #2
1. Assume that yesterday the exchange rate between the euro and the Singaporean dollar was 1 euro = 0.58 Singaporean dollars. Assume that today the euro is trading at 1 euro = 0.60 Singaporean dollars.
(a) How will the change in the exchange rate affect each of the following in Singapore in the short run?
(ii) The level of employment. Explain.
Employment in Singapore will increase because the increased aggregate demand will lead to greater output, requiring greater employment.

29. FRQ #2
(b) Suppose that Singapore wants to return the exchange rate to 1 euro = 0.58 Singaporean dollars.
(i) Should the Singaporean central bank buy or sell euros in the foreign exchange market?
This Singaporean central bank should sell euros. (This will increase the supply of euros on the foreign exchange market, lowering the price of euros in terms of Singaporean dollars.) (Or it will increase the demand for Singaporean dollars.)

30. FRQ #2
1. Assume that yesterday the exchange rate between the euro and the Singaporean dollar was 1 euro = 0.58 Singaporean dollars. Assume that today the euro is trading at 1 euro = 0.60 Singaporean dollars.
(b) Suppose that Singapore wants to return the exchange rate to 1 euro = 0.58 Singaporean dollars.
(ii) Instead of buying or selling euros, what domestic open-market operation can the Singaporean central bank use to achieve the same result? Explain.
The Singaporean central bank could sell government securities (bonds). This will raise interest rates in Singapore, attracting foreign investment to Singapore and raising demand for Singaporean dollars.

31. U.S. Dollar S1
Euros/dollar e2 e1 D2 D
Quantity of US dollars

32. Euros/Singaporean dollar
Quantity of Singaporean dollars

33. Singaporea dollar/euro
Quantity of euros

34. Euro S1 S2
Dollars/euro e1 e2 D
Quantity of euros

35. Loanable Funds SLF1 Real Interest Rate r2 r1 DLF2 DLF1
DLF1
Quantity of Loanable Funds
SLF1 r1 r2
QLF1
QLF2
DLF2