the world ofinternational finance f ernando q uijano, y vonn q uijano, k yle t hiel & a parna s...

The World of International Finance

FERNANDO QUIJANO, YVONN QUIJANO,

KYLE THIEL & APARNA SUBRAMANIAN

PREPARED BY:

© 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan • Sheffrin • Perez

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1 Can the price of hamburgers around the world give us a clue as to the proper value for exchange rates?

Big Macs and Purchasing Power Parity

2 What factors may allow the United States to continue running large trade deficits with the rest of the world?

World Savings and U.S. Current Account Deficits

3 Why did a group of European countries adopt a common currency?

The First Decade of the Euro

4 What are the causes of financial collapses that occur throughout the globe?

The Argentinean Financial Crisis

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HOW EXCHANGE RATES ARE DETERMINED

What Are Exchange Rates?

19.1

• exchange rateThe price at which currencies trade for one another in the market.

• euroThe common currency in Europe.

• appreciation of a currencyAn increase in the value of a currency relative to the currency of another nation.

• depreciation of a currencyA decrease in the value of a currency relative to the currency of another nation.

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How Demand and Supply Determine Exchange Rates

HOW EXCHANGE RATES ARE DETERMINED19.1

FIGURE 19.1The Demand for and Supply of U.S. Dollars

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Changes in Demand or Supply


FIGURE 19.2Shifts in the Demand for U.S. Dollars

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FIGURE 19.3Shifts in the Supply of U.S. Dollars

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Let’s summarize the key facts about the foreign exchange market, using euros as our example:

1 The demand curve for dollars represents the demand for dollars in exchangefor euros. The curve slopes downward. As the dollar depreciates, there will

be an increase in the quantity of dollars demanded in exchange for euros.

2 The supply curve for dollars is the supply of dollars in exchange for euros. The curve slopes upward. As the dollar appreciates, there will be an increase in the quantity of dollars supplied in exchange for euros.

3 Increases in U.S. interest rates and decreases in U.S. prices will increase the demand for dollars, leading to an appreciation of the dollar.

4 Increases in European interest rates and decreases in European prices will increase the supply of dollars in exchange for euros, leading to a depreciation of the dollar.

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REAL EXCHANGE RATES AND PURCHASING POWER PARITY19.2

• real exchange rateThe price of U.S. goods and services relative to foreign goods and services, expressed in a common currency.

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FIGURE 19.4Real Exchange Rate and Net Exports as Percent of GDP,1980–2005

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• law of one priceThe theory that goods easily tradable across countries should sell at the same price expressed in a common currency.

• purchasing power parityA theory of exchange rates whereby aunit of any given currency should beable to buy the same quantity ofgoods in all countries.

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BIG MACS AND PURCHASING POWER PARITY

APPLYING THE CONCEPTS #1: Can the price of hamburgers around the world give us a clue as to the proper value for exchange rates?

For several years, The Economist measured the price of a Big Mac throughout the world and checked to see whether the law of one price held. Table 19.1 contains the results for selected countries and the market-exchange rate predicted by the theory of purchasing power parity.

To obtain the exchange rate, divide the price of Big Macs in the foreign country by the dollar price.

Table 19.1 BIG MAC PRICING AROUND THE WORLD VERSUS ACTUAL EXCHANGE RATES

Country

Price of a Big Mac in Local

Currency

Price of a Big Mac in

Dollars

Predicted Purchasing Power Exchange Rate

Based on Big Mac Pricing (Foreign Currency

per U.S. Dollar)

ActualExchange Rate

(Foreign Currency per U.S. Dollar)

United States 3.15 dollars $3.15 ____ ____United Kingdom 1.89 pounds 3.32 0.60 0.57Hong Kong 12.0 HK dollars 1.55 3.81 7.75Switzerland 6.31 Swiss francs 4.93 2.00 1.28Mexico 28.2 pesos 2.66 8.95 10.6Japan 250 yen 2.14 79.4 114

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THE CURRENT ACCOUNT, THE FINANCIALACCOUNT, AND THE CAPITAL ACCOUNT19.3

• balance of paymentsA system of accounts that measurestransactions of goods, services, income, and financial assets between domestic households, businesses, and governments and residents of the rest of the world during a specific time period.

