1. The World ofInternational Finance F ERNANDO Q UIJANO, Y VONN Q UIJANO, K YLE T HIEL & A PARNA S UBRAMANIAN PREPARED BY: © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez

2. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 2 of 28 1 Can the price of hamburgers around the world give us a clue as to the proper value for exchange rates? Big Macs and Purchasing Power Parity 2 What factors may allow the United States to continue running large trade deficits with the rest of the world? World Savings and U.S. Current Account Deficits 3 Why did a group of European countries adopt a common currency? The First Decade of the Euro 4 What are the causes of financial collapses that occur throughout the globe? The Argentinean Financial Crisis

3. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 3 of 28 HOW EXCHANGE RATES ARE DETERMINED What Are Exchange Rates? 19.1 exchange rate The price at which currencies trade for one another in the market. euro The common currency in Europe. appreciation of a currency An increase in the value of a currency relative to the currency of another nation. depreciation of a currency A decrease in the value of a currency relative to the currency of another nation.

4. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 4 of 28 How Demand and Supply Determine Exchange Rates HOW EXCHANGE RATES ARE DETERMINED 19.1  FIGURE 19.1 The Demand for and Supply of U.S. Dollars

5. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 5 of 28 Changes in Demand or Supply HOW EXCHANGE RATES ARE DETERMINED 19.1  FIGURE 19.2 Shifts in the Demand for U.S. Dollars

6. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 6 of 28 Changes in Demand or Supply HOW EXCHANGE RATES ARE DETERMINED 19.1  FIGURE 19.3 Shifts in the Supply of U.S. Dollars

7. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 7 of 28 Changes in Demand or Supply HOW EXCHANGE RATES ARE DETERMINED 19.1 Let’s summarize the key facts about the foreign exchange market, using euros as our example: 1The demand curve for dollars represents the demand for dollars in exchange for euros. The curve slopes downward. As the dollar depreciates, there will be an increase in the quantity of dollars demanded in exchange for euros. 2The supply curve for dollars is the supply of dollars in exchange for euros. The curve slopes upward. As the dollar appreciates, there will be an increase in the quantity of dollars supplied in exchange for euros. 3Increases in U.S. interest rates and decreases in U.S. prices will increase the demand for dollars, leading to an appreciation of the dollar. 4Increases in European interest rates and decreases in European prices will increase the supply of dollars in exchange for euros, leading to a depreciation of the dollar.

8. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 8 of 28 REAL EXCHANGE RATES AND PURCHASING POWER PARITY 19.2 real exchange rate The price of U.S. goods and services relative to foreign goods and services, expressed in a common currency.

9. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 9 of 28 REAL EXCHANGE RATES AND PURCHASING POWER PARITY 19.2  FIGURE 19.4 Real Exchange Rate and Net Exports as Percent of GDP, 1980–2005

10. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 10 of 28 REAL EXCHANGE RATES AND PURCHASING POWER PARITY 19.2 law of one price The theory that goods easily tradable across countries should sell at the same price expressed in a common currency. purchasing power parity A theory of exchange rates whereby a unit of any given currency should be able to buy the same quantity of goods in all countries.

11. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 11 of 28 BIG MACS AND PURCHASING POWER PARITY APPLYING THE CONCEPTS #1: Can the price of hamburgers around the world give us a clue as to the proper value for exchange rates? For several years, The Economist measured the price of a Big Mac throughout the world and checked to see whether the law of one price held. Table 19.1 contains the results for selected countries and the market-exchange rate predicted by the theory of purchasing power parity. To obtain the exchange rate, divide the price of Big Macs in the foreign country by the dollar price. Table 19.1BIG MAC PRICING AROUND THE WORLD VERSUS ACTUAL EXCHANGE RATES Country Price of a Big Mac in Local Currency Price of a Big Mac in Dollars Predicted Purchasing Power Exchange Rate Based on Big Mac Pricing (Foreign Currency per U.S. Dollar) Actual Exchange Rate (Foreign Currency per U.S. Dollar) United States3.15 dollars$3.15____ United Kingdom1.89 pounds3.320.600.57 Hong Kong12.0 HK dollars1.553.817.75 Switzerland6.31 Swiss francs4.932.001.28 Mexico28.2 pesos2.668.9510.6 Japan250 yen2.1479.4114

12. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 12 of 28 THE CURRENT ACCOUNT, THE FINANCIAL ACCOUNT, AND THE CAPITAL ACCOUNT 19.3 balance of payments A system of accounts that measures transactions of goods, services, income, and financial assets between domestic households, businesses, and governments and residents of the rest of the world during a specific time period. current account The sum of net exports (exports minus imports) plus income received from abroad plus net transfers from abroad.

13. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 13 of 28 THE CURRENT ACCOUNT, THE FINANCIAL ACCOUNT, AND THE CAPITAL ACCOUNT 19.3 financial account The value of a country’s net sales (sales minus purchases) of assets. capital account The value of capital transfer and transaction in nonproduced, nonfinancial assets in the international accounts.

14. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 14 of 28 THE CURRENT ACCOUNT, THE FINANCIAL ACCOUNT, AND THE CAPITAL ACCOUNT 19.3 Rules for Calculating the Current, Financial, and Capital Accounts Here is a simple rule for understanding transactions on the current, financial, and capital accounts: Any action that gives rise to a demand for foreign currency is a deficit item. Any action that gives rise to a supply of foreign currency is a surplus item. The current, financial, and capital accounts of a country are linked by a very important relationship: current account + financial account + capital account = 0

15. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 15 of 28 THE CURRENT ACCOUNT, THE FINANCIAL ACCOUNT, AND THE CAPITAL ACCOUNT 19.3 Rules for Calculating the Current, Financial, and Capital Accounts

16. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 16 of 28 THE CURRENT ACCOUNT, THE FINANCIAL ACCOUNT, AND THE CAPITAL ACCOUNT 19.3 Rules for Calculating the Current, Financial, and Capital Accounts net international investment position Domestic holding of foreign assets minus foreign holdings of domestic assets.

17. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 17 of 28 FIXED AND FLEXIBLE EXCHANGE RATES 19.4 To set the stage for understanding exchange rate systems, let’s recall what happens when a country’s exchange rate appreciates—increases in value. There are two distinct effects: 1The increased value of the exchange rate makes imports less expensive for the residents of the country where the exchange rate appreciated. 2The increased value of the exchange rate makes U.S. goods more expensive on world markets.

18. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 18 of 28 WORLD SAVINGS AND U.S. CURRENT ACCOUNT DEFICITS APPLYING THE CONCEPTS #2: What factors may allow the United States to continue running large trade deficits with the rest of the world? The 2006 Economic Report of the President directly addressed the issue of whether the United States can continue to run large current account deficits and, of course, financial account surpluses. In the report, the government recognized that the current account deficits would eventually be reduced. However, the government also highlighted a number of factors that suggested the deficits could continue for a long period of time. For the United States to continue to run a current account deficit, other countries in the world need to continue to purchase U.S. assets. In 2005, four major countries experienced circumstances that encouraged them to save by purchasing assets from abroad: Japan, Germany, Russia, and China. For the United States to continue to run trade deficits in the future, these or other countries must want to continue to save more than they want to invest domestically.

19. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 19 of 28 FIXED AND FLEXIBLE EXCHANGE RATES 19.4 Fixing the Exchange Rate foreign exchange market intervention The purchase or sale of currencies by government to influence the market exchange rate.  FIGURE 19.5 Government Intervention to Raise the Price of the Dollar

20. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 20 of 28 FIXED AND FLEXIBLE EXCHANGE RATES 19.4 Fixed Versus Flexible Exchange Rates flexible exchange rate system A currency system in which exchange rates are determined by free markets. FLEXIBLE EXCHANGE RATE SYSTEM fixed exchange rate system A system in which governments peg exchange rates to prevent their currencies from fluctuating. FIXED EXCHANGE RATES

21. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 21 of 28 BUSH OFFICIAL WARNS CHINA ABOUT PROTECTIONISM Gutierrez also called on China to get tougher on piracy of intellectual property. China is thought to be the world’s primary provider of pirated intellectual property. Chinese officials did promise to adopt stricter enforcement of piracy issues and have shut down a total of 23 facilities making pirated DVDs and CDs. Last year’s record $202 billion trade deficit with China has prompted the possible legislative actions. China needs to open its markets to U.S. goods and do more to resolve currency disputes with the U.S. according to U.S. Commerce Secretary Carlos Gutierrez. Gutierrez is attempting to be proactive in resolving trade differences with China prior to the Senate vote this week on sanctioning the country over currency manipulation. Extra Application 5 If the Chinese yuan was allowed to float freely, the dollar price of yuan would increase substantially and reduce imports of Chinese goods to the U.S. since they would be more expensive to U.S. consumers. Demand for Chinese goods by U.S. consumers results in demand for yuan to pay for these goods. This increase in yuan demand (priced in dollars) should push the dollar price of yuan higher.

22. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 22 of 28 FIXED AND FLEXIBLE EXCHANGE RATES 19.4 Fixed Versus Flexible Exchange Rates balance of payments deficit Under a fixed exchange rate system, a situation in which the supply of a country’s currency exceeds the demand for the currency at the current exchange rate. BALANCE OF PAYMENTS DEFICITS AND SURPLUSES balance of payments surplus Under a fixed exchange rate system, a situation in which the demand of a country’s currency exceeds the supply for the currency at the current exchange rate. devaluation A decrease in the exchange rate to which a currency is pegged under a fixed exchange rate system. revaluation An increase in the exchange rate to which a currency is pegged under a fixed exchange rate system.

23. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 23 of 28 FIXED AND FLEXIBLE EXCHANGE RATES 19.4 The U.S. Experience with Fixed and Flexible Exchange Rates Exchange Rate Systems Today Fixed exchange rate systems provide benefits, but they require countries to maintain similar economic policies—especially to maintain similar inflation rates and interest rates. The flexible exchange rate system has worked well enough since the breakdown of Bretton Woods.

24. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 24 of 28 THE FIRST DECADE OF THE EURO APPLYING THE CONCEPTS #3: Why did a group of European countries adopt a common currency? January 1, 1999, was the day 11 European countries agreed to use a common currency. Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal, and Spain irrevocably fixed their exchange rates to the euro. In 2002, euro notes and coins were actually put into circulation. A European central bank manages the monetary affairs related to the euro. It plays a role similar to the role the Federal Reserve Bank plays in the United States. Economists will carefully watch this experiment unfold in the twenty-first century. The jury is still out on whether adopting a common currency was a wise economic move for the countries that joined the new regime. Will the benefits of a larger market outweigh the disadvantages of having one monetary policy for all the members?

25. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 25 of 28 DEUTSCHE BÖRSE WITHDRAWS EURONEXT BID Some investors in both the Börse and Euronext hoped that shareholders would be allowed to vote on both proposals. Euronext declined to allow the Börse vote. While some European politicians and officials hoped there would be a “European solution” to the market fragmentation, that scenario now appears less likely to happen in the near term. Stock exchange mergers should provide more investors with market access to certain country’s stocks that were harder to purchase prior to the merger and also contribute to greater market efficiency. Euronext, the Paris-based stock exchange, recently agreed to combine with the New York Stock Exchange (NYSE). After the announcement, the German Börse also attempted to combine with Euronext but now confirms it has withdrawn its bid. Euronext will now seek confirmation from its shareholders regarding the NYSE partnership. Extra Application 6

26. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 26 of 28 MANAGING FINANCIAL CRISES 19.5 Hardly a year goes by without some international financial crisis. Even when a country takes strong, institutional steps to peg its currency, a collapse is still possible.

27. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 27 of 28 THE ARGENTINEAN FINANCIAL CRISIS APPLYING THE CONCEPTS #4: What are the causes of financial collapses that occur throughout the globe? During the late 1980s, Argentina suffered from hyperinflation. As part of its financial reforms, Argentina pegged its currency to the U.S. dollar, making pesos “convertible” into dollars. To issue pesos, the central bank had to have an equal amount of dollars, or its equivalents in other hard currencies, on hand. Some economists believed that this reform would bring stability to the financial system. Unfortunately, they proved wrong. Several problems developed: As the dollar appreciated, Argentina began to suffer from a large trade deficit Wage increases also pushed up the real exchange rate Argentina had to borrow extensively in dollar-denominated loans. Eventually, Argentina was forced to default on its international debt in 2002 and freeze bank accounts. The hopes of the reforms in the early 1990s had become a bitter memory.

28. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 28 of 28 appreciation of a currency balance of payments balance of payments deficit balance of payments surplus capital account current account depreciation of a currency devaluation euro exchange rate financial account fixed exchange rate system flexible exchange rate system foreign exchange market intervention law of one price net international investment position purchasing power parity real exchange rate revaluation