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Ch. 32: International Ch. 32: International FinanceFinance

James R. Russell, Ph.D., Professor of Economics & Management, Oral Roberts James R. Russell, Ph.D., Professor of Economics & Management, Oral Roberts UniversityUniversity©2005 Thomson Business & Professional Publishing, A Division of Thomson ©2005 Thomson Business & Professional Publishing, A Division of Thomson LearningLearning

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The Balance of The Balance of PaymentsPayments Balance of PaymentsBalance of Payments: a periodic statement : a periodic statement

(usually annual) of the money value of all (usually annual) of the money value of all transactions between residents of one country transactions between residents of one country and residents of all other countries.and residents of all other countries.

Provides information about a nation’s:Provides information about a nation’s:– imports and exportsimports and exports– domestic residents’ earnings on assets located domestic residents’ earnings on assets located

abroadabroad– foreign earnings on domestic assetsforeign earnings on domestic assets– gifts to and from foreign countries (including gifts to and from foreign countries (including

foreign aid)foreign aid)– official transactions by governments and central official transactions by governments and central

banks.banks.

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The Balance of The Balance of PaymentsPayments

DebitDebit: any transaction that supplies the : any transaction that supplies the country’s currency in the foreign exchange country’s currency in the foreign exchange market.market.

Foreign Exchange MarketForeign Exchange Market: the market in : the market in which currencies of different countries are which currencies of different countries are exchanged.exchanged.

CreditCredit: any transaction that creates a demand : any transaction that creates a demand for the country’s currency in the foreign for the country’s currency in the foreign exchange market.exchange market.

Current AccountCurrent Account: includes all payments related : includes all payments related to the purchase and sale of goods and services. to the purchase and sale of goods and services. Components include: exports, imports, and net Components include: exports, imports, and net unilateral transfers abroad.unilateral transfers abroad.

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Exhibit 1: Debits and Credits

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Exhibit 2: U.S. Balance of Payments, Year Z

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Exhibit 2: U.S. Balance of Payments, Year Z

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Current AccountCurrent Account

Current AccountCurrent Account: includes all : includes all payments related to the purchase and payments related to the purchase and sale of goods and services. Includes:sale of goods and services. Includes:

Exports of Goods and ServicesExports of Goods and Services: : exports of goods, exports of services, exports of goods, exports of services, and income from assets owned abroad. and income from assets owned abroad. Recorded as credits (+).Recorded as credits (+).

Imports of Goods and ServicesImports of Goods and Services: : imports of goods, imports of services, imports of goods, imports of services, and income from foreign owned and income from foreign owned domestic assets. Recorded as a debit domestic assets. Recorded as a debit (-).(-).

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Current AccountCurrent Account

Net Unilateral Transfers AbroadNet Unilateral Transfers Abroad: : Net one-way money payments. Net one-way money payments.

From Americans or U.S. From Americans or U.S. Government to foreigners or Government to foreigners or foreign governments (-). orforeign governments (-). or

From foreigners or foreign From foreigners or foreign governments to Americans or the governments to Americans or the U.S. Government (+).U.S. Government (+).

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Current AccountCurrent Account

Merchandise Trade BalanceMerchandise Trade Balance: the : the difference between the value of difference between the value of merchandise exports and imports.merchandise exports and imports.

Merchandise Trade DeficitMerchandise Trade Deficit: : amount that merchandise exports is amount that merchandise exports is less than merchandise imports.less than merchandise imports.

Merchandise Trade SurplusMerchandise Trade Surplus: : amount that merchandise exports is amount that merchandise exports is greater than merchandise importsgreater than merchandise imports

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Exhibit 3: U.S. Merchandise Trade Balance

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Capital AccountCapital Account

Capital AccountCapital Account: all payments related to : all payments related to the purchase and sale of assets and to the purchase and sale of assets and to borrowing and lending activities.borrowing and lending activities.

Outflow of U.S. CapitalOutflow of U.S. Capital: American : American purchases of foreign assets and U.S. loans purchases of foreign assets and U.S. loans to foreigners are outflows of U.S. Capitalto foreigners are outflows of U.S. Capital

Inflow of Foreign CapitalInflow of Foreign Capital: Foreign : Foreign purchases of U.S. assets and foreign loans purchases of U.S. assets and foreign loans to Americans are inflows of foreign to Americans are inflows of foreign capital.capital.

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Official Reserve Account Official Reserve Account and Statistical and Statistical DiscrepancyDiscrepancy Official Reserve AccountOfficial Reserve Account: :

official reserve balances in the official reserve balances in the form of foreign currencies, gold, form of foreign currencies, gold, its reserve position in the its reserve position in the International Monetary Fund, and International Monetary Fund, and Special Drawing Rights. Special Drawing Rights.

