1. International Finance and the Foreign Exchange Market

2. Open economy An economy that has interactions in trade or finance with other countries.
Closed economy An economy that has no interactions in trade or finance with other countries.
Balance of payments The record of a country’s trade with other countries in goods, services, and assets.
The following table shows the balance of payments for the United States in 2010.
Notice that the table contains three “accounts”: the current account, the financial account, and the capital account.

3. The Balance of Payments, 2010 (billions of dollars)
CURRENT ACCOUNT
Exports of goods
$1,289
Imports of goods
−1,935
Balance of trade
−646
Exports of services
549
Imports of services
−403
Balance of services
146
Income received on investments
663
Income payments on investments
−498
Net income on investments
165
Net transfers
−136
Balance on current account
−471
The sum of the balance of trade and the balance of services equals net exports.
The Balance of Payments, 2010 (billions of dollars)
FINANCIAL ACCOUNT
Increase in foreign holdings of assets in the United States
1,259
Increase in U.S. holdings of assets in foreign countries
−1,005
Balance on financial account
254
BALANCE ON CAPITAL ACCOUNT
Statistical discrepancy
217
Balance of payments

4. (a) Trade flows for the US (in billions of dollars)
(b) Trade flows for Japan (in billions of dollars)
In 2010, the United States ran a trade deficit with all its major trading partners and with every region of the world except for Latin America.
Japan ran trade deficits with China, Latin America, and the Middle East, and it ran trade surpluses with the United States, Europe, and Asia. In each panel, the green arrows represent exports from the United States or Japan, and the red arrows represent imports.

5. Balance of Payments
Current account transactions: all payments (and gifts) related to the purchase or sale of goods and services and income flows during the current period
Four categories:
Merchandise trade (import and export of goods)
Service trade (import and export of services)
Income from investments
Unilateral transfers (gifts to and from foreigners)

6. Net Exports = the Balance of Trade + the Balance of Services
The current account balance also includes net income on investments and net transfers. Because these items are relatively small, it is often a convenient simplification to think of net exports as being equal to the current account balance.

7. Balance of Payments
Financial account transactions: transactions that involve changes in the ownership of real and financial assets
The financial account includes both
direct investments by foreigners in the U.S. and by Americans abroad, and,
loans to and from foreigners.
Under a pure flexible-rate system, official reserve transactions are zero; therefore:
a financial-account deficit implies a capital-account surplus.
a financial-account surplus implies a capital-account deficit.

8. The Financial Account
There is a capital outflow from the United States when an investor in the United States buys a bond issued by a foreign company or government or when a U.S. firm builds a factory in another country.
There is a capital inflow into the United States when a foreign investor buys a bond issued by a U.S. firm or by the government or when a foreign firm builds a factory in the United States.
Another way of thinking of the balance on the financial account is as a measure of net capital flows, or the difference between capital inflows and capital outflows.

9. Balance of Payments
Capital account transactions: transactions that involve relatively minor transactions, such as migrants’ transfers and sales and purchases of non-produced, non-financial assets such as a copyright, patent, trademark, or right to natural resources
Prior to 1999, the capital account recorded all the transactions included now in both the financial account and the capital account. In other words, capital account transactions went from being a very important part of the balance of payments to being a relatively unimportant part.

10. Balance of Payments
Balance of payments: accounts that summarize the transactions of a country’s citizens, businesses, and governments with foreigners
Imports create a demand for foreign currency (and a supply of the domestic currency) and are recorded as a debit item.
Exports create a supply of foreign currency (and demand for the domestic currency) and are recorded as a credit item.

11. Why Is the Balance of Payments Always Zero?
The sum of the current account balance, the financial account balance, and the capital account balance equals the balance of payments.
To make the balance on the current account equal the balance on the financial account, we include an entry called the statistical discrepancy.
Changes in foreign holdings of dollars are known as official reserve transactions.
A current account deficit must be exactly offset by a financial account surplus, leaving the balance of payments equal to zero.

12. Balance of Payments
Under a pure flexible rate system, the foreign exchange market will bring the quantity demanded and the quantity supplied into balance, and as a result, it will also bring the total debits into balance with the total credits.

13. Current Acct & Net Foreign Investment
4/21/2017
Current Acct & Net Foreign Investment
Current Account as % of GDP surplus (+) or deficit (-)
+ 2
- 2
- 4
- 6
1978
1983
1988
1993
1998
2003
2008
Net Foreign Investment as % of GDP surplus (+) or deficit (-)
+ 4
+ 2
- 2
1978
1983
1988
1993
1998
2003
2008
Under a flexible exchange rate system the inflow and outflow of capital exert a major impact on current account balances.

