1. International Finance 1

2. Learning Objectives Explain how international trade is financed
Describe a country’s balance of payments accounts
Explain what determines the amount of international borrowing and lending 2

3. Learning Objectives (cont.)
Explain why the United States changed from being a lender to being a borrower in the mid-1980s
Explain how the foreign exchange value of the dollar is determined
Explain why the foreign exchange value of the dollar fluctuates 3

4. Learning Objectives Explain how international trade is financed
Describe a country’s balance of payments accounts
Explain what determines the amount of international borrowing and lending
We will address all three objectives simultaneously. 4

5. Financing International Trade
Balance of Payments Accounts
Balance of payments accounts record a country’s international trading, borrowing, and lending. 5

6. Balance of Payments: Credits
Credits, + (receipts from foreigners)
Exports of goods and services
Income receipts
Unilateral current transfers to the US
Financial inflows
“Dollars in”

7. Balance of Payments: Debits
Debits, - (payment to foreigners)
Imports of goods and services
Income payments
Unilateral current transfers to foreigners
Financial outflows
“Dollars out”

8. Balance of Payments Paired Transactions
Every international transaction enters the balance of payments twice, once as a credit and once as a debit
If you buy something from a foreigner, you must pay her. She must then spend or store your payment.

9. Examples of Paired Transactions
Credit
Debit
JD buys an Italian bike (Masi) (current account)
Sale of bank deposit by Chase Bank (Financial account)

10. Examples of Paired Transactions
Credit
Debit
JD buys an Italian bike (Masi) (current account)
-$1000 US good import
Sale of bank deposit by Chase Bank (Financial account)
+$1000 US asset export

11. Examples of Paired Transactions
Credit
Debit
Julia buys meal at l’Escargot d’Or (current account)
Sale of claim on BofA card (Financial account)

12. Examples of Paired Transactions
Credit
Debit
Julia buys meal at l’Escargot d’Or (current account)
-$200 US service import
Sale of claim on BofA card (Financial account)
+$200 US asset export

13. Examples of Paired Transactions
Credit
Debit
TJ buys 1 share of Shell (Dutch) (Financial account)
Shell deposits in US bank (Financial account)

14. Examples of Paired Transactions
Credit
Debit
TJ buys 1 share of Shell (Dutch) (Financial account)
-$55 US asset import
Shell deposits in US bank (Financial account)
+$55 US asset export

15. Credits to the Current Account
Credits, + (receipts from foreigners)
Exports of goods and services
income receipts
unilateral current transfers to the US

16. Debits to the Current Account
Debits, - (payment to foreigners)
Imports of goods and services
Income payments
Unilateral current transfers to foreigners

17. Credits to the Financial Account
Credits, + (receipts from foreigners)
Financial inflows
Increase in foreign-owned assets (U.S. liabilities)
Decrease in U.S.-owned assets (U.S. claims).

18. Debits to the Financial Account
Debits, - (payment to foreigners)
Financial outflows
Decrease in foreign-owned assets (U.S. liabilities)
Increase in U.S.-owned assets (U.S. claims)

19. Financing International Trade
The balance of payments accounts include:
1) Current account
Exports of goods and services + US income receipts
Imports of goods and services+US income payments
Unilateral current transfers, net
US receipts – US payments
“Net interest income” = US income receipts –US income payments 6

20. Financing International Trade
The balance of payments accounts include:
2) Financial account*
Records changes in foreign assets in the United States minus changes US assets abroad
* Prior to 1997, the Financial account was known as the Capital account 7

21. Financing International Trade
The balance of payments accounts include:
3) Official settlements account
Records the change in official U.S. reserves.
Official U.S reserves -- mainly the government’s holdings of foreign currency.
If official reserves increase, the official settlements accounts balance is negative.
Part of the Financial account & it’s small! 8

22. Financing International Trade
Fundamental balance of payments accounts identity:
Current account + Financial account = 0 8

