1. Exchange Rates and the Balance of Payments
Chapter 34
Exchange Rates and the Balance of Payments

2. Introduction
The price of one currency in terms of another is set by the interaction of supply and demand in international financial markets.
Among the participants in these markets are governments seeking to change or maintain exchange rates.

3. Learning Objectives
Distinguish between the balance of trade and the balance of payments
Identify the key accounts within the balance of payments
Outline how exchange rates are determined in the markets for foreign exchange

4. Learning Objectives
Discuss factors that can induce changes in equilibrium exchange rates
Understand how policymakers can go about attempting to fix exchange rates
Explain alternative approaches to limiting exchange rate variability

5. Chapter Outline
The Balance of Payments and International Capital Movements
Determining Foreign Exchange Rates
The Gold Standard and the International Monetary Fund
Fixed Exchange Rates

6. Did You Know That...
Exchange rates between currencies are a factor in determining the location of vehicle production?
The recent decline in the value of the dollar against the yen and the euro led foreign automakers to locate more vehicle assembly in the U.S.?

7. The Balance of Payments and International Capital Movements
Balance of Trade
The value of goods and services bought and sold in the world market
The difference between exports and imports of goods
Balance of Payments
A summary record of a country’s economic transactions with foreign residents and governments over a year

8. Surplus (+) and Deficit (-) Items on the International Accounts
Surplus Items (+) Deficit Items (-)
Exports of merchandise Imports of merchandise
Private and government gifts from Private and governmental gifts to foreigners foreigners
Foreign use of domestically owned Use of foreign-owned transportation transportation
Foreign tourists’ expenditures in this country Tourism expenditures abroad
Foreign military spending in this country Military spending abroad
Interest and dividend receipts from foreigners Interest and dividends paid to foreigners
Sales of domestic assets to foreigners Purchases of foreign assets
Funds deposited in this country by foreigners Funds placed in foreign depository institutions
Sales of gold to foreigners Purchases of gold from foreigners
Sales of domestic currency to foreigners Purchases of foreign currency
Table 34-1

9. The Balance of Payments and International Capital Movements
Accounting Identities
Statements that certain numerical measurements are equivalent by accepted definition

10. The Balance of Payments and International Capital Movements
When family expenditures exceed income, the family must do one of the following:
Reduce its money holdings, or sell stocks, bonds, or other assets
Borrow
Receive gifts from friends or relatives
Receive a public transfer from a government
Cannot continue indefinitely

11. The Balance of Payments and International Capital Movements
Accounting identities
Net lending by households must equal net borrowing by businesses and governments
Disequilibrium
When a situation cannot continue indefinitely

12. The Balance of Payments and International Capital Movements
Households, businesses, and governments must reach equilibrium.
When nations trade or interact, certain identities or constraints must hold.

13. The Balance of Payments and International Capital Movements
Three categories of balance of payments transactions
Current account transactions
Capital account transactions
Official reserve account transactions

14. The Balance of Payments and International Capital Movements
Current account transactions
Merchandise trade transactions
Importing and exporting of merchandise
Balance = merchandise exports - merchandise imports

15. The Balance of Payments and International Capital Movements
Current account transactions
Service exports and imports
Invisible or intangible items
Shipping
Insurance
Tourism
Banking
Income from investments

16. The Balance of Payments and International Capital Movements
Current account transactions
Unilateral transfers
Gifts by citizens
Gifts by governments

17. Example: Multinational Firms in Trade Statistics
When economic activities are conducted by multinational firms, there are different trade statistics that will be calculated depending on whether the activities are measured according to the ownership of resources or according to the location of productive activities.

18. Example: Multinational Firms in Trade Statistics
When the U.S. Commerce Department reports trade statistics on an ownership basis, exports and imports are adjusted to reflect purchases and sales involving foreign affiliates of U.S. firms.

