2. 38 - 1 Copyright McGraw-Hill/Irwin, 2002 U.S. Export Transaction U.S. Import Transaction Balance of Payments Flexible Exchange Rates The Market for Currency Determinants of Exchange Rates Fixed Exchange Rates Exchange Controls and Rationing International Exchange Rate Systems Recent U.S. Trade Deficits Key Terms Previous Slide Next Slide End Show EXCHANGE RATES, THE BALANCE OF PAYMENTS, AND TRADE DEFICITS 21 C H A P T E R

3. 38 - 2 Copyright McGraw-Hill/Irwin, 2002 U.S. Export Transaction U.S. Import Transaction Balance of Payments Flexible Exchange Rates The Market for Currency Determinants of Exchange Rates Fixed Exchange Rates Exchange Controls and Rationing International Exchange Rate Systems Recent U.S. Trade Deficits Key Terms Previous Slide Next Slide End Show U.S. EXPORT TRANSACTION Assume $2 = £1 $300,000 in American computers purchased by a British buyer for £150,000 £150,000 check is exchanged for $300,000 at a New York bank  

4. 38 - 3 Copyright McGraw-Hill/Irwin, 2002 U.S. Export Transaction U.S. Import Transaction Balance of Payments Flexible Exchange Rates The Market for Currency Determinants of Exchange Rates Fixed Exchange Rates Exchange Controls and Rationing International Exchange Rate Systems Recent U.S. Trade Deficits Key Terms Previous Slide Next Slide End Show U.S. IMPORT TRANSACTION Assume $2 = £1 £150,000 in British compact discs purchased by a U.S. buyer for $300,000 £150,000 check purchased from U.S. bank to pay for CDs for $300,000  

5. 38 - 4 Copyright McGraw-Hill/Irwin, 2002 U.S. Export Transaction U.S. Import Transaction Balance of Payments Flexible Exchange Rates The Market for Currency Determinants of Exchange Rates Fixed Exchange Rates Exchange Controls and Rationing International Exchange Rate Systems Recent U.S. Trade Deficits Key Terms Previous Slide Next Slide End Show Foreign Exchange Markets A market in which the money (currency) of one nation can be used to purchase (can be exchanged for) the money of another nation. In order to purchase foreign goods and services the buyer must first purchase the foreign country’s currency. The foreign exchange markets make this purchase possible.

6. 38 - 5 Copyright McGraw-Hill/Irwin, 2002 U.S. Export Transaction U.S. Import Transaction Balance of Payments Flexible Exchange Rates The Market for Currency Determinants of Exchange Rates Fixed Exchange Rates Exchange Controls and Rationing International Exchange Rate Systems Recent U.S. Trade Deficits Key Terms Previous Slide Next Slide End Show Points to remember: U.S. exports create a foreign demand for dollars which creates a supply of foreign currencies which are available to American buyers... Financing an U.S. import creates a domestic demand for foreign currencies which decreases the supply of foreign currencies. U.S. IMPORT TRANSACTION

7. 38 - 6 Copyright McGraw-Hill/Irwin, 2002 U.S. Export Transaction U.S. Import Transaction Balance of Payments Flexible Exchange Rates The Market for Currency Determinants of Exchange Rates Fixed Exchange Rates Exchange Controls and Rationing International Exchange Rate Systems Recent U.S. Trade Deficits Key Terms Previous Slide Next Slide End Show BALANCE OF PAYMENTS This is a statement compiled by the U.S. Commerce Department that shows all the payments a nation receives from foreign countries and all the payments it makes to them. It is a statement of foreign exchange.

8. 38 - 7 Copyright McGraw-Hill/Irwin, 2002 U.S. Export Transaction U.S. Import Transaction Balance of Payments Flexible Exchange Rates The Market for Currency Determinants of Exchange Rates Fixed Exchange Rates Exchange Controls and Rationing International Exchange Rate Systems Recent U.S. Trade Deficits Key Terms Previous Slide Next Slide End Show U.S. BALANCE OF PAYMENTS * (2007) Current Account 1)U.S. goods exports............................................................................... $+1149 2)U.S. goods imports............................................................................... -1968 3)Balance on goods......(lines 1 + 2)............................................................. - 819 4)U.S. services exports............................................................................ + 497 5)U.S. services imports............................................................................- 378 6)Balance on services........(lines 4 +5)....................................................................... + 119 7)Balance on goods and services.......(lines 3 + 6)......................................................... - 700 8)Net investment income..(net interest & dividend payments on foreign financial assets)..... + 82 9)Net transfers (foreign aid, pensions for US retirees living abroad, money sent home by immigrants) - 113 10)Balance on current account...(lines 7 + 8+ 9)........................................................ - 731 Capital Account 11)Foreign purchases of assets in the U.S..(foreigners buying US assets)...........+ 2058 12)U.S. purchases of assets abroad...(US citizens buying foreign assets).............- 1289 13)Balance on capital account..........(lines 11 + 12)..................................................... + 768 14)Balance on current and capital account (10 + 13)....................................................... + 37 Official Reserves account 14)Official reserves (the amount the Federal Reserve must inject or subtract to bring the balance to 0) - 37 BALANCE OF PAYMENTS $ 0 *in billion of US dollars

