International Finance

and the Foreign Exchange Market

Open economy An economy that has interactions in trade or finance with other countries.

Closed economy An economy that has no interactions in trade or finance with other countries.

Balance of payments The record of a country’s trade with other countries in goods, services, and

assets.The following table shows the balance of payments for the United States in 2010.

Notice that the table contains three “accounts”: the current account, the financial account,

and the capital account.

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illion

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CURRENT ACCOUNT

Exports of goods $1,289

Imports of goods −1,935

Balance of trade −646

Exports of services 549

Imports of services −403

Balance of services 146

Income received on investments 663

Income payments on investments −498

Net income on investments 165

Net transfers −136

Balance on current account −471

FINANCIAL ACCOUNT

Increase in foreign holdings of assets in the United States 1,259

Increase in U.S. holdings of assets in foreign countries −1,005

Balance on financial account 254

BALANCE ON CAPITAL ACCOUNT 0

Statistical discrepancy 217

Balance of payments 0

The sum of thebalance of tradeand the balance

of services equalsnet exports.

In 2010, the United States ran a trade deficit with all its major trading partners and with every region of the world except for Latin America.

Japan ran trade deficits with China, Latin America, and the Middle East, and it ran trade surpluses with the United States, Europe, and Asia. In each panel, the green arrows represent exports from the United States

or Japan, and the red arrows represent imports.

(a) Trade flows for the US (in billions of dollars)

(b) Trade flows for Japan (in billions of

dollars)

Balance of Payments• Current account transactions:

all payments (and gifts) related to the purchase or sale of goods and services and income flows during the current period

• Four categories:• Merchandise trade

(import and export of goods)• Service trade

(import and export of services)• Income from investments• Unilateral transfers

(gifts to and from foreigners)

Net Exports = the Balance of Trade + the Balance of ServicesThe current account balance also includes net

income on investments and net transfers. Because these items are relatively small, it is often a

convenient simplification to think of net exports as being equal to the current account balance.

Balance of Payments• Financial account transactions:

transactions that involve changes in the ownership of real and financial assets

• The financial account includes both • direct investments by foreigners in

the U.S. and by Americans abroad, and,• loans to and from foreigners.

• Under a pure flexible-rate system, official reserve transactions are zero; therefore:• a financial-account deficit implies

a capital-account surplus.• a financial-account surplus implies

a capital-account deficit.

The Financial Account

There is a capital outflow from the United States when an investor in the United States buys a bond

issued by a foreign company or government or when a U.S. firm builds a factory in another country.

There is a capital inflow into the United States when a foreign investor buys a bond issued by a U.S. firm or by the government or when a foreign

firm builds a factory in the United States.Another way of thinking of the balance on the financial account is as a measure of net capital flows, or the difference between capital inflows and capital outflows.

Balance of Payments• Capital account transactions:

transactions that involve relatively minor transactions, such as migrants’ transfers and sales and purchases of non-produced, non-financial assets such as a copyright, patent, trademark, or right to natural resources

• Prior to 1999, the capital account recorded all the transactions included now in both the financial account and the capital account. In other words, capital account transactions went from being a very important part of the balance of payments to being a relatively unimportant part.

Balance of Payments

• Imports create a demand for foreign currency (and a supply of the domestic currency) and are recorded as a debit item.

• Exports create a supply of foreign currency (and demand for the domestic currency) and are recorded as a credit item.

• Balance of payments: accounts that summarize the transactions of a country’s citizens, businesses, and governments with foreigners

11 of 39© 2013 Pearson Education, Inc. Publishing as Prentice Hall

The sum of the current account balance, the financial account balance, and the capital account balance

equals the balance of payments.

To make the balance on the current account equal the balance on the financial account, we include an entry

called the statistical discrepancy.

Changes in foreign holdings of dollars are known as official reserve transactions.

A current account deficit must be exactly offset by a financial account surplus, leaving the balance of

payments equal to zero.

Why Is the Balance of Payments Always Zero?

Balance of Payments• Under a pure flexible rate system, the

foreign exchange market will bring the quantity demanded and the quantity supplied into balance, and as a result, it will also bring the total debits into balance with the total credits.

• Under a flexible exchange rate system the inflow and outflow of capital exert a major impact on current account balances.

Current Acct & Net Foreign Investment

1978 1983 1988 1993 2003

- 4

- 2

0

+ 2

1998

1978 1983 1988 1993 20031998

Current Account as % of GDPsurplus (+) or deficit (-)

Net Foreign Investment as % of GDPsurplus (+) or deficit (-)

0

+ 2

- 2

+ 4

2008

2008

- 6

Labatt’s beer is produced in Canada.

In 1990, in Ontario, a six-pack of Labatt’s beer sold for $6.60 Canadian.