14. At the time, the exchange rate was
Labatt’s beer is produced in Canada.
In 1990, in Ontario, a six-pack of Labatt’s beer sold for $6.60 Canadian.
Across the border in Michigan, a six pack of the same beer was on sale for $2.75 U.S.
At the time, the exchange rate was
$0.75 U.S. = $1.00 Canadian.

15. In Ontario, $6.60 Canadian.
In Michigan, $2.75 U.S.
$0.75 U.S. = $1.00 Canadian.
1. How much would it cost in U.S. currency to buy the beer in Ontario?
2. How much would it cost in Canadian currency to buy the beer in Michigan?
3. Is there an arbitrage opportunity?
4. Where would you buy and where would you sell?
5. How much profit could you expect on a six-pack?
$2.75 / .75 = $3.67 Can
$ $2.75 = $2.20 US ($2.93 Canadian)
Buy in Michigan, sell in Ontario
$6.60 x .75 = $4.95 US

16. Exchange Rates- Then Now
Number of 1 country’s currency that is equal to 1 unit of another country’s
$1 = € $1 = £
Then
$1 = € $1 = £
Now
1€ = $ £ = $
1€ = $ £ = $

17. Foreign Exchange Market
Market where different currencies are traded, one for another.
The exchange rate enables people in one country to translate the prices of foreign goods into units of their own currency.
An appreciation of a nation’s currency will make foreign goods cheaper.
A depreciation of a nation’s currency will make foreign goods more expensive.

18. How many $$ does it take to get one of theirs?
How many $$ you get with one of theirs?
Currency Pair
Price
EUR/USD
1.3548
AUD/USD
0.9098
GBP/USD
1.6365
JPY/USD
0.0097
CAD/USD
0.9404
CHF/USD
1.1013
Currency Pair
Price
USD/EUR
0.7381
USD/AUD
1.0987
USD/GBP
0.6112
USD/JPY
USD/CAD
1.0636
USD/CHF
0.9080

19. International Rates 1 0.009328 1.222 0.7705 1.733 0.7403 0.7894 ¥en
Currency Last Trade
U.S. $
¥en 12/04
Euro 12/04
Can $ 12/04
U.K. £ 12/04
Aust $ 12/04
SFranc 12/04 1
1.222
0.7705
1.733
0.7403
0.7894
¥en
107.2
131
82.59
185.8
79.36
84.62
Euro
0.8181
0.6303
1.418
0.6057
0.6458
Can $
1.298
1.586
2.249
0.9608
1.025
U.K. £
0.577
0.7053
0.4446
0.4272
0.4555
Aust $
1.351
0.0126
1.651
1.041
2.341
1.066
SFranc
1.267
1.548
0.976
2.195
0.9378

20. Appreciation Depreciation or
Currency $
Appreciate/
Depreciate
Yahoo April 2008
Yahoo April 2005
Yahoo
Mar 2004
Dec 2003
Text
Oct 2002
U.S. $ 1
¥en
103.21
105.6
107.2
123.3
Euro
0.8237
0.8181
1.01
Can $
1.0197
1.244
1.31
1.298
1.5987
U.K. £
0.5051
0.5232
0.5506
0.577
0.6391
Aust $
1.0561
1.2943
1.337
1.351
1.84
SFranc
1.0125
1.1879
1.287
1.267
1.49

21. Determinants of the Exchange Rate
flexible rate system - the exchange rate is determined by supply and demand.
The dollar demand for foreign exchange originates from American demand for foreign goods, services, & assets (real or financial).
The supply of foreign exchange originates from sales of goods, services, & assets from Americans to foreigners.

22. There are three sources of foreign currency demand for the U. S
There are three sources of foreign currency demand for the U.S. dollar:
Foreign demand for goods and services produced in the United States.
Foreign investment in the United States either through foreign direct investment—buying or building factories or other facilities in the United States—or through foreign portfolio investment—buying stocks and bonds issued in the United States.
Currency traders who believe that the value of the dollar in the future will be greater than its value today.

23. Changes in the Exchange Rate
Determinants:
A change in national income (relative to trading partners) people buy more, or less of everything.
A change in the inflation rate in one country.
a. Higher rate decreases demand
b. Lower demand - depreciation
A change in interest rates (relative to rates abroad).
a. High rates attract money
b. Currency appreciates
4. Changes in tastes

24. Foreign Exchange Market Equilibrium S(sales to foreigners) D2 D1
If incomes increase in the United States, U.S. imports of foreign goods and services will grow.
Dollar price of foreign exchange (for pounds) D2
S(sales to foreigners)
The increase in imports will increase the demand for pounds in the foreign exchange market
$1.80 b
causing the dollar price of the pound to rise from $1.50 to $1.80.
$1.50 a D1
Quantity of
foreign exchange (pounds) Q1 Q2

