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U.S. Export Transaction U.S. Import Transaction Balance of Payments Flexible Exchange Rates The Market for Currency 36 C HAPTE R Determinants of Exchange Rates Fixed Exchange Rates Exchange Controls and Rationing International Exchange Rate Systems Recent U.S. Trade Deficits Key Terms EXCHANGE RATES, THE BALANCE OF PAYMENTS, AND TRADE DEFICITS BALANCE OF PAYMENTS (the sum of all the transactions that take place between a country’s residents and the residents of all foreign nations, ie. all the payments a nation receives from foreign countries and all the payments it makes to them). Comprised of 3 Accounts: U.S. Export Transaction U.S. Import Transaction 1) Current Account- summarizes US trade in currently produced goods Balance of Payments and services; comprised of: Flexible Exchange Rates The Market for Currency a) Balance on Goods & Services- difference between a country’s Determinants of Exchange Rates imports and exports of goods. Fixed Exchange Rates b) Balance on Current Account – balance on G & S plus + Net Exchange Controls and Rationing inv. Income + Net Transfers i) Net Inv. Income- difference between the interest and dividend Recent U.S. Trade payments foreigners paid the US for use of exported capital and Deficits what the US paid foreigners for imported foreign capital. Key Terms ii) Net Transfers- foreign aid, pensions paid to US citizens living outside US. International Exchange Rate Systems 2) Capital Account- summarizes the purchase or sale of real or financial assets and the flows of monetary payments that accompany them. a) Balance on Capital Account- Current Account plus foreign purchases of assets in US and US purchases of assets abroad. BALANCE OF PAYMENTS cont’d 3) Official Reserves Account- quantities of foreign currencies U.S. Export Transaction held by a foreign govt. drawn on to make up any net deficit in the combined current and capital accounts (sort of like when you dip into Balance of Payments Flexible Exchangeyour Rates savings account to pay for a special purchase) U.S. Import Transaction The Market for Currency Determinants of Exchange Rates Balance of Payments- must always sum to zero, ie. always in balance; Deficits & Surpluses occur in the Current and Capital Account Fixed Exchange Rates Exchange Controls and Rationing International Exchange Rate Systems Recent U.S. Trade Deficits Key Terms -Check out this explanation [If you bought a parachute from a factory in Germany–Current Account] [If you bought a parachute factory in Germany – capital investment, so Capital Account] Current Account [trade in currently produced goods, svcs, net investment & transfers] (1) U.S. goods exports……………………………………………$+ 683 U.S. Export Transaction (2) U.S. goods imports………………………………………..…...-1,167 U.S. Import Transactionon goods [visibles]………..…………………………………………..$-484 (3) Balance Balance of Payments (4) U.S. exports of services [shipping, insur., tourists, bank.] +289 Flexible Exchange Rates (5) U.S. imports of services…………………………………..…….- 240 The Market for Currency (6) Balance on services [invisibles]………………………..................................+ 49 Determinants of (7) Balance on goods and services…………………………………….…………..-436 Exchange Rates (8)Exchange Net investment income (income earned for svc of exported capital [money] Fixed Rates Exchange Controls and [Profits received from overseas investment (interest, dividends, and rents)] Rationing ……………………………………………………………………… - 12 International Exchange (9)Systems Net transfers (gifts given to the indivs, foreign aid, pensions, etc.)…… - 56 Rate (10)U.S.Balance on current account…………………………………………………... -504 Recent Trade Deficits Capital Account [buying/selling of physical & financial assets[stocks/bonds] Key Terms (11) Foreign purchases of assets in the U.S. …………………..+645 -4 (12) U.S. purchases of assets abroad……………….……………-145 (13) Balance on capital account…………………………………………….…..….+500 Official Reserves Account (14) Official reserves (Exported $4 bil. of foreign money)…….. +4 $0 Official Reserves: + = exported stock of foreign money (so dollars enter U.S.) - = imported stock of foreign money (so dollars exit U.S.) U.S. Export Transaction U.S. Import Transaction Balance of Payments Flexible Exchange Rates The Market for Currency Determinants of Exchange Rates Fixed Exchange Rates Exchange Controls and Rationing International Exchange Rate Systems Recent U.S. Trade Deficits Key Terms U.S. Export Transaction U.S. Goods export………………….…….…..+$100 U.S. Goods imports……………………………...-80 U.S. Service exorts…………………………...…+40 U.S. Service imports………………………….…-90 Goods exports…………….. Net Investment income………………..……….+20 Goods imports…………….. Net transfers………………………………….…..-15 U.S. Import Transaction Balance of Payments Flexible Exchange Rates The Market for Currency Capital inflows to the U.S…………………..….+40 Capital outflows from the U.S……………….…-10 Official reserves ………………......................…..