Across the border in Michigan, a six pack of the same beer was on

sale for $2.75 U.S. At the time, the exchange

rate was $0.75 U.S. = $1.00

Canadian.

In Ontario, $6.60 Canadian.

In Michigan, $2.75 U.S. $0.75 U.S. = $1.00

Canadian.1. How much would it cost in U.S. currency to buy the beer in Ontario? 2. How much would it cost in Canadian currency to buy the beer in Michigan? 3. Is there an arbitrage opportunity? 4. Where would you buy and where would you sell? 5. How much profit could you expect on a six-pack?

$6.60 x .75 = $4.95 US $2.75 / .75 = $3.67 Can Buy in Michigan, sell in Ontario

$4.95 - $2.75 = $2.20 US ($2.93 Canadian)

Number of 1 country’s currency that is equal to 1 unit of another country’s$1 = 0.6292 € $1 = 0.5051 £

1€ = 1.5892 $ 1£ = 1.9797 $$1 = 0.755 € $1 = 0.6787 £

1€ = 1.3245 $ 1£ = 1.4734 $

Foreign Exchange Market• Market where different currencies are

traded, one for another.• The exchange rate enables people in

one country to translate the prices of foreign goods into units of their own currency.

• An appreciation of a nation’s currency will make foreign goods cheaper.

• A depreciation of a nation’s currency will make foreign goods more expensive.

Currency Pair

Price

EUR/USD 1.3548

AUD/USD 0.9098

GBP/USD 1.6365

JPY/USD 0.0097

CAD/USD 0.9404

CHF/USD 1.1013

Currency Pair

Price

USD/EUR 0.7381

USD/AUD 1.0987

USD/GBP 0.6112

USD/JPY 103.0550

USD/CAD 1.0636

USD/CHF 0.9080

How many $$ you get with one of theirs?

How many $$ does it take to get one of theirs?

CurrencyLast Trade

U.S. $ ¥en12/04

Euro 12/04

Can $ 12/04

U.K. £ 12/04

Aust $ 12/04

SFranc 12/04

U.S. $ 10.00932

81.222 0.7705 1.733 0.7403 0.7894

¥en 107.2 1 131 82.59 185.8 79.36 84.62

Euro0.818

10.00763

21 0.6303 1.418 0.6057 0.6458

Can $ 1.298 0.01211 1.586 1 2.249 0.9608 1.025

U.K. £ 0.5770.00538

20.7053 0.4446 1 0.4272 0.4555

Aust $ 1.351 0.0126 1.651 1.041 2.341 1 1.066

SFranc 1.267 0.01182 1.548 0.976 2.195 0.9378 1

Currency$

Appreciate/

Depreciate

Yahoo April 2008 Yahoo April 2005

Yahoo Mar 2004

Yahoo Dec 2003

TextOct 2002

U.S. $ 1 1 11

1

¥en 103.21 107.293 105.6 107.2 123.3

Euro 0. 6292 0. 7689 0.8237 0.8181 1.01

Can $ 1.0197 1.244 1.31 1.298 1.5987

U.K. £ 0.5051 0.5232 0.5506 0.577 0.6391

Aust $ 1.0561 1.2943 1.337 1.351 1.84

SFranc 1.0125 1.1879 1.287 1.267 1.49

Determinants of the Exchange Rate• flexible rate system - the exchange rate is

determined by supply and demand. • The dollar demand for foreign exchange

originates from American demand for foreign goods, services, & assets (real or financial).

• The supply of foreign exchange originates from sales of goods, services, & assets from Americans to foreigners.

There are three sources of foreign currency demand for the U.S. dollar:

1.Foreign demand for goods and services produced in the United States.2.Foreign investment in the United States either through foreign direct investment—buying or building factories or other facilities in the United States—or through foreign portfolio investment—buying stocks and bonds issued in the United States.3.Currency traders who believe that the value of the dollar in the future will be greater than its value today.

Changes in the Exchange Rate• Determinants:

1. A change in national income (relative to trading partners) people buy more, or less of everything.

2. A change in the inflation rate in one country. a. Higher rate decreases demandb. Lower demand - depreciation

3. A change in interest rates (relative to rates abroad). a. High rates attract moneyb. Currency appreciates

4. Changes in tastes

Quantity offoreign exchange (pounds)

Q1

$1.50

$1.80

Dollar price of foreign exchange(for pounds)

a

Foreign ExchangeMarket Equilibrium

S(sales to

foreigners)

• If incomes increase in the United States, U.S. imports of foreign goods and services will grow.• The increase in imports will increase the demand for pounds in the foreign exchange market causing the dollar price of the pound to rise from $1.50 to $1.80.