23. U.S. Balance of Payments Accounts in 1996
Current account (billion $)
Import of goods and services -940
Exports of goods and services +830
Net interest income –10
Net transfers –40
Current account balance –160
Financial account (increases in ...)
Foreign investment in the United States +430
U.S. investment abroad -240
Statistical discrepancy –40
Financial account balance +150
Official settlements account
Decrease in official U.S. reserves +10
When US official reserves decrease, the US gov’t has decreased its holdings of foreign assets (sold currency equivalents). This is an inflow of $, hence a credit (+)
When US official reserves increase, the US gov’t has increased its holdings of foreign assets (bought currency equivalents). This is an outflow of $, hence a debit (-)
A decrease in official U.S. reserves is an inflow of $, a credit item (+) in the BOP accounts. 9

24. U.S. Balance of Payments Accounts in 1998
Current account (billion $)
Import of goods and services -1,120
Exports of goods and services +910
Net interest income +20
Net transfers –40
Current account balance –230
Financial account (increases in ...)
Foreign investment in the United States +540
U.S. investment abroad -310
Statistical discrepancy –40
Financial account balance +230
Official settlements account
Increase in official U.S. reserves - 9

25. U.S. Balance of Payments Accounts in 1999
Current account (billion $)
Import of goods and services -_____
Exports of goods and services +_____
Net interest income _____
Net transfers _____
Current account balance _____
Financial account
Foreign investment in the United States +_____
U.S. investment abroad -_____
Statistical discrepancy _____
Financial account balance _____
Official settlements account
Decrease in official U.S. reserves _____ 9

26. U.S. Balance of Payments Accounts in 1999

27. U.S. Balance of Payments Accounts in 1999

28. U.S. Balance of Payments http://www.bea.doc.gov/bea/di1.htm
Let’s visit the Bureau of Economic Analysis

29. The Balance of Payments: 1975-1998
Instructor Notes:
1) During the 1970s, fluctuations in the balance of payments were small, but during the 1980s, a large current account deficit arose.
2) That deficit decreased in the late 1980s but increase again after 1991.
3) The Financial account balance mirrors the current account balance.
4) When the current account balance is negative, the Financial account balance is positive--we borrow from the rest of the world.
5) Fluctuations in the official settlements balance are small in comparison with fluctuations in the current account balance and the Financial account balance. 10

30. Financing International Trade
Borrowers and Lenders, Debtors and Creditors
A net borrower is a country that is borrowing more from the rest of the world than it is lending.
A net lender is a country that is lending more than it is borrowing. 11

31. Financing International Trade
Borrowers and Lenders, Debtors and Creditors
Debtor nations are countries that during their entire history have borrowed more from the rest of the world than they have lent to it.
Creditor nations are countries that have invested more in the rest of the world than other countries have invested in it. 12

32. Learning Objectives (cont.)
Explain why the United States changed from being a lender to being a borrower in the mid-1980s
Explain how the foreign exchange value of the dollar is determined
Explain why the foreign exchange value of the dollar fluctuates 13

33. Financing International Trade
Borrowers and Lenders, Debtors and Creditors
The United States is both a net borrower and a debtor nation.
We became a borrower as a result of a string of current account deficits.
Is there any reason to be concerned? 14

34. Financing International Trade
No — if the borrowing is financing investment that is generating economic growth and higher income.
Yes — if the money is being used to finance consumption.
This will result in higher interest payments and consumption will eventually have to be reduced. 15

35. Financing International Trade
Current Account Balance
The current account balance (CAB) equals: 16

36. Financing International Trade
Net Exports
Largest part of the current account balance.
Determined by the government budget and private saving and investment. 17

37. Financing International Trade
Net Exports
Net exports is exports of goods and services minus imports of goods and services (X-M)
A government sector surplus or deficit is net taxes minus government purchases of goods and services (T – G)
A private sector surplus or deficit is saving minus investment (S – I) 18

38. Net Exports, the Government Budget, Saving, and Investment
Symbols and
equations
United States
in 1998
(billions of dollars)
Variables
Exports X 959
Imports M 1,110
Government purchases G 1,487
Net Taxes T 1,563
Investment I 1,367
Saving S 1,140 19

