The meaning and measurement of the balance of payments
The determinants of international capital flows
The role of the foreign exchange market and the exchange rate
The importance of real exchange rates and their role in the current account
The considerations that lead countries to choose different exchange rate regimes, such as fixed exchange rates and floating exchange rates
Why open-economy considerations affect macroeconomic policy under floating exchange rates
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Capital Flows And The Balance Of Payments
A country’s balance of payments accounts summarize its transactions with the rest of the world.
The balance of payments on current account includes the balance of payments on goods and services together with balances on factor income and transfers.
The merchandise trade balance is a frequently-cited component of the balance of payments on goods and services.
The balance of payments on financial account measures capital flows. By definition, sum of the balance of payments on current account plus the balance of payments on financial account is zero.
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The U.S. Balance of Payments on Current Account, 2004
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Presentation Notes
*The U.S. government provides only an estimate of net transfers, without the amounts going in and out. Source: Bureau of Economic Analysis.
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The U.S. Balance of Payments on Financial Account, 2004
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Source: Bureau of Economic Analysis.
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The Balance of Payments
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The green arrows represent payments that are counted in the balance of payments on current account. The red arrows represent payments that are counted in the balance of payments on financial account. Because the total flow into the United States must equal the total flow out of the United States, the sum of the balance of payments on current account plus the balance of payments on financial account is zero.
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The Loanable Funds Model - Revisited
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Presentation Notes
According to the loanable funds model of the interest rate, the equilibrium interest rate is determined by the intersection of the supply of loanable funds, S, and the demand for loanable funds, D. At point E, the equilibrium interest rate is 4%.
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Loanable Funds Markets in Two Countries
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Here we show two countries, the United States and Britain, each with its own loanable funds market. The equilibrium interest rate is 6% in the U.S. market but only 2% in the British market. This creates an incentive for capital to flow from Britain to the United States.
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International Capital Flows
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Presentation Notes
British lenders lend to borrowers in the United States, leading to equalization of interest rates at 4% in both countries. At that rate, American borrowing exceeds American lending; the difference is made up by capital inflows from Britain. Meanwhile, British lending exceeds British borrowing; the excess is a capital outflow to the United States.
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The Role Of The Exchange Rate
Currencies are traded in the foreign exchange market.
The prices at which currencies trade are known as exchange rates.
When a currency becomes more valuable in terms of other currencies, it appreciates.
When a currency becomes less valuable in terms of other currencies, it depreciates.
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The Foreign Exchange Market
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The foreign exchange market matches up the demand for a currency from foreigners who want to buy domestic goods, services, and assets with the supply of a currency from domestic residents who want to buy foreign goods, services, and assets. Here, the equilibrium in the market for dollars is at point E, corresponding to an equilibrium exchange rate of † 0.95 per $1.00. The equilibrium exchange rate is the exchange rate at which the quantity of a currency demanded in the foreign exchange market is equal to the quantity supplied.
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Equilibrium in the Foreign Exchange Market: A Hypothetical Example
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Effects of Increased Capital Inflows
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An Increase in the Demand for U.S. Dollars
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An increase in the demand for U.S. dollars might result from a higher rate of return available in the United States. The demand curve for U.S. dollars shifts from D1 to D2. So the equilibrium number of euros per U.S. dollar rises—the dollar appreciates. As a result, the balance of payments on current account falls as the balance of payments on financial account rises.
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Real Exchange Rates
Real exchange rates are exchange rates adjusted for international differences in aggregate price levels.
Positive real exchange rate =
Pesos per U.S. dollars × PUS /PMex
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Real Versus Nominal Exchange Rates, 1992–2003
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The line labeled “nominal exchange rate” shows the exchange rate between the Mexican peso and the U.S. dollar, expressed as pesos per U.S. dollar. The line labeled “real exchange rate” shows the real exchange rate, with price indexes for both countries set so that 1992=100. The peso lost two-thirds of its nominal value in terms of the U.S. dollar, but this doesn’t mean that the prices of Mexican goods and services fell two-thirds relative to U.S. goods and services. Source: OECD Factbook 2005.
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Purchasing Power Parity Versus the Nominal Exchange Rate, 1990–2003
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The purchasing power parity between the United States and Canada—the exchange rate at which a basket of goods and services would have cost the same amount in both countries— changed very little over the period shown, staying near C$1.2 per US$1. But the nominal exchange rate fluctuated widely. Source: OECD Factbook 2005.
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Economics in Action: The Dollar and the Current Account Deficit, 1973–2003
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The U.S. balance of payments on current account has generally followed movements in the real exchange rate. Here, we compare the real exchange rate of the U.S. dollar against a basket of foreign currencies with the current account deficit, measured as a percentage of GDP. Notice how the large appreciation and depreciation of the U.S. dollar in the 1980s were followed, with a lag, by a large rise and fall in the current account deficit. Source: OECD Economic Outlook.
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Exchange Rate Policy
An exchange rate regime is a rule governing policy toward the exchange rate.
A country has a fixed exchange rate when the government keeps the exchange rate against some other currency at or near aparticular target.
A country has a floating exchange rate when the government lets the exchange rate go wherever the market takes it.
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Exchange Market Intervention
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In both panels the imaginary country of Genovia is trying to keep the value of its currency, the geno, fixed at US$1.50. In panel (a), there is a surplus of genos on the foreign exchange market. To keep the geno from falling, the Genovian government can buy genos and sell U.S. dollars. In panel (b), there is a shortage of genos. To keep the geno from rising, the Genovian government can sell genos and buy U.S. dollars.
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Exchange Market Intervention
Government purchases or sales of currency in the foreign exchange market are exchange market interventions.
Foreign exchange reserves are stocks of foreign currency that governments maintain to buy their own currency on the foreign exchange market.
Foreign exchange controls are licensing systems that limit the right of individuals to buy foreign currency.
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For Inquiring Minds:The Road to the Euro
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The exchange rate between the French franc and the German mark tells the tale of Europe’s long march to a common currency. European nations made several attempts to fix exchange rates in the 1970s and 1980s. The first two attempts failed, but since 1987 they were mostly successful. The exchange rate was “locked” in the late 1990s, and at the end of 2001, the franc and the mark were replaced by the euro.
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Exchange Rates And Macroeconomic Policy
A devaluation is a reduction in the value of a currency that previously had a fixed exchange rate.
A revaluation is an increase in the value of a currency that previously had a fixed exchange rate.
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Monetary Policy and the Exchange Rate
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Here we show what happens in the foreign exchange market if Genovia cuts its interest rate. Residents of Genovia have a reduced incentive to keep their funds at home, so they invest more abroad. As a result, the supply of genos shifts rightward from S1 to S2. Meanwhile, foreigners have less incentive to put funds into Genovia, so the demand for genos shifts leftward from D1 to D2. The geno depreciates: the equilibrium exchange rate falls from X1 to X2.
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International Business Cycles
The fact that one country’s imports are another country’s exports creates a link between the business cycle in different countries. Floating exchange rates, however, may reduce the strength of that link.