• current accountThe sum of net exports (exportsminus imports) plus income receivedfrom abroad plus net transfers fromabroad.

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• financial accountThe value of a country’s net sales(sales minus purchases) of assets.

• capital accountThe value of capital transfer andtransaction in nonproduced,nonfinancial assets in theinternational accounts.

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Rules for Calculating the Current, Financial, and Capital Accounts

Here is a simple rule for understanding transactions on the current, financial, and capital accounts: Any action that gives rise to a demand for foreign currency is a deficit item. Any action that gives rise to a supply of foreign currency is a surplus item.

The current, financial, and capital accounts of a country are linked by a very important relationship:

current account + financial account + capital account = 0

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• net international investment positionDomestic holding of foreign assetsminus foreign holdings of domestic

assets.

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FIXED AND FLEXIBLE EXCHANGE RATES19.4

To set the stage for understanding exchange rate systems, let’s recall what happens when a country’s exchange rate appreciates—increases in value. There are two distinct effects:

1 The increased value of the exchange rate makes importsless expensive for the residents of the country where theexchange rate appreciated.

2 The increased value of the exchange rate makes U.S. goods more expensive on world markets.

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WORLD SAVINGS AND U.S. CURRENT ACCOUNT DEFICITS

APPLYING THE CONCEPTS #2: What factors may allow the United States to continue running large trade deficits with

the rest of the world?

The 2006 Economic Report of the President directly addressed the issue of whether the United States can continue to run large current account deficits and, of course, financial account surpluses. In the report, the government recognized that the current account deficits would eventually be reduced. However, the government also highlighted a number of factors that suggested the deficits could continue for a long period of time.

For the United States to continue to run a current account deficit, other countries in the world need to continue to purchase U.S. assets.

In 2005, four major countries experienced circumstances that encouraged them to save by purchasing assets from abroad: Japan, Germany, Russia, and China.

For the United States to continue to run trade deficits in the future, these or other countries must want to continue to save more than they want to invest domestically.

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FIXED AND FLEXIBLE EXCHANGE RATES19.4Fixing the Exchange Rate

• foreign exchange market interventionThe purchase or sale of currencies by governmentto influence the market exchange rate.

FIGURE 19.5Government Intervention toRaise the Price of the Dollar

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FIXED AND FLEXIBLE EXCHANGE RATES19.4Fixed Versus Flexible Exchange Rates

• flexible exchange rate systemA currency system in which exchangerates are determined by free markets.

FLEXIBLE EXCHANGE RATE SYSTEM

• fixed exchange rate systemA system in which governments pegexchange rates to prevent theircurrencies from fluctuating.

FIXED EXCHANGE RATES

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BUSH OFFICIAL WARNS CHINA ABOUT PROTECTIONISM

• Gutierrez also called on China to get tougher on piracy of intellectual property.

• China is thought to be the world’s primary provider of pirated intellectual property.

• Chinese officials did promise to adopt stricter enforcement of piracy issues and have shut down a total of 23 facilities making pirated DVDs and CDs.

• Last year’s record $202 billion trade deficit withChina has prompted the possible legislative actions.

China needs to open its markets to U.S. goods and do more to resolve currency disputes with the U.S. according to U.S. Commerce Secretary Carlos Gutierrez. Gutierrez is attempting to be proactive in resolving trade differences with China prior to the Senate vote this week on sanctioning the country over currency manipulation.

Extra Application 5

If the Chinese yuan was allowed to float freely, the dollar price of yuan would increase substantially and reduce imports of Chinese goods to the U.S. since they would be more expensive to U.S. consumers. Demand for Chinese goods by U.S. consumers results in demand for yuan to pay for these goods. This increase in yuan demand (priced in dollars) should push the dollar price of yuan higher.

