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Chapter 34
Exchange Rates and the Balance of Payments
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Overview
In this chapter the financial arrangements that accommodate international trade are discussed. Various
concepts of international payments balances and the difference between the balance of payments and
the balance of trade are analyzed. The freely floating exchange rate system of international monetar y
arrangements is presented. In this presentation the fact that the demand for foreign goods and services is
equivalent to the demand for foreign currency or a supply of domestic currency to the foreign exchange
markets is developed. Similarly, foreign demand for domestic goods and services is equivalent to the supply
of foreign currency, or demand for domestic currency, on foreign exchange markets. The international
supply and demand for a particular country’s currency determines the per-unit value of that country’s
currency relative to other countries’ currencies, i.e., the foreign exchange rate. The fact that changes in the
demand for a particular country’s goods and services lead to corresponding changes in demand (supply)
for that country’s currency is addressed. From such changes ensues a change in exchange rates, where
some currencies appreciate and others depreciate. Next, a fixed exchange rate system and its advantages
and disadvantages are discussed, and the International Monetary Fund and its role are presented. Then
dirty or managed floats and the gold standard are examined. As was true for the flexible exchange rate
system, the various types of fixed exchange rate systems provide for eventual international payments
equilibrium.
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Learning Objectives
After studying this chapter students should be able to
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Distinguish between the balance of trade and the balance of payments.
Identify the key accounts within the balance of payments.
Outline how exchange rates are determined in the markets for foreign exchange.
Discuss factors that can induce changes in equilibrium exchange rates.
Understand how policymakers can go about attempting to fix exchange rates.
Explain alternative approaches to limiting exchange rate variability.
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Outline
I. The Balance of Payments and International Capital Movements: The balance of payments is
a system of accounts that measures transactions of goods, services, income, and financial assets
between domestic households, businesses, and governments and between governments and residents
of the rest of the world during a specific time period. Balance of payments transactions are normally
grouped into three categories: current transactions, capital account transactions, and official reserve
account transactions. (See Table 34-1.)
A. Accounting Identities: Values that are equivalent by definition.
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B.
C.
D.
E.
1. Disequilibrium: Disequilibrium exists when the item that brings about a balance in an
accounting identity cannot continue indefinitely.
2. Equilibrium: Certain economic adjustment mechanisms have evolved to ensure equilibrium.
3. An Accounting Identity Among Nations: If a nation interacts with other nations, an
accounting identity insures a balance, but not necessarily an equilibrium.
Current Account Transactions: All payments and gifts that are related to the purchase or sale
of both goods and services constitute the current account in international trade. (See Table 34-2.)
1. Merchandise Trade Exports and Imports: The largest portion of any nation’s balance of
payments current accounts is typically the importing and exporting of merchandise goods.
The balance of trade is defined as the difference between the value of merchandise exports
and the value of merchandise imports.
2. Service Exports and Imports: The services exports and imports have to do with invisible
or intangible items that are bought and sold, such as shipping, insurance, tourist expenditures,
and banking services. Also, income earned by foreigners on U.S. investments and income
earned by Americans on foreign investments is part of service imports and exports.
3. Unilateral Transfers: Americans give gifts to relatives and others abroad. The federal
government grants gifts to foreign nations. Foreigners give gifts to Americans and some
foreign governments have even granted money to the U.S. government. Net unilateral
transfers are the total amount of gifts given by Americans minus the total amount received
by Americans from abroad.
4. Balancing the Current Account: If the sum of net exports plus unilateral transfers plus net
investment income exceeds zero, a current account surplus is said to exist; if the sum of net
exports plus unilateral transfers plus net investment income is negative, there is a current
account deficit.
Capital Account Transactions: Capital account transactions concern the buying and selling
of real and financial assets in international transactions. They occur when foreigners invest in
the United States or Americans invest in other countries. In the absence of interventions by
finance ministries or central banks, the current account and capital account must sum to zero.