-5 Determinants of Exchange Rates 1. The U.S. is experiencing a balance on goods(deficit/surplus)of ($10/$20/$30). Fixed Exchange Rates Goods exports (____) – goods imports (____) = $_____ Exchange Controls and 2. The U.S.’s balance on goods and services is a (deficit/surplus) of $30 billion. Rationing (goods/services exports(____) – goods/services imports (____) = ______) International Exchange Rate SystemsU.S.’s balance on the current account is (+25/-$25). 3. The Recent U.S. Tradeon [Balance Deficits g/s(___) + net investment income(___) + net transfers(___) = C.A.(___)]. 4. The balance on the capital account is a (surplus/deficit) of ($20/$30/$40). Key Terms [capital inflow(___) – capital outflow(___) = _______] 5. The U.S. is experiencing a balance of payments (surplus/deficit) of $5. [don’t include official reserves here] 6. The “official reserves account indicates the U.S. (imported/exported) $5 billion of its stock of foreign reserves. [A + here means we will export a stock of foreign money($’s will enter U.S.] [A - here means we will import a stock of foreign money($’s will exit U.S.] Balance on Goods Bal. on Curr. Acct. U.S. Export Transaction U.S. Goods export………………….…….…..+$100 U.S. Goods imports……………………………..-80 U.S. Service exports…………………………... +40 U.S. Service imports………………………….…-90 Net Investment income………………..……….+20 Goods exports…………….. Goods imports…………….. Net transfers………………………………….….-15 20 -50 G/S -30 Bal. Cap. Flexibleon Exchange RatesAcct. The Market for Currency Capital inflows to the U.S…………………..….+40 Capital outflows from the U.S……………..….-10 Official reserves ………………......................….-5 -25 5 U.S. Import Transaction Balance of Payments Curr. Acct 30 5 Determinants of Exchange Rates 1. The U.S. is experiencing a balance on goods(deficit/surplus)of ($10/$20/$30). FixedGoods Exchange Rates exports ($100) – goods imports ($80) = $20. Exchange and balance on goods and services is a (deficit/surplus) of $30 billion. 2. TheControls U.S.’s Rationing (goods/services exports($140) – goods/services imports ($170) = -$30) International Exchange 3. The Rate SystemsU.S.’s balance on the current account is (+25/-$25). [Balance Recent U.S. Tradeon g/s(-$30) + net investment income($20)+ net transfers(-$15)=C.A.(-$25)]. Deficits 4. The balance on the capital account is a (surplus/deficit) of ($20/$30/$40). Key Terms [capital inflow($40) – capital outflow(-$10) = $30] 5. The U.S. is experiencing a balance of payments (surplus/deficit) of $5. [don’t include official reserves here] 6. The “official reserves account indicates the U.S. (imported/exported) $5 billion of its stock of foreign reserves. [A + here means we will export a stock of foreign money($’s will enter U.S.] [A - here means we will import a stock of foreign money($’s will exit U.S.] Balance on Goods Bal. on Curr. Acct. U.S. Export Transaction U.S. Goods export………………….…….…..+$100 U.S. Goods imports……………………………..-80 U.S. Service exports…………………………... +40 U.S. Service imports………………………….…-90 Net Investment income………………..……….+20 Goods exports…………….. Goods imports…………….. Net transfers………………………………….….-15 20 -50 G/S -30 Bal. Cap. Flexibleon Exchange RatesAcct. The Market for Currency Capital inflows to the U.S…………………..….+40 Capital outflows from the U.S……………..….-10 Official reserves ………………......................….-5 -25 5 U.S. Import Transaction Balance of Payments Curr. Acct 30 5 Determinants of Exchange Rates 1. The U.S. is experiencing a balance on goods(deficit/surplus)of ($10/$20/$30). FixedGoods Exchange Rates exports ($100) – goods imports ($80) = $20. Exchange and balance on goods and services is a (deficit/surplus) of $30 billion. 2. TheControls U.S.’s Rationing (goods/services exports($140) – goods/services imports ($170) = -$30) International Exchange 3. The Rate SystemsU.S.’s balance on the current account is (+25/-$25). [Balance Recent U.S. Tradeon g/s(-$30) + net investment income($20) + net transfers(-$15)=C.A.(-$25)] Deficits 4. The balance on the capital account is a (surplus/deficit) of ($20/$30/$40). Key Terms [capital inflow($40) – capital outflow(-$10) = $30] 5. The U.S. is experiencing a balance of payments (surplus/deficit) of $5. [don’t include official reserves here] 6. The “official reserves account indicates the U.S. (imported/exported) $5 billion of its stock of foreign reserves. [A + here means we will export a stock of foreign money($’s will enter U.S.] [A - here means we will import a stock of foreign money($’s will exit U.S.] A Few notes on BOP • If you look at the U.S. balance of payments or any other country you will see that the balance of the current account will offset the capital U.S. Export Transaction except for immaterial differences (ignore these, they are account, U.S. Import Transaction primarily timing differences). Balance of Payments • The reason is a logical and simple one: each country is unable to use Flexible Exchange Rates the other countries currency and, thus, all each country can do is The Market for Currency "trade". Using China as an example, the U.S. has a current account Determinants of Exchange deficit