D1

Q2

D2

b

Quantity offoreign exchange (pounds)

Q1

$1.50

Dollar price of foreign exchange(for pounds)

Inflation WithFlexible Exchange Rates

S1

• If the price level in the U.S. increased by 50 % …the U.S. demand for British goods (and pounds) would increase (relatively cheap).

D1

D2

a

$2.25

S2

Since U.S. exports to Britain would decline and thereby cause the supply of pounds to fall.

• These forces would cause the dollar to depreciate relative to the pound.

b

26 of 39© 2013 Pearson Education, Inc. Publishing as Prentice Hall

The Fall and Rise and Fall of the Dollar

1. Low U.S. interest rates have played a role in the declining value of the dollar.2. Many investors and some central banks became convinced that the value of

the dollar was too high in 2002 and that it was likely to decline in the future.

The depreciation of the dollar:1.bad news for U.S. tourists and for anyone in the United States importing foreign goods and services. 2.good news for U.S. firms exporting goods and services

Peso – Appreciation or Depreciation?

1. The US reduces tariffs on Mexican products. 2. Mexico encounters severe inflation. 3. Deteriorating political relations reduce

American tourism in Mexico. 4. The US economy moves into a severe

recession5. A bartender puts a lime in a Corona and beer

sales jump6. The Mexican government encourages

American firms to invest in Mexican oil fields 7. A large federal government budget deficit

raises interest rates in the US

Euro – Appreciation or Depreciation?

1. An American importer purchases a shipload of Bordeaux wine.

2. BMW decides to build an assembly plant in LA3. A CVCC student decides to spend a year

studying at the Sorbonne.4. A Spanish manufacturer exports machinery to

Morocco on an American freighter.5. The US incurs a balance of payments deficit

in its transactions with Belgium.6. A US government bond held by an Italian

citizen matures.7. It is widely believed that the international

value of the Euro will fall in the near future.

Monetary Policy & the Exchange Rate• An unanticipated shift to a more

restrictive monetary policy will:• raise the real interest rate, • reduce the rate of inflation, and, • at least temporarily, reduce aggregate

demand and the growth of income; • causing an appreciation in domestic

currency. • the currency appreciation (with shift the

current account toward a deficit). • An unanticipated shift to more

expansionary monetary policy will cause the opposite:• lower interest rates, and,• an outflow of capital;• leading to a currency depreciation, and,• a shift toward a current account surplus.

Fiscal Policy & the Exchange Rate• An expansionary fiscal policy may

cause:• higher interest rates, • which can increase in foreign investment,• causing a currency appreciation, and,• a decrease in exports.

1. A depreciation in the value of the U.S. dollar would

a.encourage foreigners to travel on American owned airlines.

b.make U.S. goods more expensive to foreign consumers.

c.decrease the number of dollars it takes to buy a Swiss franc.

d. make it more expensive for U.S. citizens to travel abroad.3. A nation’s trade deficit will tend to expand when

a. its economy is expanding.

b. its economy is shrinking.

c. its investment environment is less attractive to foreigners.

d. both b and c above are true.4. Under a system of flexible exchange rates, an increase in demand for a nation’s currency in the foreign exchange market willa.cause the nation’s currency to appreciate.b.make it more expensive for the nation to import goods.c.cause the nation’s balance on current account to shift toward a surplus.d.make it less expensive for foreigners to buy the nation’s goods.

5. Under a system of flexible exchange rates, which of the following will most likely cause a nation’s currency to appreciate on the foreign exchange market?a.a decrease in domestic interest ratesb.an increase in foreign interest ratesc.domestic inflation of 10 percent while the nation’s trading partners are experiencing stable pricesd.stable domestic prices while the nation’s trading partners are experiencing 10 percent inflation

6. Suppose a German-produced car becomes very popular in the United States. This would tend toa.affect the U.S. balance of payments but not the balance of trade.b.reduce any existing balance of trade deficit in the United States.c.increase a balance of trade surplus in the United States.d.increase a balance of trade deficit in the United States.

9. If the dollar price of the euro goes from $1 to 90 cents, the euro hasa.appreciated, and Europeans will find U.S. goods cheaper.b.appreciated, and Europeans will find U.S. goods more expensive.c.depreciated, and Europeans will find U.S. goods cheaper.d.depreciated, and Europeans will find U.S. goods more expensive.

10. Which of the following would cause the American demand for foreign exchange (pounds) to shift from D1 to D2?

a.an increase in the U.S. real interest rate

b.higher inflation in Britain than in the United States

c.higher income growth in Britain than in the United States

d.an increased level of vacation travel to Britain by Americans11. Which of the following would cause the demand for foreign exchange (pounds) to shift from D1 to D2?

a.an increase in the real interest rate in Britain relative to the US

b.higher inflation in Britain than in the United States

c.higher income growth in Britain than in the United States

d.an increase in the number of British citizens vacationing in the US