Thus any nation running a current account deficit must also be running a capital account surplus.
(See Table 34-2 and Figure 34-1.)
Official Reserve Account Transactions: The third type of balance-of-payments transaction
concerns official reserve assets. (See Table 34-2.)
1. Foreign currencies
2. Gold
3. Special drawing rights (SDRs): These are reserve assets that the International Monetary
Fund created to be used by countries to settle international payment obligations.
4. The reserve position in the International Monetary Fund.
5. Financial assets held by an official agency, such as the U.S. Treasury Department. This
balance added to the sum of the Current and Capital Account balance makes the Balance
of Payments equal to zero.
What Affects the Distribution of Account Balances Within Balance of Payments?: The
balance of payments is affected by a country’s domestic rate of inflation relative to that its trading
partners and relative political stability. Political instability in other countries causes “capital
flight”—moving assets to countries that are stable.
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II. Determining Foreign Exchange Rates: A foreign exchange rate is the price of foreign currency in
terms of domestic currency. If the foreign exchange rate for one euro is $1.25, one euro costs $1.25.
The exchange rate between euros and dollars is determined by the demand for and supply of euros
and dollars in the foreign exchange market.
A. Demand for and Supply of Foreign Currency: Flexible or floating exchange rates fluctuate in
the foreign exchange market in response to changes in supply and demand conditions. Every U.S.
transaction concerning the importation of foreign goods constitutes both a supply of dollars and
a demand for some foreign currency in the foreign exchange market and vice versa for export
transactions.
B. The Equilibrium Foreign Exchange Rate: To determine the equilibrium foreign exchange
rate, the factors that determine the supply and demand for foreign exchange must be determined.
1. Appreciation and Depreciation of Euros: Appreciation means an increase in the value of a
domestic currency in terms of other currencies. Depreciation means a decrease in the value
of a domestic currency in terms of foreign currencies. (See Figure 34-2.)
2. An Example of Derived Demand: A downward sloping demand curve for euros is derived
from the U.S. demand for European pharmaceuticals. (See Figure 34-2.)
3. Downward-Sloping Derived Demand: As the price of the euro falls, the quantity demanded
will rise. (See Figure 34-2.)
4. Supply of Euros: The supply of euros is a derived supply in that it is derived from a
European person’s demand for U.S. computer printers. The Europeans want dollars in order
to purchase U.S computer printers. If Americans offer more dollars for the same amount of
euros, the dollar price of euros would go up. Europeans will supply more euros when the
dollar price of euro goes up, because they can then buy more computer printers with the
same quantity of euros.
5. An Example: (See Figure 34-3.)
6. Total Demand for and Supply of Euros: The intersection of the supply of yen and demand
for yen curves establishes the equilibrium exchange rate. (See Figure 34-4.)
7. A Shift in Demand: An increase in demand for Japanese laptops can be translated into an
increased demand for yen. Americans supply more dollars to the foreign exchange market
by demanding more yen. There will be a decline in the foreign exchange value of the dollar.
(See Figure 34-5.)
8. A Shift in Supply: Assume that the supply curve of yen shifts outward to the right. There
will be a decline in the foreign exchange value of the yen. (See Figure 34-6.)
C. Market Determinants of Exchange Rates:
1. Changes in Real Interest Rates: If the U.S. interest rate increases relative to the rest of the
world, international investors will increase their demand for dollar-denominated assets,
thereby increasing the demand for dollars.
2. Changes in Consumer Preferences: If other countries change their preferences to U.S.
goods, this will increase the derived demand for U.S. dollars in foreign exchange markets.
3. Perceptions of Economic Stability: If the United States looks economically and politically
stable relative to other countries, more foreigners will want to put their savings into U.S.
assets. The demand for dollars will increase.