Rates (we buy more of their products & services than China does of Fixed Exchange Rateswhich puts China in a position of saying: "hmmm, what do I do ours), Exchange with Controls and these worthless U.S. dollars?" Since China, by the fact of a Rationing U.S. current account deficit, did not spend the U.S. dollars we sent International Exchange Rate Systems them on our own products/exports, and being the intelligent country Recent U.S. Tradethey are, China will always decide to "invest" or "save" their that Deficits U.S. dollars via the Capital Account by using those same US Key Terms dollars to invest in US financial assets (bonds, stocks, etc.), or real assets (land, US manufacturing plants, etc.) • So whenever you buy those shirts from China you are helping to fund the U.S. Government's deficit spending and those same U.S. dollars you paid for the shirts will be flowing directly to an American company and worker making frisbees. Said another way: • The U.S. currently has a large current account deficit with China (we're buying, net, more of their products & services than vice versa). China (businesses, households, government) has willingly elected to save many of the U.S. dollars we U.S. Export Transaction sent them for their products. Since China is an intelligent country, they will, through U.S. Import Transaction self interest, create a capital account surplus to the U.S. by saving those same U.S. Balance of Payments dollars (sent to them for their products) by investing them in U.S. financial assets Flexible Exchange Rates (U.S. bonds, U.S. stocks, U.S. saving accounts, etc.) or use those same US dollars to The Market Currency buildforU.S. plants or buy land in the U.S. The opportunity cost would be high for Determinants Chinaof to just to just hold those U.S. dollars in a mayonnaise jar or use them for Exchange Rates kindling to start their fires. Fixed Exchange Rates •Exchange Said another way, "trade" is really trade like the early settlers did since countries Controls and Rationing cannot use the other country's currency so they are forced to immediately spend it backExchange into the originating country. In the case of China, they are temporarily saving International Rate Systems the U.S. dollars they received for their products, but will ultimately spend them back Recentinto U.S. Trade our economy. Deficits •Key Terms One interesting thought, is everytime an American buys a shirt from China you are actually funding American jobs as well, which is why trade is always the way to go. In the case of China, the prevalent scenario is the US dollars spent for the Chinese shirt (U.S. import) is being lent back to the US Government (due to deficit spending) to returf the lawn on the Mall! Trade is trade and is always balanced (current account = capital account). The only question is what is being traded. Flexible Exchange Rates Two Systems: 1) Flexible or Floating- Exchange-Rate System- demand and supply determine exchange U.S. Export Transaction U.S. Import Transaction Balance of Payments Flexible Exchange Rates The Market for Currency Determinants of Exchange Rates rates, not govt. 2) Fixed Exchange-Rate System- govts. Fixed Exchange Rates Exchange Controls and Rationing Determine exchange rates and make adjustments in their economies to maintain those rates. Recent U.S. Trade International Exchange Rate Systems Deficits Key Terms DISADVANTAGES OF FLEXIBLE EXCHANGE RATES •Uncertainty and Diminished Trade U.S. Export Transaction U.S. Import Transaction Balance of Payments Flexible Exchange Rates The Market for Currency Determinants of Exchange Rates Fixed Exchange Rates •Terms of Trade Changes •Instability of a Country’s Currency Exchange Controls and Rationing International Exchange Rate Systems Recent U.S. Trade Deficits Key Terms FIXED EXCHANGE RATES U.S. Export Transaction U.S. Import Transaction Balance of Payments Flexible Exchange Rates The Market for Currency Determinants of Exchange Rates Fixed Exchange Rates Exchange Controls and Rationing International Exchange Rate Systems Use of Reserves •Currency Interventions Recent U.S. Trade Deficits Key Terms Trade Policies EXCHANGE CONTROLS & RATIONING U.S. Export Transaction U.S. Import Transaction Balance of Payments Flexible Exchange Rates The Market for Currency Determinants of Exchange Rates Fixed Exchange Rates Exchange Controls and Rationing International Exchange Rate Systems Recent U.S. Trade Deficits Key Terms •Distorted Trade •Favoritism •Restricted Choice •Black Markets INTERNATIONAL EXCHANGERATE SYSTEMS U.S. Export Transaction U.S. Import Transaction Balance of Payments Flexible Exchange Rates The Market for Currency Determinants of Exchange Rates Fixed Exchange Rates Exchange Controls and Rationing International Exchange Rate Systems Recent U.S. Trade Deficits Key Terms The Gold Standard: Fixed Exchange Rates 1879 - 1934 Devaluation The Bretton Woods System IMF - Pegged Exchange Rates Official Reserves Gold Sales IMF Borrowing Managed Floating Exchange Rates G-8 Nations Interventions