Microeconomics Chapter 20

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International Finance

Chapter 20

Copyri ght 2011 by The McGraw-H il l Companies, In c. All ri ghts reserved.McGraw-Hill/Irwin


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1. Explain how international trade is financed.

2. Define and measure our balance of payments.

3. List and discuss the different exchange rate systems.

4. Summarize how we became a debtor nation.5. Explain American exceptionality from a historical perspective.

Learning Objectives

After this chapter, you should be able to:


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The Balance of Payments

Defined: the entire flow of U.S. dollars and foreigncurrencies into and out of the country.

The balance of payments has 2 parts:1. The current accounta summary of all the goods and services

produced during the current year that we buy from or sell toforeigners.

2. The capital accountrecords the long-term transactions thatwe conduct with foreigners.

The total of both accounts always equals zero.


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U.S. Balance of Payments, 2009


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U.S. Current Account Surpluses and

Deficits, 1985-2009


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U.S. Current Account Surpluses and

Deficits

Our current accountdeficit must be balancedby our capital accountsurplus.

Our current accountdeficit has been risingrapidly since the early1990s.

The U.S. is faring worsethan other countries.

U.S. Current Account Deficitas a Percentage of GDP,

19852009


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Current Account Deficit or Surplus as

Percentage of GDP, Selected Countries, 2008


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Questions for Thought and Discussion

How did this happen? Imports > Exports! We buy much more from foreign countries

than they buy from us.

To offset this, we must balance this by selling foreigncountries U.S. stock, real estate, bonds, and other debt.

Does it matter? How much longer can we go on selling off U.S. capital assets?


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Exchange Rate Systems

The basis for international finance is the exchange ofwell over 100 national currencies.

A exchange rateis the price of a countrys currency interms of another currency.


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The Gold Standard (until 1933)

A nation is on the gold standard when it defines itscurrency in terms of gold (at a fixed ratio).

Until 1933, the U.S. dollar was worth 1/23 of an ounce

of gold.

When country A exports as much as it imports, no goldis transferred.

But, when country A imports more than it exports, ithas to ship the difference in gold.


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The Gold Standard

The gold standard was a self-correcting mechanism.

A negative balance of trade caused an outflow of gold,a lower money supply, lower prices, and ultimatelyfewer imports and more exports.

The gold standard will only work when the gold supplyincreases as quickly as the worlds need for money.

World War II caused the need for a worldwide systemthat would lend some stability to how exchange rateswere set.


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The Gold Exchange Standard, 1944-1973

A Bretton Woods (New Hampshire) conference set upthe International Monetary Fund (IMF) to supervise asystem of fixed exchange rates, all of which werebased on the U.S. dollar, which was based on gold.

The U.S. held the largest stock of the worlds gold and stood

ready to sell that gold at $35 an ounce.

Dollars were convertible into gold at $35 an ounce.

Other currencies were convertible into dollars, at fixed prices,so these currencies were indirectly convertible into gold.


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The Gold Exchange Standard, 1944-1973

A countrys money supply was not tied to gold. No longer would trade deficits or surpluses

automatically eliminate themselves. If a nation ran consistent trade deficits, it could devalue (lower)

its currency relative to the dollar.

This system worked well for 25 years after World WarII.

By the 1960s, U.S. gold stock dwindled, so othernations began to worry that the U.S. would not be ableto redeem dollars at $35 an ounce.

In 1971, President Nixon announced the U.S. would nolonger redeem dollars for gold.


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The Freely Floating Exchange Rate System,

1973 to the Present

The forces ofsupply and

demand now set

the exchange

rates.

Hypothetical demand and supply for British Pounds


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The Free Floating Exchange Rate System,

1973 to the Present

D curve: represents the desireof Americans to exchange theirdollars for pounds to buyBritish goods and services,stocks, bonds, real estate, and

other assets. S curve: represents the desire

of British citizens to purchaseAmerican goods, services, andfinancial assets.

We dont have completely freefloating exchange ratesbecause governments dointervene, usually for a limitedtime.


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Exchange Rates: Foreign Currency per U.S.

Dollar, April 8, 2010


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The relative price levels between the two countries.

The relative growth of the two countries economies.

The relative level of interest rates in the two countries.

Factors Influencing Exchange Rates


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The Yen and the Yuan

(Japanese and Chinese currency)

The two biggest trade deficits of the U.S. are with Chinaand Japan.

These countries try to keep the value of their currencies

low vis--vis the U.S. dollar to promote their exports.

The Chinese are the big exception to the freely floatingexchange rate system.

By maintaining an undervalued yuan, the Chinese are able to

make Chinese exports more attractive to American consumersby keeping down their prices.

From, this point of view, global monetary policy is now made inBeijing, not Washington.


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The Falling Dollar and the U.S. Trade Deficit

What should be pretty clear by now is that, as a nation, we havebeen living well beyond our means for more than 25 years. It also should be clear that the party cant last forever. The U.S. quickly shifted from being the worlds largest creditor

nation (which is good) to the largest debtor nation (which is not sogood).

What happened?


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From Largest Creditor to Largest Debtor

Foreign assets in theU.S. has been increasingat an increasing rate; thiswhat foreigners own inthe U.S.

So the gap between whatforeigners own in theU.S. and the U.S. stockof net foreign assets hasbeen widening.

Gap > $6 trillion in 2009.

Over $1 trillion ofAmerican currency isabroad.


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From Largest Creditor to Largest Debtor:

How Did We Get Thereand Why Worry?

How? Main reason: mounting U.S. trade deficits; we are consumption junkies.

We continue to station hundreds of thousands of troops abroad.

The interest, rent, dividends, and profits we pay foreigners continues togrow as our debt mounts.

Why Worry?

We borrow almost $2 billion a day to finance our current account deficit,mostly from East Asian countries.

If foreigners eventually want to hold fewer dollars, the value of the dollar

will plunge. This puts upward pressure on prices and interest rates, and depress

growth.


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Editorial: American Exceptionality

We are running unsustainably large budget deficits.

We have been running huge trade deficits.

Our defense spending is growing at an unsustainable

pace, while our military is stretched to the breakingpoint.

We are living well beyond our means, depending onthe kindness of foreigners.

We have lost most of our manufacturing base and arenow losing our innovative edge as well.


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Editorial: American Exceptionality, cont.

Americans have one of the lowest savings rate of allnations.

American students have among the lowest scores oninternational tests.

We import 60% of our oil.

We spend almost 2x per capita on healthcare as mostother economically advanced nations.

Considered together as a group of facts, could it bethat that the game is almost up and we are on thewrong end of the score?

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Microeconomics Chapter 20