9. 38 - 8 Copyright McGraw-Hill/Irwin, 2002 U.S. Export Transaction U.S. Import Transaction Balance of Payments Flexible Exchange Rates The Market for Currency Determinants of Exchange Rates Fixed Exchange Rates Exchange Controls and Rationing International Exchange Rate Systems Recent U.S. Trade Deficits Key Terms Previous Slide Next Slide End Show Balance of Payment Accounts Current Account is a record of a country’s currency exchange for the: –exports and imports of goods and services –net investment income – interest income earned from foreigners on our foreign investments and paid out to foreigners for their investments here –net transfers – direct payments for foreign aid, pensions to U.S. citizens living abroad, a remittances by immigrants to relatives abroad and those same payments into the U.S.

10. 38 - 9 Copyright McGraw-Hill/Irwin, 2002 U.S. Export Transaction U.S. Import Transaction Balance of Payments Flexible Exchange Rates The Market for Currency Determinants of Exchange Rates Fixed Exchange Rates Exchange Controls and Rationing International Exchange Rate Systems Recent U.S. Trade Deficits Key Terms Previous Slide Next Slide End Show Capital Account is a record of a country’s currency exchange for the purchase or sale of real or financial assets and the corresponding monetary (capital) flows to pay for them. –Real assets include office buildings, factories, homes, land. –Financial assets include stocks and bonds (government and private). Decisions about investing are based on expected returns. This would be determined by interest rates on financial assets and expected profit on real assets.

11. 38 - 10 Copyright McGraw-Hill/Irwin, 2002 U.S. Export Transaction U.S. Import Transaction Balance of Payments Flexible Exchange Rates The Market for Currency Determinants of Exchange Rates Fixed Exchange Rates Exchange Controls and Rationing International Exchange Rate Systems Recent U.S. Trade Deficits Key Terms Previous Slide Next Slide End Show Balance on the Current and Capital Accounts For both accounts exports (the sale of goods, services or assets) generate an accumulation of foreign currency and are considered a credit (+) and imports (the purchase of goods, services or assets) require the use of foreign currency and are considered a debit (-).

12. 38 - 11 Copyright McGraw-Hill/Irwin, 2002 U.S. Export Transaction U.S. Import Transaction Balance of Payments Flexible Exchange Rates The Market for Currency Determinants of Exchange Rates Fixed Exchange Rates Exchange Controls and Rationing International Exchange Rate Systems Recent U.S. Trade Deficits Key Terms Previous Slide Next Slide End Show Official Reserves Account – a measure of foreign currencies held in reserve by a country’s central bank used to make up any deficit in the combined current and capital accounts. The bottom line must be zero. You must pay for your purchases with foreign currencies. Your inflows and outflows must balance. In our country our large current account deficits tend to be balanced with large capital account surpluses.

13. 38 - 12 Copyright McGraw-Hill/Irwin, 2002 U.S. Export Transaction U.S. Import Transaction Balance of Payments Flexible Exchange Rates The Market for Currency Determinants of Exchange Rates Fixed Exchange Rates Exchange Controls and Rationing International Exchange Rate Systems Recent U.S. Trade Deficits Key Terms Previous Slide Next Slide End Show Foreign Exchange Foreign Currencies are known as foreign exchange. When the price of one country’s currency is described in terms of another country’s currency it is known as the exchange rate. One euro = One dollar One yen = 1/100 dollar One peso = 1/10 dollar

14. 38 - 13 Copyright McGraw-Hill/Irwin, 2002 U.S. Export Transaction U.S. Import Transaction Balance of Payments Flexible Exchange Rates The Market for Currency Determinants of Exchange Rates Fixed Exchange Rates Exchange Controls and Rationing International Exchange Rate Systems Recent U.S. Trade Deficits Key Terms Previous Slide Next Slide End Show Flexible Exchange Rates Flexible or floating exchange rates are determined by supply & demand of one country’s currency in terms of the value of another country’s currency. In other words supply and demand determine the prices of currencies in the foreign exchange market