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III. The Gold Standard and the International Monetary Fund
A. The Gold Standard: An international monetary system in which nations fix their exchange
rates in terms of gold. Thus, all currencies are fixed in terms of each other. Any balance of
payment problems could be made up by shipments of gold. There is a relationship between the
balance of payments and changes in domestic money supplies. When a nation had a deficit in
its balance of payments, more gold was flowing out than in. Because the domestic money
supply was also based on gold, an outflow of gold to foreigners caused an automatic reduction
in the domestic money supply. Interest rates rose, attracting foreign capital and improving the
balance of payments and national output, and prices fell. Imports were discouraged and exports
were encouraged, improving the balance of payments.
B. Bretton Woods and the International Monetary Fund: The Bretton Woods Agreement
Act of 1945 set up the International Monetary Fund (IMF) to lend to member countries with
a balance-of-payments deficit. Member governments were obligated to maintain the values
of their currencies in foreign exchange markets within 1 percent of the declared par value
(the legally established value of the monetary unit). The United States was obligated to
maintain gold prices within 1 percent of the official value of $35 an ounce. In 1971 President
Nixon suspended the convertibility of dollars into gold. In 1973 the finance ministers of the
European Economic Community announced they would let their currencies float against the
dollar. Since 1973 the United States and most other important trading countries have either had
flexible exchange rates or managed (dirty) floating exchange rates.
IV.
Fixed versus Floating Exchange Rates (See Figure 34-7.)
A. Fixing the Exchange Rate: Central banks can keep exchange rates fixed as long as they have
enough foreign exchange reserves available to deal with potentially long-lasting changes in the
demand or supply of their nation’s currency. (See Figure 34-8.)
B. Pros and Cons of a Fixed Exchange Rate:
1. Foreign Exchange Risk: Limiting foreign exchange risk is one major argument for fixed
exchange rates. The possibility that changes in the value of a nation’s currency will result in
variations in market values of assets. Hedging can also offset this type of risk.
2. The Exchange Rate as a Shock Absorber: If residents of a country are relatively immobile,
then exchange rate movements can reduce the shock of a decrease in demand for a country’s
products by having the exchange rate fall, thus increasing the quantity demanded along the
new demand curve. The unemployment effects of the decrease in demand for the country’s
exports will be smaller.
C. Splitting the Difference: Dirty Floats and Target Zones:
1. A Dirty Float: A system of managed exchange rates in between flexible and fixed exchange
rates in which central banks occasionally enter foreign exchange markets to “smooth out”
rate fluctuations.
2. Crawling Pegs: An exchange rate arrangement in which a country pegs the value of its
currency to the exchange rate of another nation’s currency, but allows the par value to
change at regular intervals.
3. Target Zones: A range of permitted exchange rate variations between upper and lower
exchange rate bands that a central bank defends by buying or selling foreign exchange
reserves.
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Points to Emphasize
Trade Balances
The belief is widely shared by newspaper columnists, TV news commentators, politicians, and other people
that if the U.S. imports much more in money value terms of goods and services than it exports to a particular
country, a problem exists. Many are upset by the fact that the United States has such a large trade imbalance
with China. They think that an equivalent export-import value should exist for every two-country relationship.
What is really important is that a nation be in a balance-of-payments equilibrium overall with all nations,
not with any specific nation. After all, do individuals behave in this way? Is it sensible to have a “trade
balance” with one’s grocer, milkman, public utility supplier, optometrist, or employer? What would life
be like if a person attempted to buy and sell equivalent values with each person and business with whom
one transacted economically? Much is bought from the grocer and nothing is sold to him. Is this a
problem? As long as a person’s overall income situation is not in “imbalance” she can be worry-free about
particular imbalances.
Exchange Rate Systems
It is useful to make a distinction between flexible and fixed exchange rate systems. Under the fixed
exchange rate system (the IMF-modified gold exchange standard or the pure gold standard), international
equilibrium imbalances are restored by changing the price level except for one price, the exchange rate.
