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Chapter 17
Financing World
Trade
Introduction
The price of one currency in terms of another is
set by the interaction of supply and demand in
international financial markets.
Among the participants in these markets are
governments seeking to change or maintain
exchange rates.
Slide 34-2
Did You Know That...
 Exchange rates between currencies
are a factor in determining the location
of vehicle production?
 The recent decline in the value of the
dollar against the yen and the euro led
foreign automakers to locate more
vehicle assembly in the U.S.?
Slide 34-3
The Balance of Payments and
International Capital Movements
 Balance of Trade
– The value of goods and services bought and sold
in the world market
– The difference between exports and imports of
goods
 Balance of Payments
– A summary record of a country’s economic
transactions with foreign residents and
governments over a year
Slide 34-4
Surplus (+) and Deficit (-) Items
on the International Accounts
Surplus Items (+)
Deficit Items (-)
Exports of merchandise
Imports of merchandise
Private and government gifts from
foreigners
Private and governmental gifts to
foreigners
Foreign use of domestically owned
transportation
Use of foreign-owned transportation
Foreign tourists’ expenditures in this country
Tourism expenditures abroad
Foreign military spending in this country
Military spending abroad
Interest and dividend receipts from foreigners
Interest and dividends paid to foreigners
Sales of domestic assets to foreigners
Purchases of foreign assets
Funds deposited in this country by foreigners
institutions
Funds placed in foreign depository
Sales of gold to foreigners
Purchases of gold from foreigners
Sales of domestic currency to foreigners
Purchases of foreign currency
Table 34-1
Slide 34-5
The Balance of Payments and
International Capital Movements
 Accounting Identities
– Statements that certain numerical
measurements are equivalent by
accepted definition
Slide 34-6
The Balance of Payments and
International Capital Movements
 When family expenditures exceed income,
the family must do one of the following:
– Reduce its money holdings, or sell stocks,
bonds, or other assets
– Borrow
– Receive gifts from friends or relatives
– Receive a public transfer from a government
 Cannot continue indefinitely
Slide 34-7
The Balance of Payments and
International Capital Movements
 Three categories of balance of
payments transactions
– Current account transactions
– Capital account transactions
– Official reserve account transactions
Slide 34-8
The Balance of Payments and
International Capital Movements
 Current account transactions
– Merchandise trade transactions
• Importing and exporting of merchandise
• Balance = merchandise exports - merchandise
imports
Slide 34-9
The Balance of Payments and
International Capital Movements
 Current account transactions
– Service exports and imports
• Invisible or intangible items
– Shipping
– Insurance
– Tourism
– Banking
– Income from investments
Slide 34-10
The Balance of Payments and
International Capital Movements
 Current account transactions
– Unilateral transfers
• Gifts by citizens
• Gifts by governments
Slide 34-11
The Balance of Payments and
International Capital Movements
 Balancing the current account
– Net exports plus unilateral transfers plus
net investment income exceeds zero
• Current account surplus
– Net exports plus unilateral transfers plus
net investment income is negative
• Current account deficit
Slide 34-12
The Balance of Payments and
International Capital Movements
 A current account surplus means the
import of money or money equivalent
which means a capital account deficit
 A current account deficit must be paid
by the export of money or money
equivalent which means a capital
account surplus
Slide 34-13
The Balance of Payments and
International Capital Movements
 Capital account transactions
– Deals with the buying and selling of real
and financial assets
Slide 34-14
The Balance of Payments and
International Capital Movements
 Official reserve account transactions
– Foreign currencies
– Gold
– Special Drawing Rights (SDRs)
• Reserve assets created by the International
Monetary Fund that countries can use to settle
international payments
Slide 34-15
The Balance of Payments and
International Capital Movements
 Official reserve account transactions
– The reserve position in the International
Monetary Fund
– Financial assets held by an official
agency such as the U.S. Treasury
Department
Slide 34-16
The Balance of Payments and
International Capital Movements
 What affects the balance of payments?
– Relative rate of inflation
– Political stability
Slide 34-17
The Balance of Payments and
International Capital Movements
 What affects the balance of payments?
– Inflation among trading partners
– Political stability
Slide 34-18
Determining Foreign
Exchange Rates
 Foreign Exchange Market
– The market for buying and selling foreign
currencies
 Exchange Rates
– The price of one currency in terms of
another
Slide 34-19
Determining Foreign
Exchange Rates
 Demand for and supply of foreign
currency
– U.S. transactions involving imports
constitute a supply of dollars and demand
for some foreign currency
– The opposite is true for export
transactions
Slide 34-20
Determining Foreign
Exchange Rates
 The equilibrium foreign exchange rate
– Appreciation
• An increase in the value of a currency in terms
of other currencies
– Depreciation
• A decrease in the value of a currency in terms
of other currencies
Slide 34-21
International Example: South
Africa’s Currency Appreciation
 Gold and platinum are key South African
exports.