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FIXED AND FLEXIBLE EXCHANGE RATES19.4Fixed Versus Flexible Exchange Rates

• balance of payments deficitUnder a fixed exchange rate system, a situation inwhich the supply of a country’s currency exceeds thedemand for the currency at the current exchange rate.

BALANCE OF PAYMENTS DEFICITS AND SURPLUSES

• balance of payments surplusUnder a fixed exchange rate system, a situation inwhich the demand of a country’s currency exceeds the supply for the currency at the current exchange rate.

• devaluationA decrease in the exchange rate to which a currency ispegged under a fixed exchange rate system.

• revaluationAn increase in the exchange rate to which a currency is pegged under a fixed exchange rate system.

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FIXED AND FLEXIBLE EXCHANGE RATES19.4The U.S. Experience with Fixed and Flexible Exchange Rates

Exchange Rate Systems Today

Fixed exchange rate systems provide benefits, but they require countries to maintain similar economic policies—especially to maintain similar inflation rates and interest rates.

The flexible exchange rate system has worked well enough since the breakdown of Bretton Woods.

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THE FIRST DECADE OF THE EURO

APPLYING THE CONCEPTS #3: Why did a group of European countries adopt a common currency?

January 1, 1999, was the day 11 European countries agreed to use a common currency. Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal, and Spain irrevocably fixed their exchange rates to the euro. In 2002, euro notes and coins were actually put into circulation.

A European central bank manages the monetary affairs related to the euro. It plays a role similar to the role the Federal Reserve Bank plays in the United States.

Economists will carefully watch this experiment unfold in the twenty-first century. The jury is still out on whether adopting a common currency was a wise economic move for the countries that joined the new regime.

Will the benefits of a larger market outweigh the disadvantages of having one monetary policy for all the members?

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DEUTSCHE BÖRSE WITHDRAWS EURONEXT BID

• Some investors in both the Börse and Euronext hoped that shareholders would be allowed to vote on both proposals.

• Euronext declined to allow the Börse vote.

• While some European politicians and officials hoped there would be a “European solution” to the market fragmentation, that scenario now appears less likely to happen in the near term.

Stock exchange mergers should provide more investors with market access to certain country’s stocks that were harder to purchase prior to the merger and also contribute to greater market efficiency.

Euronext, the Paris-based stock exchange, recently agreed to combine with the New York Stock Exchange (NYSE). After the announcement, the German Börse also attempted to combine with Euronext but now confirms it has withdrawn its bid. Euronext will now seek confirmation from its shareholders regarding the NYSE partnership.

Extra Application 6

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MANAGING FINANCIAL CRISES19.5

Hardly a year goes by without some international financial crisis.

Even when a country takes strong, institutional steps to peg its currency, a collapse is still possible.

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THE ARGENTINEAN FINANCIAL CRISIS

APPLYING THE CONCEPTS #4: What are the causes offinancial collapses that occur throughout the globe?

During the late 1980s, Argentina suffered from hyperinflation. As part of its financial reforms, Argentina pegged its currency to the U.S. dollar, making pesos “convertible” into dollars. To issue pesos, the central bank had to have an equal amount of dollars, or its equivalents in other hard currencies, on hand. Some economists believed that this reform would bring stability to the financial system. Unfortunately, they proved wrong.

Several problems developed:

• As the dollar appreciated, Argentina began to suffer from a large trade deficit

• Wage increases also pushed up the real exchange rate

• Argentina had to borrow extensively in dollar-denominated loans.

Eventually, Argentina was forced to default on its international debt in 2002 and freeze bank accounts. The hopes of the reforms in the early 1990s had become a bitter memory.

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appreciation of a currency

balance of payments

balance of payments deficit

balance of payments surplus

capital account

current account

depreciation of a currency

devaluation

euro

exchange rate

financial account

fixed exchange rate system

flexible exchange rate system

foreign exchange market intervention

law of one price

net international investment position

purchasing power parity

real exchange rate

revaluation

the world ofinternational finance f ernando q uijano, y vonn q uijano, k yle t hiel & a parna s...

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