Exchange Rates, the Balance of Payments,

& Trade DeficitsChapter 21

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21.1 Learning Target

I can explain how the U.S. Balance of payments is calculated.

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Financing International Trade

U.S. export transaction U.S. exports create a foreign demand for dollars

Fulfilling that demand increases the supply of foreign currencies owned by U.S. banks & available to U.S. buyers

U.S. import transaction Creates a domestic demand for foreign currencies

Fulfilling that demand reduces the supplies of foreign currencies held by U.S. banks & available to U.S. consumers

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The balance of payments

Sum of all the transactions that take place between its residents & the residents of foreign nations

Includes: imports & exports of goods, services, tourist expenditures, interest & dividends received or paid abroad, & purchases and sales of financial or real assets abroad.

The U.S. Commerce Department’s Bureau of Economic Analysis compiles the balance-of-payments statement annually

Shows flow of payments into & out of the country

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Current account

The section in a nation’s international balance of payments that records:

Exports & imports of goods & services, its net investment income & net transfers

Exports have a (+) symbol (credit)…imports have a (-) symbol (debit)

Balance of trade – difference between its exports & imports of goods

Trade deficit – import more than export Trade surplus- export more than import

Balance on current account – sum of all transactions in the current account

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Capital & financial account Capital

Measures debt forgiveness

Financial

Summarizes the purchase or sale of real or financial assets and the corresponding flows of monetary payments that accompany them

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Payments, deficits, & surpluses

Balance-of-payments deficit Occurs when a nation must draw

down its official reserves to balance the capital & financial account with the current account

Balance-of-payments surplus Occurs when a nation adds to its

official reserves in order to balance the two accounts

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21.2 Learning Targets

I can explain how exchange rates are determined in currency markets.

I can discuss the difference between flexible exchange rates and fixed exchange rates.

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Flexible (Floating) Exchange Rates

Demand & supply determine exchange rates & in which no government intervention occurs

Depreciation & appreciation

Depreciation – more of its currency is needed to buy a single unit of some other currency

Appreciation – fewer units of the currency is needed to buy some other currency

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Determinants of exchange rates

The following factors cause a nation’s currency to appreciate or depreciate in the foreign exchange market

1. Changes in tastes

2. Relative income changes

3. Relative price-level changes

4. Relative interest rates

5. Speculation

6. Changes in Relative Expected Returns on Stocks, Real Estate, & Production Facilities

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Flexible rates & the balance of payments

Proponents of flexible exchange rates say they have an important feature:

They automatically adjust & eventually eliminate balance-of-payments deficits or surpluses.

Disadvantages of flexible exchange rates

Uncertainty & diminished trade Instability

Wide fluctuations stimulate & then depress industries producing exported goods

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Fixed (Pegged) exchange rates Governments determine exchange rates & make

necessary adjustments in their economies to maintain those rates

How a fixed exchange rate is maintained:1. Use of reserves

Currency interventions

2. Trade policies

3. Exchange controls & rationingObjections Distorted trade, favoritism, restricted choice (controls

would limit freedom of consumer choice), & black markets

4. Domestic macroeconomic adjustments

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21.3 Learning Targets

I can explain the causes & consequences of U.S. trade deficits.

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The Current System: The Managed Float

Managed floating exchange rates Exchange rates among major

currencies are free to float

In support of the Managed Float

Concerns with the Managed Float

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Recent U.S. trade deficits

Causes of the trade deficits Economic growth China (fixed exchange rate) Rapid rise in price of oil Decline in U.S. savings rate

Implications of U.S. trade deficits

Increase U.S. indebtedness Trade deficits must be financed by

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