 The increased demand for these
commodities has also increased the demand
for South African rand.
 As interest rates in South Africa became
relatively higher, the demand for South
African financial assets also increased.
Slide 34-22
International Example: South
Africa’s Currency Appreciation
 The result of these changes has been
an appreciation of the rand.
 The dollar price of the rand has
doubled since the end of 2001.
Slide 34-23
Determining Foreign
Exchange Rates
 Market determinants of exchange rates
– Changes in real interest rates
– Changes in productivity
– Changes in product preferences
– Perceptions of economic stability
Slide 34-24
The Gold Standard and the
International Monetary Fund
 Gold Standard
– An international monetary system in which
nations fix their exchange rates in terms
of gold
– All currencies are fixed in terms of all
others, and any balance of payments
deficits or surpluses can be made up by
shipments of gold
Slide 34-25
The Gold Standard and the
International Monetary Fund
 Gold standard
– A balance of payments deficit
• More gold flowed out than flowed in
• Equivalent to an restrictive monetary policy
– A balance of payments surplus
• More gold flowed in than out
• Equivalent to an expansionary monetary policy
Slide 34-26
The Gold Standard and the
International Monetary Fund
 Problems with the gold standard
– A nation gives up control of its monetary
policy
– New gold discoveries often caused
inflation
Slide 34-27
The Gold Standard and the
International Monetary Fund
 Bretton Woods and the International
Monetary Fund
– 1944—representatives of capitalist
countries met in Bretton Woods,
New Hampshire
• Created a new international payment system
to replace the gold standard
Slide 34-28
The Gold Standard and the
International Monetary Fund
 End of the old IMF
– On August 15, 1971, President Richard
Nixon suspended the convertibility
of the dollar into gold.
– On December 18, 1971, the United States
devalued the dollar relative to the
currencies of 14 major industrial nations.
Slide 34-29
Current Foreign Exchange Rate
Arrangements
Figure 34-7
Slide 34-30
Fixed versus Floating
Exchange Rates
 To maintain a fixed exchange rate, the
central bank of a country can buy and
sell currencies.
 It must use its own foreign exchange
reserves to engage in these financial
market transactions.
Slide 34-31
A Fixed Exchange Rate
• The supply of ringgit shifts to
the right as Thai residents
demand more U.S. goods
• The value of the ringgit will fall
The Bank of Malaysia buys
ringgit with dollars shifting the
demand for ringgit to the right
Figure 34-8
Slide 34-32
International Example:
Central Banks’ Currencies of Choice
 A central bank allocates foreign exchange
reserves based on its perception of which
currencies will be needed most frequently to
alter the demand for its own currency.
 The U.S. dollar is the currency most
commonly held in foreign exchange
reserves; but the euro, the Japanese yen,
and the British pound also comprise a
measurable portion of these accounts.
Slide 34-33
Fixed Exchange Rates
 Pros and cons of fixed exchange rates
– Pros
• Limiting foreign exchange risk
– The possibility that changes in the value of
a nation’s currency will result in variations in
market value of assets
Slide 34-34
Fixed Exchange Rates
 Pros and cons of fixed exchange rates
– Cons
• A country’s residents can avoid foreign
exchange risk by hedging
– A financial strategy that reduces the chance
of suffering losses arising from foreign
exchange risk
Slide 34-35
The Dirty Float
and Managed Exchange Rates
 Dirty Float
– A system between flexible and fixed
exchange rates in which central banks
occasionally enter foreign exchange
markets to influence rates
Slide 34-36
Managed Exchange Rates
 What do you think?
– Is it possible to “manage” foreign
exchange rates?
 One study concludes that neither the
Fed nor the central banks of the other
G7 can successfully influence
exchange rates in the long run.
Slide 34-37
Issues and Applications: Japan’s Finance
Ministry Learns a New Currency Trick
 As the value of the dollar has declined against the
Japanese yen in recent years, American consumers
must pay more for Japanese-made goods.
 In response, the Japanese government began
buying dollars on the foreign exchange market.
 Of late, the government has been using private
banks to implement the foreign exchange
transactions needed to arrest the yen appreciation.
Slide 34-38
Key Terms and Concepts
 appreciation
 balance of
payments
 floating (flexible)
exchange rate
system
 balance of trade
 foreign exchange
market
 capital account
transactions
 foreign exchange
risk
 depreciation
 trade deficit
 derived demand
 unilateral transfers
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Pearson AddisonWesley. All rights
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reserved.