25. Flexible Exchange Rates
Inflation With
Flexible Exchange Rates S2
If the price level in the U.S. increased by 50 % …
Dollar price of foreign exchange (for pounds)
the U.S. demand for British goods (and pounds) would increase (relatively cheap). D2 S1
$2.25 b
Since U.S. exports to Britain would decline and thereby cause the supply of pounds to fall.
$1.50 a
These forces would cause the dollar to depreciate relative to the pound. D1
Quantity of
foreign exchange (pounds) Q1

26. The Fall and Rise and Fall of the Dollar
Low U.S. interest rates have played a role in the declining value of the dollar.
Many investors and some central banks became convinced that the value of the dollar was too high in 2002 and that it was likely to decline in the future.
The depreciation of the dollar:
bad news for U.S. tourists and for anyone in the United States importing foreign goods and services.
good news for U.S. firms exporting goods and services

27. Peso – Appreciation or Depreciation?
The US reduces tariffs on Mexican products.
Mexico encounters severe inflation.
Deteriorating political relations reduce American tourism in Mexico.
The US economy moves into a severe recession
A bartender puts a lime in a Corona and beer sales jump
The Mexican government encourages American firms to invest in Mexican oil fields
A large federal government budget deficit raises interest rates in the US

28. Euro – Appreciation or Depreciation?
An American importer purchases a shipload of Bordeaux wine.
BMW decides to build an assembly plant in LA
A CVCC student decides to spend a year studying at the Sorbonne.
A Spanish manufacturer exports machinery to Morocco on an American freighter.
The US incurs a balance of payments deficit in its transactions with Belgium.
A US government bond held by an Italian citizen matures.
It is widely believed that the international value of the Euro will fall in the near future.

29. Monetary Policy & the Exchange Rate
An unanticipated shift to a more restrictive monetary policy will:
raise the real interest rate,
reduce the rate of inflation, and,
at least temporarily, reduce aggregate demand and the growth of income;
causing an appreciation in domestic currency.
the currency appreciation (with shift the current account toward a deficit).
An unanticipated shift to more expansionary monetary policy will cause the opposite:
lower interest rates, and,
an outflow of capital;
leading to a currency depreciation, and,
a shift toward a current account surplus.

30. Fiscal Policy & the Exchange Rate
An expansionary fiscal policy may cause:
higher interest rates,
which can increase in foreign investment,
causing a currency appreciation, and,
a decrease in exports.

31. 1. A depreciation in the value of the U.S. dollar would
encourage foreigners to travel on American owned airlines.
make U.S. goods more expensive to foreign consumers.
decrease the number of dollars it takes to buy a Swiss franc.
make it more expensive for U.S. citizens to travel abroad.
A nation’s trade deficit will tend to expand when
its economy is expanding.
its economy is shrinking.
its investment environment is less attractive to foreigners.
both b and c above are true.
4. Under a system of flexible exchange rates, an increase in demand for a nation’s currency in the foreign exchange market will
cause the nation’s currency to appreciate.
make it more expensive for the nation to import goods.
cause the nation’s balance on current account to shift toward a surplus.
make it less expensive for foreigners to buy the nation’s goods.

32. 5. Under a system of flexible exchange rates, which of the following will most likely cause a nation’s currency to appreciate on the foreign exchange market?
a decrease in domestic interest rates
an increase in foreign interest rates
domestic inflation of 10 percent while the nation’s trading partners are experiencing stable prices
stable domestic prices while the nation’s trading partners are experiencing 10 percent inflation
6. Suppose a German-produced car becomes very popular in the United States. This would tend to
affect the U.S. balance of payments but not the balance of trade.
reduce any existing balance of trade deficit in the United States.
increase a balance of trade surplus in the United States.
increase a balance of trade deficit in the United States.

33. 9. If the dollar price of the euro goes from $1 to 90 cents, the euro has
appreciated, and Europeans will find U.S. goods cheaper.
appreciated, and Europeans will find U.S. goods more expensive.
depreciated, and Europeans will find U.S. goods cheaper.
depreciated, and Europeans will find U.S. goods more expensive.

34. 10. Which of the following would cause the American demand for foreign exchange (pounds) to shift from D1 to D2?
an increase in the U.S. real interest rate
higher inflation in Britain than in the United States
higher income growth in Britain than in the United States
an increased level of vacation travel to Britain by Americans
11. Which of the following would cause the demand for foreign exchange (pounds) to shift from D1 to D2?
an increase in the real interest rate in Britain relative to the US
higher inflation in Britain than in the United States
higher income growth in Britain than in the United States
an increase in the number of British citizens vacationing in the US