Statistical DiscrepancyStatistical Discrepancy: : adjustment to the balance of adjustment to the balance of payments due to incomplete or payments due to incomplete or inaccurate information. inaccurate information.

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What the Balance Of What the Balance Of Payments EqualsPayments Equals Current Account BalanceCurrent Account Balance

– Exports of goods and servicesExports of goods and services– Imports of goods and servicesImports of goods and services– Net unilateral transfersNet unilateral transfers

Capital Account BalanceCapital Account Balance– Outflow of U.S. capitalOutflow of U.S. capital– Inflow of foreign capitalInflow of foreign capital

Official Reserve BalanceOfficial Reserve Balance– Increase in U.S. official reserve assetsIncrease in U.S. official reserve assets– Increase in foreign official assets in the Increase in foreign official assets in the

U.S.U.S. Statistical DiscrepancyStatistical Discrepancy

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Self-TestSelf-Test

If an American retailer buys Japanese If an American retailer buys Japanese cars from a Japanese manufacturer, cars from a Japanese manufacturer, is this transaction recorded as a debit is this transaction recorded as a debit or a credit? Explain your answer.or a credit? Explain your answer.

Exports of goods and services equal Exports of goods and services equal $200 billion and imports of goods and $200 billion and imports of goods and services equal $300 billion. What is services equal $300 billion. What is the merchandise trade balance?the merchandise trade balance?

What is the difference between the What is the difference between the merchandise trade balance and the merchandise trade balance and the current account balance?current account balance?

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Flexible Exchange Flexible Exchange RatesRates

Exchange RateExchange Rate: the : the price of one currency price of one currency in terms of another in terms of another currency.currency.

Flexible Exchange Flexible Exchange Rate SystemRate System: A : A system whereby system whereby exchange rates are exchange rates are determined by the determined by the forces of supply and forces of supply and demand for a demand for a currency.currency.

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The Demand For Goods The Demand For Goods and Currenciesand Currencies

Country Country AA’s demand for Country ’s demand for Country BB’s ’s goods leads to a demand for goods leads to a demand for BB’s ’s currency and a supply of currency and a supply of AA’s ’s currency on the foreign exchange currency on the foreign exchange market.market.

BB’s demand for ’s demand for AA’s goods leads to a ’s goods leads to a demand for demand for AA’s currency and a ’s currency and a supply of supply of BB’s currency on the foreign ’s currency on the foreign exchange market.exchange market.

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Exhibit 4: The Demand for Goods and the Supply of Currencies

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Exhibit 5: Translating U.S. Demand for Pesos into U.S. Supply of Dollars and Mexican Demand for Dollars into Mexican Supply of Pesos

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Exhibit 6: A Flexible Exchange Rate System

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Changes in the Changes in the Equilibrium RateEquilibrium Rate Difference in Income Growth RatesDifference in Income Growth Rates

– Higher Relative Growth = Weaker CurrencyHigher Relative Growth = Weaker Currency– Lower Relative Growth = Stronger CurrencyLower Relative Growth = Stronger Currency

Difference in Relative Inflation RatesDifference in Relative Inflation Rates – Higher Relative Inflation = Weaker CurrencyHigher Relative Inflation = Weaker Currency– Lower Relative Inflation = Stronger CurrencyLower Relative Inflation = Stronger Currency

Changes in Real Interest RatesChanges in Real Interest Rates– Higher Relative Real Interest Rates = Stronger Higher Relative Real Interest Rates = Stronger

CurrencyCurrency– Lower Relative Interest Rates = Weaker Lower Relative Interest Rates = Weaker

CurrencyCurrency

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Exhibit 7: The Growth Rate of Income and the Exchange Rate (US Growth Higher)

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Exhibit 8: Inflation, Exchange Rates, and Purchasing Power Parity (PPP) Higher US Inflation

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Purchasing Power Purchasing Power Parity TheoryParity Theory

Purchasing Power Purchasing Power Parity TheoryParity Theory: : the exchange rates the exchange rates between any two between any two currencies will currencies will adjust to reflect adjust to reflect changes in the changes in the relative price levels relative price levels of the two of the two countries.countries.

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Self-TestSelf-Test

In the foreign exchange market, how is the In the foreign exchange market, how is the demand for dollars linked to the supply of demand for dollars linked to the supply of pesos?pesos?

What could cause the U.S. dollar to What could cause the U.S. dollar to appreciate against the Mexican peso on the appreciate against the Mexican peso on the foreign exchange market?foreign exchange market?

Suppose the U.S. economy grows while the Suppose the U.S. economy grows while the Swiss economy does not. How will this Swiss economy does not. How will this affect the exchange rate between the dollar affect the exchange rate between the dollar and the Swiss franc? Why?and the Swiss franc? Why?

