CHAPTER 38Balance of Payments, Exchange Rates & Trade Deficits

In chapter 37 we examined comparative advantage as the underlying economic basis of world trade when nations export and import goods/services between one another.

In this chapter we want to focus on the corresponding money flows used to pay for such transactions.

Balance of PaymentsA nation’s balance of payments is the sum of all the financial transactions that take place between its residents and the residents of foreign nations.

Most of these transactions fall into the two main categories including;

International trade involves either purchasing or selling currently produced goods or services across an international border.

International asset transactions involve the transfer of the property rights to either real or financial assets between the citizens of one country and the citizens of another country.

Pluses and MinusesWhen we sell goods/services to another nation there is a return flow of money back into the U.S. This inflow is a (+) or a credit to our balance of payments account, but when we import goods/services from other nations the money flows out and creates a (−) or a debit to our balance of payments account.

The current account consists of buying and selling goods and services, net investment income which is the difference between the interest and dividend payments between countries, and net transfers which include foreign aid, pensions paid to U.S. citizens living abroad, remittances by immigrants to family members abroad, and tourism dollars spent here or abroad.

By adding all transactions in the current account we obtain the balance on the current account, item 10, which in 2009 was −$420 billion. This means these transactions created out-payments from the U.S. greater than the in-payments to the U.S.

Key Point: People can only trade one of two things with each other; currently produced goods and services or preexisting assets. Therefore, if trading partners have an imbalance in their trade of currently produced goods and services, the only way to make up for that imbalance is with a net transfer of assets from one party to another.

For example- If the U.S. sends dollars to China to buy imports ( current account deficit), then China will either use those U.S. dollars to buy our products (current account credit), or invest those dollars in financial assets or real assets (capital account credit).

The capital account mainly measures debt forgiveness. The −$3 billion in item 11 tells us that Americans forgave $3 billion more of debt owed to them by foreigners than foreigners forgave debt owed to them by Americans.

The financial account summarizes international asset transactions having to do with buying and selling real or financial assets such as stocks, bonds, real estate, or businesses.

The balance on the capital and financial accounts, item 15, equals +$420 billion which is offset by the −$420 billion current account, item 10.

The balance of payments will always = 0.

Flexible Exchange Rates There are two pure types of exchange rate systems.

A flexible or floating exchange rate system- through which demand and supply determine exchange rates and in which no government intervention occurs.

A fixed exchange rate system- through which governments determine exchange rates and make necessary adjustments in their economies to maintain those rates.

We will be looking at flexible exchange rates where the forces of supply and demand determine the prevailing exchange rate.

Let’s examine the rate, or price, at which U.S. dollars might be exchanged for British pounds. The intersection of the supply curve and the demand curve will determine the dollar price of pounds. Here, that price, or exchange rate, is $2 = 1£.

Dollar price of a pound

Qty. of pounds0

S£

D£

Q

2$2 = 1£

Pound price of a $

S$

D$

Q

½ $1 = ½£

Quantity of $’s

Appreciation & Depreciation

An exchange rate determined by market forces can, and often does, change daily like stock and bond prices. These exchange rates can be found in a good daily newspaper or on the internet.

When the dollar price of pounds rises, for example, from $2 =1£ to $3 = 1£, the dollar has depreciated relative to the pound, and the pound has appreciated relative to the dollar.

When a currency depreciates, more units of it (dollars) are needed to buy a single unit of some other currency (pounds). One dollar initially bought ½£, but now buys only ⅓£. However, the pound initially bought $2, but now buys $3 so it has appreciated.

When the dollar price of pounds falls, for example, from $2=1£ to $1=1£, the dollar has appreciated relative to the pound. The dollar initially bought ½£ but now buys 1£.

When a currency appreciates, fewer units of it (dollars) are needed to buy a single unit of some other currency (pounds). On the other hand the pound initially bought $2 but now buys only $1 so the pound has depreciated.

Key Point: In general the relationship between the U.S. dollar and another currency are as follows.If the demand for pounds increases (↑D) or the supply of pounds decreases (↓S), the pound will appreciate. This means that anything which raises the dollar price of a pound will cause it to get stronger.

If the demand for pounds decreases (↓D) or the supply of pounds increases (↑S), the pound will depreciate. This means that anything which lowers the dollar price of a pound will cause it to get weaker.

Determinants of Exchange Rates

1) Change in tastes- If we have goods that another country wants and they are willing to pay for, then they will give us their currency (↑S) and buy our currency (↑D). The dollar will appreciate and the foreign currency will depreciate.

2) Relative Income Changes- As an economies income increases it will buy more goods (both domestic and foreign). So if the U.S. economy is growing faster than another nation, we will be importing more than we are exporting. The value of the dollar will depreciate.

3) Relative Price Level Changes- If the price level is rising faster domestically than it is in other countries, then U.S. consumers will buy more foreign goods and this will depreciate the dollar.

4) Relative Interest Rate Changes- Here we look at the lenders side of interest rates, not the borrowers side. If interest rates are rising faster in the U.S. than elsewhere, then it means the U.S. is a good place to save money.

More foreign money will flow into the U.S. economy and the value of the dollar will appreciate.

Recent U.S. Trade deficitsThe United States has experienced large and persistent trade deficits in recent years. These deficits rose rapidly between 2001 and 2006 before declining when consumers and businesses greatly curtailed their purchase of imports during the recession of 2007-2009.

Economists expect the trade deficits to expand, absolutely and relatively, toward prerecession levels when the economy recovers and U.S. income and imports again rise.

Causes of Trade Deficits

First, the U.S. economy expanded more rapidly between 2001 and 2007 than the economies of several U.S. trading partners. The strong income growth enabled Americans to greatly increase their purchases of imported products.

Another factor explaining large trade deficits is the enormous U.S. trade imbalance with China. In 2007 the U.S. imported $257 billion more than it exported to China.

The U.S. is China’s largest export market, and although China has greatly increased its imports from the U.S., its standard of living has not yet risen sufficiently for its households to afford large quantities of U.S. goods.

Adding to the problem, China’s government has fixed the exchange rate of its currency, the yuan, to a basket of currencies that includes the U.S. dollar. Therefore, China’s large trade surpluses have not caused the yuan to appreciate much against the dollar.

Another factor underlying the large U.S. trade deficits is a continuing trade deficit with oil-exporting nations, or OPEC.

A declining savings rate has also contributed to the large trade deficits.