Under a fixed exchange rate system many prices are forced to change in order to preserve the exchange
rate. Payments are brought into balance by having surplus nations inflate their price levels and having
deficit nations deflate their price levels. Nations are to change their price levels to accommodate agreed
upon exchange rates. Under a flexible exchange rate system, only one price changes, the exchange rate.
Nations need not induce recession or inflation in order to right payments disequilibrium. All that is
necessary is that exchange rates change, and income and price effects will eventually restore equilibrium.
It is easy to see why the IMF-modified gold exchange system failed. Some nations felt they should pursue
their own (domestic) economic goals. Monetary and fiscal policy, which are tools to manipulate aggregate
demand in the desired direction, could not be pursued independently of international payments system.
What nation would pursue a monetary and fiscal policy aimed at inducing a recession in order to correct
a payments or trade deficit? Similarly, inflation scared Germany, and thus Germany was not inclined to
inflate its economy and price level in order to eliminate its payments surplus. If nations pursue independent
domestic economic goals, the cooperation and discipline required under a fixed exchange rate system
simply will not happen. A flexible exchange rate system imposes no such consequences. Let exchange
rates float and pursue domestic economic goals without concern for international payments disequilibrium.
Capital Account and the Current Account
A country that runs a current account deficit must also run a capital account surplus if central banks and
finance ministries do not intervene in the foreign exchange markets. The idea behind this is that when all
transactions are voluntary, the overall market value of what is gained is equal to the value of what is given
up. In terms of floating exchange rates, every purchase of foreign goods by a U.S. resident involves the
purchase of foreign currency. This means that foreigners must sell an equivalent amount (in dollar terms)
of currency to U.S. residents. If there is a current account deficit, then U.S. purchases of foreign goods and
services and investment income are greater in value terms than are sales of goods and services. Foreigners
must supply enough of their currencies to finance the U.S. current account deficit. This is measured as the
capital account surplus where foreigners accumulate dollar-denominated financial and real assets.
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Miller • Economics Today, Fifteenth Edition
For Those Who Wish to Stress Theory
Exchange Rate Determination Systems and International
Payments Equilibrium
Under the gold standard in a world consisting of the United States and Britain, if the United States has a
payments deficit, Britain must have a payments surplus. Both countries have tied their currencies to a
specific quantity of gold and thus each has set the value of its currency unit in terms of the other’s. The
gold standard is thus a fixed exchange rate system. If the United States is importing (in value) more in
goods and services than it is exporting, or if it is lending or giving away in transfers more than it is
receiving, then it will have a payments deficit and Britain will have a payments surplus. Gold will flow
from the United States to Britain. The money supply in the United States falls and Britain’s money supply
rises. The quantity theory of money predicts that a decrease in the money supply will decrease the price
level in the United States by decreasing aggregate demand. Britain’s price level will rise as its money
supply increases relative to that of the United States, and Britain will buy more from the United States and
less from domestic producers. The United States will export more to Britain and import less. This process
continues until the international payments disequilibrium has been eliminated.
Under a flexible exchange rate system the United States has a payments deficit because its citizens are
(on balance) buying more from, giving more to, and/or lending more to the British than the British are to
them. This means there will be an increase in demand for British pounds relative to the U.S. dollar.
Conversely, there would be an increase in the supply of U.S. dollars relative to British pounds. The U.S.
dollar depreciates relative to the pound, and the pound appreciates relative to the dollar. Even though
neither country has experienced a change in its price level, U.S. goods are now relatively cheaper than
British goods to British buyers, and British goods are relatively more expensive to U.S. buyers. At the
same U.S. price level, the appreciated pound can buy more than it could before. At the same British price
level, the depreciated U.S. dollar can buy less than it could before. People in the United States import less
from Britain and buy more domestically. People in Britain import more from the United States and purchase
less locally. The net result will be a movement toward payments equilibrium. The process continues until
payments equilibrium is restored.
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Further Questions for Class Discussion
1.