39. Net Exports, the Government Budget, Saving, and Investment
Surpluses and deficits in 1998
Net Exports X - M = 959 – 1,110 = – 151
Government sector T - G = 1,563 – 1,487 = 76
Private sector S - I = 1,140 – 1,367 = –227 20

40. Net Exports, the Government Budget, Saving, and Investment
Relationship among surpluses and deficits in 1998
National accounts Y = C + I + G + X – M
= C + S + T
Rearranging X – M = S – I + T – G
Net exports X – M –151
equals:
Government sector T – G 76
plus
Private sector S – I –227 21

41. Net Exports, the Government Budget, Saving, and Investment
Symbols and
equations
United States
in 1996
(billions of dollars)
Variables
Exports X 855
Imports M 954
Government purchases G 1,407
Net Taxes T 1,340
Investment I 1,116
Saving S 1,084 19

42. Net Exports, the Government Budget, Saving, and Investment
Surpluses and deficits in 1996
Net Exports X - M = 855 – 954 = -99
Government sector T - G = 1,340 – 1,407 = –67
Private sector S - I = 1,084 – 1,116 = –32 20

43. Net Exports, the Government Budget, Saving, and Investment
Relationship among surpluses and deficits in 1996
National accounts Y = C + I + G + X – M
= C + S + T
Rearranging X – M = S – I + T – G
Net exports X – M –99
equals:
Government sector T – G –67
plus
Private sector S – I –32 21

44. Financing International Trade
The Twin Deficits
The government sector balance (T-G) and the Current Account balance (X-M) tend to move in the same direction
The US has frequently had a deficit on both
Hence, they are known as the twin deficits. 22

45. The Twin Deficits Instructor Notes:
1) Net exports and the government budget deficit move in similar ways with a time lag of two years.
2) If the government sector deficit increases, as it did in and again in , net exports two years later decrease. 23

46. Financing International Trade
Is U.S. Borrowing for Consumption or Investment
Net exports were –$99 billion in 1996
The government buys structures (e.g. highways, dams) that exceed $200 billion/year.
The government spends on education and health care—increases human capital. 24

47. Financing International Trade
Is U.S. Borrowing for Consumption or Investment
Our borrowing is financing investment 25

48. Learning Objectives (cont.)
Explain why the United States changed from being a lender to being a borrower in the mid-1980s
Explain how the foreign exchange value of the dollar is determined
Explain why the foreign exchange value of the dollar fluctuates 26

49. The Exchange Rate
The foreign exchange market is the market in which the currency of one country is exchanged for the currency of another.
The foreign exchange rate is the price at which one currency exchanges for another.
In April 1997==>$1 = 123 Japanese yen 27

50. The Exchange Rate

51. The Exchange Rate
Currency depreciation is the fall in the value of one currency in terms of another.
The dollar depreciates if in later months it will buy less yen than before (e.g. 90 yen as compared to 114).
Currency appreciation is the rise in the value of one currency in terms of another currency. 28

52. The Exchange Rate Demand in the Foreign Exchange Market
The quantity of dollars demanded in the foreign exchange market depends upon:
1) The exchange rate
2) Interest rates in the United States and other countries
3) The expected future exchange rate 29

53. The Exchange Rate The Law of Demand for Foreign Exchange
The demand for dollars is a derived demand.
They (RoW) buy dollars in order to buy U.S.-made goods and services.
Holding other things the same, the higher the exchange rate, the less is the quantity of dollars demanded. 30

54. The Demand for Dollars D 150 100 50 1.1 1.2 1.3 1.4 1.5
Other things remaining
the same, a rise in the
exchange rate decreases
the quantity of dollars
demanded... D
150
Exchange rate (yen per dollar)
100
…and a fall in the
exchange rate
increases the quantity
of dollars demanded
Instructor Notes:
If the exchange rate fall, the quantity of dollars demanded increases and there is a movement downward along the demand curve for dollars. 50
1.1
1.2
1.3
1.4
1.5
Quantity (trillions of dollars per day) 34

55. The Exchange Rate
Why do exchange rates influence the quantity of dollars demanded?
1) Exports Effect
2) Expected Profit Effect 35