19. The Balance of Payments and International Capital Movements
Balancing the current account
Net exports plus unilateral transfers plus net investment income exceeds zero
Current account surplus
Net exports plus unilateral transfers plus net investment income is negative
Current account deficit

20. The Balance of Payments and International Capital Movements
A current account surplus means the import of money or money equivalent which means a capital account deficit
A current account deficit must be paid by the export of money or money equivalent which means a capital account surplus

21. The Balance of Payments and International Capital Movements
Capital account transactions
Deals with the buying and selling of real and financial assets

22. The Balance of Payments and International Capital Movements
The current account and capital account must sum to zero, in the absence of interventions by finance ministries or central banks.
Capital Account  Current Account  0

23. The Balance of Payments and International Capital Movements
Official reserve account transactions
Foreign currencies
Gold
Special Drawing Rights (SDRs)
Reserve assets created by the International Monetary Fund that countries can use to settle international payments

24. The Balance of Payments and International Capital Movements
Official reserve account transactions
The reserve position in the International Monetary Fund
Financial assets held by an official agency such as the U.S. Treasury Department

25. The Balance of Payments and International Capital Movements
What affects the balance of payments?
Relative rate of inflation
Political stability

26. The Balance of Payments and International Capital Movements
What affects the balance of payments?
Inflation among trading partners
Political stability

27. Determining Foreign Exchange Rates
Foreign Exchange Market
The market for buying and selling foreign currencies
Exchange Rates
The price of one currency in terms of another

28. Determining Foreign Exchange Rates
Demand for and supply of foreign currency
U.S. transactions involving imports constitute a supply of dollars and demand for some foreign currency
The opposite is true for export transactions

29. Determining Foreign Exchange Rates
The equilibrium foreign exchange rate
Appreciation
An increase in the value of a currency in terms of other currencies
Depreciation
A decrease in the value of a currency in terms of other currencies

30. Deriving the Demand for Japanese Yen
Panel (b)
U.S. Demand Curve for Japanese Laptop Computers D
100
1,500
300
1,250
500
1,000
Price per Unit ($)
700
750
Quantity of Japanese Laptops
per Week
Figure 34-2, Panels (a) and (b)

31. Deriving the Demand for Japanese Yen
Panel (b)
U.S. Demand Curve for Japanese Laptop Computers D
100
1,500
300
1,250
500
1,000
Price per Unit ($)
700
750
Quantity of Japanese Laptops
per Week
Figure 34-2, Panels (c) and (b)

32. Deriving the Demand for Japanese Yen
Panel (e)
U.S. Derived Demand for Yen D1 10
.0150 30
.0125
Price per Franc ($) 50
.0100 70
.0075
Quantity of Yen
Demanded per Week (millions)
Figure 34-2, Panels (d) and (e)

33. Determining Foreign Exchange Rates
Supply of Japanese Yen
Price of U.S. microprocessor = $200
Exchange rate = $0.01 for 1 yen
200,000 yen = 1 microprocessor
Exchange rate = $0.0125
16,000 Yen $0.0125/Yen) = 1 microprocessor

34. Determining Foreign Exchange Rates60
0.0125 50
0.0100
Price per Yen ($) 40
0.0075
Quantity of Yen Supplied per Week (millions)
Figure 34-3

35. Total Demand for and Supply of Japanese Yen2
0.0125 3
0.0100 E
Price per Yen($)
Trillions of Yen per Year
Figure 34-4

36. A Shift in the Demand Schedule2 S D 1 4
0.0120 E 2 3
0.0100 E 1
Price per Yen ($)
Trillions of Yen per Year
Figure 34-5

37. A Shift in the Supply of Japanese YenD 3
0.0100 E
Price per Yen ($) S 1 E 1 5
0.0050
Trillions of Yen per Year
Figure 34-6

38. International Example: South Africa’s Currency Appreciation
Gold and platinum are key South African exports.
The increased demand for these commodities has also increased the demand for South African rand.
As interest rates in South Africa became relatively higher, the demand for South African financial assets also increased.

39. International Example: South Africa’s Currency Appreciation
The result of these changes has been an appreciation of the rand.
The dollar price of the rand has doubled since the end of 2001.