Why does no country today operate on a gold standard? To be on a gold standard is to allow a
country’s money supply, price level, level of economic activity, and employment in the short run to
depend in part on international gold movements. The governments and citizens of modern countries
are unwilling to let these important macroeconomic variables depend on the international sector.
2.
How might different economic growth rates in different countries affect the exchange rate? The
country that grows fastest will experience increases in income levels that are greater than in the rest
of the world. Its citizens’ demand for all types of goods and services, including imported ones, will
rise relative to its exports. Other things equal, its currency will depreciate as its demand for foreign
exchange increases.
3.
In the financial crisis that began in September of 2008, U.S. and foreign investors shifted large amounts
of funds used for investment into U.S. Treasury securities, driving the interest rates on these securities
to very low levels, in some cases to less than 1 percent. The Federal Reserve decreased the federal
funds rate from 2.5 percent to 1.0 percent during that period as well. At the same time, there was a
major appreciation of the U.S. dollar against most foreign currencies, especially the euro, which fell
from a high of about $1.50 per euro to about $1.25 per euro between September and November. What
determinant of foreign exchange rates appears to account for the dollar appreciation? The most likely
determinant was perceptions of economic stability. Recall that when the United States looks more
politically and economically stable relative to other countries, foreigners put more of their savings
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into U.S. assets rather than into their own domestic assets. There is an increase in the demand for
dollars in the foreign exchange market, and the dollar appreciates while foreign currency depreciates.
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4.
Is a “strong” dollar necessarily a good thing? The second Bush administration announced with
regularity that a strong dollar (i.e., one that is appreciating) was better for the economy than a “weak”
dollar. The idea seems to be that strong is good and weak is bad. Students will often be surprised to
learn that a strong dollar can have “bad” effects on the economy. A strong (appreciating) dollar
should decrease employment and profits in the United States since a “strong” dollar makes U.S
goods more expensive to foreigners and results in U.S.-made goods taking a decreasing share of
the international market. The result is a decrease in U.S. exports and thus a decrease in domestic
employment. In addition, a stronger dollar makes foreign-produced goods cheaper in terms of dollars.
Imports increase and foreigners’ shares of domestic markets increase. U.S. firms that compete with
imported goods will thus have decreasing sales and therefore decreasing employment.
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Answers to Questions for Critical Analysis
Going Loony over an Appreciating Loonie (p. 872)
Businesses that catered to Canadian tourists and U.S. firms that exported goods to Canada gained from the
appreciation of the loonie as their sales, employment, and profits increased. U.S. firms that imported goods
from Canada and U.S. citizens who traveled to Canada experienced higher costs. Importers also would
have experienced lower sales and employment as the loonie appreciated and made them less competitive
with competing U.S.-made products.
Measuring the Value of Zimbabwe’s Dollar (p. 881)
As the price level in Zimbabwe increased, Zimbabweans would have increased the demand for foreign
exchange to buy foreign goods that were cheaper at existing exchange rates. The increase in demand for
foreign exchange would have caused Zimbabwe’s dollar to depreciate. The very large increase in the price
level would have exacerbated this process.

You Are There
Literally Betting the House on an Exchange Rate (p. 884)
1.
They would prefer a fixed exchange rate because they would be able to avoid foreign exchange risk
and be able to pay a lower interest rate.
2.
These borrowers could hedge by converting some of their earnings in Hungarian forints into Swiss
francs either by using currency swaps or simply putting some of their savings in Swiss francs to
somewhat insulate themselves from exchange rate risk.
 Issues and Applications
The Current Account Deficit for One Group of Nations Is the Current Account
Surplus for Another (pp. 884–886)
1.
Yes. These countries’ current account balances must also be equal amounts with opposite signs so
that they sum to zero (plus any change in official reserve transactions balances).
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2.
The sum would turn out to be zero because the total amount spent on goods, services, and capital
items, and official reserve transactions by all of the countries in the global economy must be exactly
equal to the amount received from selling goods, services, and capital items plus official reserve
transactions by all countries in the global economy. Every dollar spent or transferred must be equal
to the amount received.
