Exchange Rates, the Balance of Payments, and Trade Deficits

Chapter 21

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter Objectives

• How currencies are exchanged• Balance sheet for recording

international payments• How exchange rates are

determined • Flexible vs. fixed exchange

rates • Causes and consequences of

trade deficits21-2

International Transactions

• International trade–Buy/sell current goods or services–Imports and exports

• International asset transactions–Buy/sell real or financial assets–Buy stock–Sell your house to a foreigner

• Requires currency exchange

21-3

Balance of Payments

• Sum of international financial transactions

• Current account–Balance on goods and services

–Net investment income

–Net transfers

–Balance on current account 21-4

Balance of Payments

• Capital and financial account–Capital account–Financial account

• Balance of payments accounts sum to zero

• Current account deficits generate asset transfers to foreigners

• Official reserves21-5

U.S. Trade Balances

Goods and Services, Select Nations, 2007

SurplusDeficit

Australia

Belgium

Canada

China

Germany

Mexico

Netherlands

+10.0

-67.0

-45.3

+9.8

-256.6

-77.3

+14.3

Source: Bureau of Economic Analysis

-10-20-30-40-50-60-70-250 10 20

Japan -85.0

21-6

Flexible Exchange Rates

• Demand for pounds• Supply of pounds• Market equilibrium• Increase in dollar price of pounds

–Dollar depreciates–Pound appreciates

• Decrease in dollar price of pounds–Dollar appreciates–Pound depreciates

21-7

Q0

Do

llar

Pri

ce o

f 1

Po

un

d

Quantity of Pounds

P

Flexible Exchange RatesThe Market for Foreign Currency (Pounds)

D1

S1

DollarDepreciates(PoundAppreciates)

DollarAppreciates(PoundDepreciates)

ExchangeRate: $2 = £1

$2

$3

$1

Q1

21-8

Flexible Exchange Rates

• Determinants of exchange rates• Factors that shift demand/supply

–Changes in tastes–Relative income changes–Relative price-level changes

• Purchasing-power-parity theory–Relative interest rates–Relative expected returns on

assets–Speculation

21-9

Q0

Do

llar

Pri

ce o

f 1

Po

un

d

Quantity of Pounds

P

Flexible Exchange RatesThe Market for Foreign Currency (Pounds)

D1

S1

ExchangeRate: $2 = £1

$2

$3

$1

Q1

D2

ExchangeRate: $3 = £1

BalanceOf Payments

Deficit

Q2

x a

b

c

21-10

Flexible Exchange Rates

• Eliminate balance of payments deficit or surplus

• Disadvantages of flexible exchange rates–Volatility –Uncertainty and diminished trade–Terms-of-trade changes–Instability

21-11

Fixed Exchange Rates

• Government intervention–Use of reserves

• Trade policies• Exchange controls and rationing

–Distorted trade–Favoritism–Restricted choice–Black markets

• Macroeconomic adjustments21-12

Exchange Rate Systems

• Gold standard 1879-1934–Fixed exchange rate system

• Bretton Woods 1944-1971–Fixed exchange rate system

indirectly tied to gold

• Managed float 1971-present

21-13

Managed Float

• Dependence on foreign exchange markets

• Occasional intervention

• In support of managed float

• Concerns with managed float

21-14

U.S. Trade Deficit

• Large and persistent• Causes of trade deficits

–High U.S. growth (relatively)–China–Price oil–Low U.S. saving rate

• Implications of trade deficits–Increased current consumption–Increased indebtedness 21-15

Speculation in Currency Markets

• Positive or negative influence?• Contributes to currency market

fluctuations• Self-fulfilling expectations • Smoothing short-term

fluctuations• Absorbing risk• Futures market at work• Positive role played overall

21-16

Key Terms• balance of payments• current account• balance on goods and

services• trade deficit• trade surplus• balance on current

account• capital and financial

account• balance on capital and

financial• balance-of-payments

deficits and surpluses• official reserves

• flexible- or floating- exchange-rate system

• fixed-exchange-rate system

• purchasing-power-parity theory

• currency interventions• managed floating

exchange rate

21-17