56. The Exchange Rate Changes in the Demand for Dollars
A change in any other influence on the dollars that people plan to buy in the foreign exchange market:
Changes the demand for dollars
Shifts the demand curve for dollars 36

57. The Exchange Rate
The other factors that change the demand for dollars are:
1) Interest rates in the United States and other countries
interest rate differential = US rate – other rate
2) The expected future exchange rate 37

58. Changes in the Demand for Dollars
150
Increase in the
demand for dollars
Exchange rate (yen per dollar)
100
Decrease
in the
demand for
dollars
Instructor Notes:
A change in any influence on the quantity of dollars that people plan to buy, other than the exchange rate, brings a change in the demand for dollars. 50 D0
1.1
1.2
1.3
1.4
1.5
Quantity (trillions of dollars per day) 40

59. Changes in the Demand for Dollars
increases if:
The demand for dollars
decreases if:
The U.S interest rate differential increases
The expected future exchange rate rises
The U.S. interest rate differential decreases
The expected future exchange rate falls 41

60. The Exchange Rate Supply in the Foreign Exchange Market
The quantity of dollars supplied in the foreign exchange market depends upon:
1) The exchange rate
2) Interest rates in the United States and other countries
3) The expected future exchange rate 42

61. The Exchange Rate The Law of Supply for Foreign Exchange
U.S. residents supply dollars in the foreign exchange market when they buy imports.
Holding other things the same, the higher the exchange rate, the higher is the quantity of dollars supplied. 43

62. The Exchange Rate
Why do exchange rates influence the quantity of dollars supplied?
1) Imports Effect
2) Expected Profit Effect 44

63. The Supply of Dollars
Other things remaining
the same, a rise in the
exchange rate increases
the quantity of dollars
supplied... S
150
Exchange rate (yen per dollar)
100
…and a fall in the
exchange rate
decreases the quantity
of dollars supplied
Instructor Notes:
If the exchange rate fall, the quantity of dollars supplied decreases and there is a movement downward along the supply curve for dollars. 50
1.1
1.2
1.3
1.4
1.5
Quantity (trillions of dollars per day) 48

64. The Exchange Rate Changes in the Supply of Dollars
A change in any other influence on the dollars that people plan to sell in the foreign exchange market:
Changes the supply of dollars
Shifts the supply curve of dollars 49

65. The Exchange Rate
The other factors that change the supply of dollars are:
1) Interest rates in the United States and other countries
2) The expected future exchange rate 50

66. The Supply of Dollars S1 S0 S2 150 100 50 1.1 1.2 1.3 1.4 1.5
Decrease in the
supply of dollars
150
Exchange rate (yen per dollar)
100
Increase in the
supply of dollars
Instructor Notes:
A change in any influence on the quantity of dollars that people plan to sell, other than the exchange rate, brings a change in the supply of dollars. 50
1.1
1.2
1.3
1.4
1.5
Quantity (trillions of dollars per day) 53

67. Changes in the Supply of Dollars
increases if:
The supply of dollars
decreases if:
The U.S interest rate differential decreases
The expected future exchange rate falls
The U.S. interest rate differential increases
The expected future exchange rate rises 54

68. The Exchange Rate Market Equilibrium
If the exchange rate is too high, there is a surplus of dollars.
If the exchange rate is too low, there is a shortage of dollars. 55

69. The Exchange Rate Market Equilibrium
At the equilibrium exchange rate, there is neither a shortage nor a surplus. 56

70. Equilibrium Exchange Rate
Surplus at
150 yen per dollar S
150
Exchange rate (yen per dollar)
Equilibrium at
100 yen per dollar
100
Instructor Notes:
1) If the exchange rate is 100 yen per dollar, there is neither a shortage nor a surplus of dollars and the exchange rate remains constant.
2) The market is in equilibrium. 50
Shortage at
50 yen per dollar D
1.1
1.2
1.3
1.4
1.5
Quantity (trillions of dollars per day) 62