What does the Purchasing Power Parity What does the Purchasing Power Parity Theory say? Give an example to illustrate Theory say? Give an example to illustrate your answer.your answer.

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Fixed Exchange RatesFixed Exchange Rates

Fixed Exchange Rate SystemFixed Exchange Rate System: the system : the system where a nation’s currency is set at a fixed where a nation’s currency is set at a fixed rate relative to all other currencies, and rate relative to all other currencies, and central banks intervene in the foreign central banks intervene in the foreign exchange market to maintain the fixed rate.exchange market to maintain the fixed rate.

OvervaluationOvervaluation: when a currency’s current : when a currency’s current price, in terms of other currencies, is above price, in terms of other currencies, is above the equilibrium price.the equilibrium price.

UndervaluationUndervaluation: when a currency’s : when a currency’s current price, in terms of other currencies, is current price, in terms of other currencies, is below the equilibrium price.below the equilibrium price.

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Exhibit 9: A Fixed Exchange Rate System

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Exhibit 10: Fixed Exchange Rates and an Overvalued Dollar

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What’s so Bad About What’s so Bad About An Overvalued Dollar?An Overvalued Dollar?

As U.S. exports As U.S. exports become more become more expensive for other expensive for other countries, they buy countries, they buy fewer U.S. exports. fewer U.S. exports. If exports fall If exports fall below imports, the below imports, the U.S. is in a trade U.S. is in a trade deficit.deficit.

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Government Involvement Government Involvement in a Fixed Exchange in a Fixed Exchange SystemSystem

Suppose there is a surplus of pesos.Suppose there is a surplus of pesos. The Fed might buy pesos with dollars, The Fed might buy pesos with dollars,

causing the demand for pesos will causing the demand for pesos will increase and its demand curve will shift to increase and its demand curve will shift to the right. the right.

The Banco de Mexico might buy the peso The Banco de Mexico might buy the peso with its reserve dollars, increasing the with its reserve dollars, increasing the demand for pesos and the equilibrium demand for pesos and the equilibrium rate.rate.

Or, the Fed and the Banco de Mexico Or, the Fed and the Banco de Mexico might both buy pesos.might both buy pesos.

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Options Under a Fixed Options Under a Fixed Exchange Rate SystemExchange Rate System

Devaluation and RevaluationDevaluation and Revaluation– Devaluation occurs when the Devaluation occurs when the

official price of a currency is official price of a currency is lowered.lowered.

– Revaluation occurs when the Revaluation occurs when the official price of a currency is raised.official price of a currency is raised.

Protectionist Trade PolicyProtectionist Trade Policy Changes in Monetary PolicyChanges in Monetary Policy

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The Gold StandardThe Gold StandardFixed Exchange Rate Fixed Exchange Rate SystemSystem

To have a gold standard, To have a gold standard, countries must:countries must:

Define their currencies Define their currencies in terms of gold.in terms of gold.

Stand ready and willing Stand ready and willing to convert gold into to convert gold into paper money and paper money and paper money into gold.paper money into gold.

Link their money Link their money supplies to their supplies to their holdings of gold.holdings of gold.

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Economists and The Economists and The Gold StandardGold Standard

Some economists argue “The gold Some economists argue “The gold system subjects domestic monetary system subjects domestic monetary policy to international instead of policy to international instead of domestic considerations.”domestic considerations.”

Some economists argue the same Some economists argue the same thing about the fixed exchange rate thing about the fixed exchange rate system.system.

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Self-TestSelf-Test

Under a fixed exchange rate system, Under a fixed exchange rate system, if one currency is overvalued then if one currency is overvalued then another currency must be another currency must be undervalued. Explain why this is undervalued. Explain why this is true.true.

How does an overvalued dollar How does an overvalued dollar affect U.S. exports and imports?affect U.S. exports and imports?

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Self-TestSelf-Test

In each case, identify whether the U.S. In each case, identify whether the U.S. dollar is overvalued or undervalued:dollar is overvalued or undervalued:– The fixed exchange rate is 2 dollars = 1 pound The fixed exchange rate is 2 dollars = 1 pound

and the equilibrium exchange rate is 3 dollars = and the equilibrium exchange rate is 3 dollars = 1 pound.1 pound.

– The fixed exchange rate is 1.25 dollars = 1 euro The fixed exchange rate is 1.25 dollars = 1 euro and the equilibrium exchange rate is 1.10 and the equilibrium exchange rate is 1.10 dollars = 1 euro.dollars = 1 euro.

– The fixed exchange rate is 1 dollars = 10 pesos The fixed exchange rate is 1 dollars = 10 pesos and the equilibrium exchange rate is 1 dollars = and the equilibrium exchange rate is 1 dollars = 14 pesos.14 pesos.

Under a fixed exchange rate system, Under a fixed exchange rate system, why might the United States want to why might the United States want to devalue its own currency?devalue its own currency?