40. Determining Foreign Exchange Rates
Market determinants of exchange rates
Changes in real interest rates
Changes in productivity
Changes in product preferences
Perceptions of economic stability

41. The Gold Standard and the International Monetary Fund
An international monetary system in which nations fix their exchange rates in terms of gold
All currencies are fixed in terms of all others, and any balance of payments deficits or surpluses can be made up by shipments of gold

42. The Gold Standard and the International Monetary Fund
A balance of payments deficit
More gold flowed out than flowed in
Equivalent to an restrictive monetary policy
A balance of payments surplus
More gold flowed in than out
Equivalent to an expansionary monetary policy

43. The Gold Standard and the International Monetary Fund
Problems with the gold standard
A nation gives up control of its monetary policy
New gold discoveries often caused inflation

44. The Gold Standard and the International Monetary Fund
Bretton Woods and the International Monetary Fund
1944—representatives of capitalist countries met in Bretton Woods, New Hampshire
Created a new international payment system to replace the gold standard
Members could change the par value once by 10 percent and after that par value changes needed IMF approval

45. The Gold Standard and the International Monetary Fund
End of the old IMF
On August 15, 1971, President Richard Nixon suspended the convertibility of the dollar into gold.
On December 18, 1971, the United States devalued the dollar relative to the currencies of 14 major industrial nations.

46. Current Foreign Exchange Rate Arrangements
Figure 34-7

47. Fixed versus Floating Exchange Rates
To maintain a fixed exchange rate, the central bank of a country can buy and sell currencies.
It must use its own foreign exchange reserves to engage in these financial market transactions.

48. A Fixed Exchange Rate Figure 34-8
• The supply of ringgit shifts to the right as Thai residents demand more U.S. goods
• The value of the ringgit will fall
The Bank of Malaysia buys
ringgit with dollars shifting the demand for ringgit to the right
Figure 34-8

49. International Example: Central Banks’ Currencies of Choice
A central bank allocates foreign exchange reserves based on its perception of which currencies will be needed most frequently to alter the demand for its own currency.
The U.S. dollar is the currency most commonly held in foreign exchange reserves; but the euro, the Japanese yen, and the British pound also comprise a measurable portion of these accounts.

50. Fixed Exchange Rates Pros and cons of fixed exchange rates Pros
Limiting foreign exchange risk
The possibility that changes in the value of a nation’s currency will result in variations in market value of assets

51. Fixed Exchange Rates Pros and cons of fixed exchange rates Cons
A country’s residents can avoid foreign exchange risk by hedging
A financial strategy that reduces the chance of suffering losses arising from foreign exchange risk
A nation’s output and employment can fall in the short run if demand for its products decreases and its labor is relatively immobile

52. The Dirty Float and Managed Exchange Rates
A system between flexible and fixed exchange rates in which central banks occasionally enter foreign exchange markets to influence rates

53. Managed Exchange Rates
What do you think?
Is it possible to “manage” foreign exchange rates?
One study concludes that neither the Fed nor the central banks of the other G7 can successfully influence exchange rates in the long run.

54. Managed Exchange Rates
Crawling Pegs
An automatically adjusting target for the value of a nation’s currency
The exchange rate gradually adjusts the upward or downward by a country’s central bank buying or selling its currency as needed to keep it consistent with long-run forces.

55. Managed Exchange Rates
Target Zones
Upper and lower limits or bands for values of an exchange rate are established and maintained by central banks

56. Issues and Applications: Japan’s Finance Ministry Learns a New Currency Trick
As the value of the dollar has declined against the Japanese yen in recent years, American consumers must pay more for Japanese-made goods.
In response, the Japanese government began buying dollars on the foreign exchange market.
Of late, the government has been using private banks to implement the foreign exchange transactions needed to arrest the yen appreciation.

57. Summary Discussion of Learning Objectives
The balance of trade versus the balance of payments
Balance of trade
Exports of goods-imports
Balance of payments
A system of account for all transactions between a nation’s residents and the rest of the world

58. Summary Discussion of Learning Objectives
The key accounts within the balance of payments
Current account
Capital account
Official reserve transactions account

59. Summary Discussion of Learning Objectives
Exchange rate determination in the market for foreign exchange
The equilibrium exchange rate is the exchange rate at which the quantity of a country’s currency is equal to the quantity supplied

60. Summary Discussion of Learning Objectives
Factors that can induce changes in equilibrium exchange rates
Changes in desired imports or exports
Changes in real interest rates
Changes in relative productivity
Tastes and preferences of consumers
Perceptions of stability

61. Summary Discussion of Learning Objectives
How policymakers can attempt to keep exchange rates fixed
A country’s central bank increases the demand for its country’s currency if the exchange rate begins to fall
Alternative approaches to limiting exchange rate variability
Dirty floats
Crawling pegs
Target zones

62. Exchange Rates and the Balance of Payments
End of Chapter 34
Exchange Rates and the Balance of Payments