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Answers to Even-Numbered Problems
34-2. a.
b.
c.
d.
e.
deficit
surplus
surplus
deficit
deficit
34-4. a. The demand for the rand increases, so the dollar-rand exchange rate rises. Because more
dollars must be given in exchange for the rand, the dollar depreciates and the rand appreciates.
b. The demand for the rand would decrease, so the dollar-rand exchange rate falls. Because fewer
dollars must be given in exchange for the rand, the dollar appreciates and the rand depreciates.
34-6. Because fewer U.S. dollars are required to purchase each yen, the dollar has appreciated. The
percentage appreciation was 100 times (0.125  0.11)/0.125  12 percent.
34-8. Increased foreign lending to Japan causes an increase in the demand for the yen, and the yen
appreciates. The Bank of Japan should buy foreign currencies in exchange for the yen. This will
increase the supply of the yen, which pushes the equilibrium exchange rate toward its original
level.
34-10. When the U.S. dollar is pegged to gold at a rate of $35 and the pound at a rate of £17.50, the
dollar-pound exchange rate equals $35/17.50  2 ($/£).
34-12. a. The demand for yuan will decrease, which would cause the equilibrium dollar-yuan exchange
rate to begin to decline. To prevent a yuan depreciation from occurring, the Bank of China can
purchase yuan with dollars, thereby raising the demand for yuan to its previous level at the
original exchange rate. Hence, the Bank of China should reduce its dollar reserves.
b. To purchase more U.S. financial assets, Chinese residents must obtain more dollars, so they
will increase the quantity of yuan supplied at each exchange rate. This would cause the
equilibrium dollar-yuan exchange rate to begin to decline. To prevent a yuan depreciation from
occurring, the Bank of China can purchase yuan with dollars, thereby causing the demand for
yuan to increase sufficiently to push the equilibrium exchange rate back to its original level.
Thus, the Bank of China should reduce its dollar reserves.
c. U.S. residents increase the quantity of yuan demanded at any given exchange rate in order to
purchase Chinese furniture, so the demand for yuan increases. This would tend to cause the
equilibrium dollar-yuan exchange rate to rise, resulting in a yuan appreciation. To keep this
from happening, the Bank of China can purchase dollars with yuan, thereby increasing the
supply of yuan and pushing the equilibrium exchange rate back down. Consequently, the Bank
of China should increase its dollar reserves.
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Selected References
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Aghevli, B.B., “The Balance of Payments and the Money Supply Under the Gold Standard Regime:
U.S. 1879–1914,” American Economic Review, March 1975.
Baillie, R. and P. MacMahon, The Foreign Exchange Market, New York: Cambridge University Press.
Bordo, Michael D., “The Classical Gold Standard; Some Lessons for Today,” Review (Federal Reserve
Bank of St. Louis), May 1981, pp. 2–17.
Dreyer, Jacob S., Goffried Haberler, and Thomas D. Willett, Exchange Rate Flexibility, American
Enterprise Institute Publications, 1978.
Friedman, Milton, Dollars and Deficits, Englewood Cliffs, N.J.: Prentice-Hall, 1968.
Hamouda, Omar F., Robin Rowley, and Bernard M. Wolf, eds., The Future of the International Monetary
System, New York: M.E. Sharpe, 1989.
Hawtrey, R.G., The Gold Standard in Theory and Practice, London: Longmans, Green, 1947.
Hung, Juann, “Assessing the Exchange Rate’s Impact on U.S. Manufacturing Profits,” Federal Reserve
Bank of New York Quarterly Review, Vol. 17, No. 4, Winter 1992–1993.
Lanyi, A., “The Case for Floating Exchange Rates Reconsidered,” Essays in International Finance,
No. 72, Princeton, N.J.: Princeton University Press, 1969.
Root, Franklin R., International Trade and Investment, 6th ed., Cincinnati, Ohio: Southwestern, 1990.