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Fixed Exchange Rates Fixed Exchange Rates Versus Flexible Exchange Versus Flexible Exchange RatesRates

Fixed Exchange RatesFixed Exchange Rates provide provide certainty, and that certainty of price certainty, and that certainty of price & exchange promotes international & exchange promotes international trade. Persistent balance of trade trade. Persistent balance of trade problems could develop. problems could develop.

Flexible Exchange RatesFlexible Exchange Rates allow a allow a country to adopt policies to meet country to adopt policies to meet domestic economic goals. But, domestic economic goals. But, flexible exchange rates can flexible exchange rates can dampen international trade.dampen international trade.

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Optimal Currency Optimal Currency AreasAreas

Optimal Optimal Currency AreaCurrency Area: a : a geographic area in geographic area in which exchange which exchange rates can be fixed rates can be fixed or a common or a common currency used currency used without sacrificing without sacrificing domestic domestic economic goals.economic goals.

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Optimal Currency AreasOptimal Currency Areas

Assume : Demand for Canadian goods is falling as Assume : Demand for Canadian goods is falling as demand for U.S. goods are rising:demand for U.S. goods are rising:

Trade and Labor MobilityTrade and Labor Mobility: if labor is mobile, : if labor is mobile, then changes in relative demand pose no major then changes in relative demand pose no major economic problems for either country.economic problems for either country.

Trade and Labor ImmobilityTrade and Labor Immobility: The results : The results depend on whether the Exchange Rates are fixed depend on whether the Exchange Rates are fixed of flexible:of flexible:– If exchange rates are flexible, the value of U.S. If exchange rates are flexible, the value of U.S.

currency changes vis-à-vis Canadian currency.currency changes vis-à-vis Canadian currency.– If exchange rates are fixed, U.S. goods will not If exchange rates are fixed, U.S. goods will not

become relatively more expensive for become relatively more expensive for Canadians and Canadian goods will not Canadians and Canadian goods will not become relatively less expensive for become relatively less expensive for Americans..Americans..

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Costs, Benefits, and Costs, Benefits, and Optimal Currency Optimal Currency AreasAreas

Costs of flexible exchange rates include Costs of flexible exchange rates include the cost of exchanging one currency for the cost of exchanging one currency for another and the added risk of not another and the added risk of not knowing the value of what one’s currency knowing the value of what one’s currency will be on the foreign market.will be on the foreign market.

When labor in countries within a certain When labor in countries within a certain geographic area is mobile enough to geographic area is mobile enough to move easily and quickly in response to move easily and quickly in response to changes in relative demand, the countries changes in relative demand, the countries are said to constitute an optimal currency are said to constitute an optimal currency area.area.

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The Current The Current International Monetary International Monetary SystemSystem

Managed FloatManaged Float: a managed : a managed flexible exchange rate system, flexible exchange rate system, under which nations now and then under which nations now and then intervene to adjust their official intervene to adjust their official reserve holdings to moderate reserve holdings to moderate major swings in exchange rates.major swings in exchange rates.

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Proponents of the Proponents of the Managed Float System Managed Float System Say:Say:

It allows nations to pursue It allows nations to pursue independent monetary policies.independent monetary policies.

It solves trade problems without It solves trade problems without trade restrictions.trade restrictions.

It is flexible and therefore can It is flexible and therefore can easily adjust to shocks.easily adjust to shocks.

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Opponents of the Opponents of the Managed Float System Managed Float System Say:Say: It promotes exchange rate volatility and It promotes exchange rate volatility and

uncertainty and results in less uncertainty and results in less international trade than would be the international trade than would be the case under fixed exchange rates.case under fixed exchange rates.

It promotes inflation.It promotes inflation. Changes in exchange rates alter trade Changes in exchange rates alter trade

balances in the desired direction only balances in the desired direction only after a long time. In the short run, a after a long time. In the short run, a depreciation in a currency can make the depreciation in a currency can make the situation worse instead of better.situation worse instead of better.

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Self-TestSelf-Test

What is an optimal currency area? Give an What is an optimal currency area? Give an example.example.

Country 1 produces good X and Country 2 Country 1 produces good X and Country 2 produces good Y. People in both countries begin produces good Y. People in both countries begin to demand more of good X and less of good Y. to demand more of good X and less of good Y. Assume there is no labor mobility between the two Assume there is no labor mobility between the two countries and that a flexible exchange rate system countries and that a flexible exchange rate system exists. What will happen to the unemployment exists. What will happen to the unemployment rate in country 2? Explain your answer.rate in country 2? Explain your answer.

How important is labor mobility in determining How important is labor mobility in determining whether or not an area is an optimal currency whether or not an area is an optimal currency area?area?

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The EndThe End