15. 38 - 14 Copyright McGraw-Hill/Irwin, 2002 U.S. Export Transaction U.S. Import Transaction Balance of Payments Flexible Exchange Rates The Market for Currency Determinants of Exchange Rates Fixed Exchange Rates Exchange Controls and Rationing International Exchange Rate Systems Recent U.S. Trade Deficits Key Terms Previous Slide Next Slide End Show Appreciation & Depreciation of Currencies The values of currencies are described in terms of appreciation and depreciation. –If demand for a currency increases that currency appreciates (it becomes more expensive); if demand for a currency decreases that currency depreciates (it becomes less expensive). –If supply of a currency increases that currency depreciates; if supply of a currency decreases that currency appreciates.

16. 38 - 15 Copyright McGraw-Hill/Irwin, 2002 U.S. Export Transaction U.S. Import Transaction Balance of Payments Flexible Exchange Rates The Market for Currency Determinants of Exchange Rates Fixed Exchange Rates Exchange Controls and Rationing International Exchange Rate Systems Recent U.S. Trade Deficits Key Terms Previous Slide Next Slide End Show THE MARKET FOR CURRENCY P Q D S EXCHANGE RATE: $2 = £1 Dollar price of one pound Quantity of pounds 321321 Pound appreciates D1D1

17. 38 - 16 Copyright McGraw-Hill/Irwin, 2002 U.S. Export Transaction U.S. Import Transaction Balance of Payments Flexible Exchange Rates The Market for Currency Determinants of Exchange Rates Fixed Exchange Rates Exchange Controls and Rationing International Exchange Rate Systems Recent U.S. Trade Deficits Key Terms Previous Slide Next Slide End Show THE MARKET FOR CURRENCY P Q D1D1 S EXCHANGE RATE: $3 = £1 Dollar price of one pound Quantity of pounds 321321 Pound depreciates D

18. 38 - 17 Copyright McGraw-Hill/Irwin, 2002 U.S. Export Transaction U.S. Import Transaction Balance of Payments Flexible Exchange Rates The Market for Currency Determinants of Exchange Rates Fixed Exchange Rates Exchange Controls and Rationing International Exchange Rate Systems Recent U.S. Trade Deficits Key Terms Previous Slide Next Slide End Show Appreciation & Depreciation of Currencies If an nation’s currency appreciates, some foreign currency depreciates relative to it.

19. 38 - 18 Copyright McGraw-Hill/Irwin, 2002 U.S. Export Transaction U.S. Import Transaction Balance of Payments Flexible Exchange Rates The Market for Currency Determinants of Exchange Rates Fixed Exchange Rates Exchange Controls and Rationing International Exchange Rate Systems Recent U.S. Trade Deficits Key Terms Previous Slide Next Slide End Show THE MARKET FOR CURRENCY P Q D S EXCHANGE RATE: $2 = £1 Dollar price of one pound Quantity of pounds 321321 Dollar depreciates Dollar appreciates

20. 38 - 19 Copyright McGraw-Hill/Irwin, 2002 U.S. Export Transaction U.S. Import Transaction Balance of Payments Flexible Exchange Rates The Market for Currency Determinants of Exchange Rates Fixed Exchange Rates Exchange Controls and Rationing International Exchange Rate Systems Recent U.S. Trade Deficits Key Terms Previous Slide Next Slide End Show DETERMINANTS OF EXCHANGE RATES Changes in Tastes Relative Income Changes Relative Price Changes Purchasing power parity theory Relative Interest Rates Speculation Flexible exchange rates automatically adjust to eliminate balance of payments deficits or surpluses.

21. 38 - 20 Copyright McGraw-Hill/Irwin, 2002 U.S. Export Transaction U.S. Import Transaction Balance of Payments Flexible Exchange Rates The Market for Currency Determinants of Exchange Rates Fixed Exchange Rates Exchange Controls and Rationing International Exchange Rate Systems Recent U.S. Trade Deficits Key Terms Previous Slide Next Slide End Show Trading in the Foreign Exchange Market When an importer enters the foreign exchange market (FEX) he/she will be both a buyer and a seller of currency. As an importer you will be a buyer of the currency you need and a seller of the currency you have. Buyers = Demand Sellers = Supply