71. Learning Objectives (cont.)
Explain why the United States changed from being a lender to being a borrower in the mid-1980s
Explain how the foreign exchange value of the dollar is determined
Explain why the foreign exchange value of the dollar fluctuates 63

72. The Exchange Rate Changes in the Exchange Rate
Why the Exchange Rate is Volatile
Supply and demand are not independent of each other.
A change in the expected future exchange rate or U.S. interest rate differential shifts both supply and demand. 64

73. Exchange Rate Fluctuations
1994 to 1995
S95
Exchange rate (yen per dollar)
100
Instructor Notes:
1) Between 1994 and 1995, the dollar depreciated from 100 to 84 yen per dollar.
2) The exchange rate was expected to depreciate, which decreased the demand for dollars and increased the supply. 84
D94
D95 Q0
Quantity (trillions of dollars per day) 66

74. Exchange Rate Fluctuations
1995 to 1997
D97
123
Exchange rate (yen per dollar)
Instructor Notes:
1) Between 1995 and 1997, the dollar appreciated form 84 to 123 yen per dollar.
2) This appreciation occurred because a weak Japanese economy and low interest rates in Japan generated an expectation of a weak yen and a strong dollar.
3) The supply of dollars decreased, the demand for dollars increase, and the dollar rose in value. 84
D95 Q0
Quantity (trillions of dollars per day) 68

75. The Exchange Rate Exchange Rate Expectations
Two expectations that effect the value of money are:
1) Purchasing power parity
2) Interest rate parity 69

76. The Exchange Rate Purchasing Power Parity
Money is worth what it will buy.
Purchasing power parity means equal value of money. 70

77. The Exchange Rate Purchasing Power Parity
If prices increase in other countries but remain constant in the United States, people will generally expect that the value of the U.S. dollar is too low and will expect it to rise.
Supply of and demand for dollars change
The exchange rate changes 71

78. The Exchange Rate Interest Rate Parity
Money is worth what it can earn.
Interest rate parity means equal interest rates. 72

79. The Exchange Rate Interest Rate Parity
If the rate of return is higher in the United States than in another country, the demand for U.S. dollars rise and the exchange rate rises until expected interest rates are equal. 73

80. The Exchange Rate The Fed in the Foreign Exchange Market
Since the Fed influences the supply of money, it also has an impact on the exchange rate
The Fed can intervene in the foreign exchange market and smooth out fluctuations in the exchange rate 74

81. Foreign Exchange Market InterventionS D1 D2
130
Target exchange
rate
130
Exchange rate (yen per dollar)
120
130
Instructor Notes:
1) If demand decreases from D0 to D2, the Fed buys dollars to decrease supply.
2) Persistent intervention on one side of the market cannot be sustained
130 D0
1.1
1.2
1.3
1.4
1.5
Quantity (trillions of dollars per day) 77

82. The End

83. U.S. Balance of Payments Accounts in 1999
Current account (billion $)
Import of goods and services -1221
Exports of goods and services 956
Net interest income -18
Net transfers -48
Current account balance -331
Financial account
Foreign investment in the United States +711
U.S. investment abroad -439
Statistical discrepancy 12
Financial account balance _____
Official settlements account
Decrease in official U.S. reserves _____ 9

84. Financing International Trade
The balance of payments accounts include:
4) Balance of official reserve transactions equals:
Net increase in foreign official reserve claims on the US
less: the net increase in US official reserves
Measures the degree to which monetary authorities in the US and abroad joined with other lenders to cover the US current account deficit
The bookkeeping offset to this is the official settlements accounts balance 8

85. Financing International Trade
Official settlements accounts balance (a.k.a “the balance of payments”) equals:
Current account balance
plus: the non-reserve portion of the capital & financial account balance
plus: the statistical discrepancy
Measures the payments gap that official reserve transactions need to cover 8

86. Financing International Trade
Official settlements accounts balance (a.k.a “the balance of payments”)
Played an important historical role as a measure of disequilibrium in international payments (still plays this role for many countries)
Negative balance of payments (deficit) may signal a crisis – means a country is running down its foreign reserves (or borrowing foreign reserves) 8