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Chapter 33
International Finance
© 2006 Thomson/South-Western
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Balance of Payments
A country’s balance of payments
summarizes all economic transactions
that occur during a given period between
residents (people, firms, and
governments) of that country and
residents of other countries
Balance of payments measures a flow, or
the balance of economic transactions
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Balance of Payments
Balance-of-payments accounts are
maintained according to the principles of
double-entry bookkeeping, in which
entries on one side of the ledger are called
credits, and entries on the other side are
called debits.
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Merchandise Trade Balance
Equals the value of merchandise exports
minus the value of merchandise imports
Reflects trade in goods, or tangible
products, and is often referred to as the
trade balance
 If
the value of merchandise exports exceeds
the value of merchandise imports, there is a
trade surplus
 If the value of merchandise imports exceeds
the value of merchandise exports, there is a
trade deficit
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Exhibit 1: Relative to GDP, U.S. Imports Have Topped
Exports Since 1976, and the Trade Deficit Has Widened
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Exhibit 2: U.S. Trade Deficits in 2003 by
Country or Region
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Balance on Goods and Services
Balance on goods and services: the portion
of a country’s balance-of-payments
account that measures the value of a
country’s exports of goods and services
minus the value of its imports of goods and
services (net exports)
Merchandise trade balance focuses on the
flow of goods, but services (intangibles) are
also traded internationally
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Unilateral Transfers
Unilateral transfers consist of government
transfers to foreign residents: foreign aid,
personal gifts to individuals abroad, etc.
Net unilateral transfers equal the unilateral
transfers received from abroad by U.S.
residents minus unilateral transfers sent to
foreign residents by U.S. residents
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Balance on Current Account
The portion of a country’s balance-ofpayments account that measures that
country’s balance on goods and services plus
its net unilateral transfers
Can be negative = current account deficit
Can be positive = current account surplus
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Capital Account
The record of a country’s
international transactions involving
purchases or sales of financial and
real assets
Between 1917 and 1982, the United States
ran a deficit in the capital account
 U.S.
residents purchased more foreign assets
than foreigners purchased assets in the U.S.
 This reversed itself in 1983, and since then
foreigners have purchased more U.S. assets
than the other way around
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U.S. Balance of Payments 2003
(billions of dollars)
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U.S. Balance of Payments 2003
(billions of dollars)
All transactions requiring payments from
foreigners to U.S. residents are entered as credits,
indicated by a plus sign (+), because they result in
an inflow of funds from foreign residents to U.S.
residents.
All transactions requiring payments to foreigners
from U.S. residents are entered as debits, indicated
by a minus sign (), because they result in an
outflow of funds from U.S. residents to foreign
residents. As you can see, a surplus in the capital
account of $579.0 billion more than offsets a
current account deficit of $541.8 billion.
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U.S. Balance of Payments
 The statistical discrepancy that balances
payments is a negative $37.2 billion
 Statistical discrepancy: the official “fudge
factor” that:
measures the error in the balance-of-payments
satisfies the double-entry bookkeeping
requirement that total debits equal total
credits
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Foreign Exchange and Exchange Rates
Foreign exchange: foreign money needed
to carry out international transactions
Exchange rate: the price measured in the
currency of one country that is needed to
purchase one unit of another country’s
currency
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The Euro and Exchange Rates
The euro is now the common currency of the
euro area
The price, or exchange rate, of the euro in terms
of the dollar is the number of dollars required to
purchase one euro
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Foreign Exchange
Currency depreciation: with respect to the
dollar, an increase in the number of dollars
needed to purchase 1 unit of foreign exchange
in a flexible rate system
Currency appreciation: With respect to the
dollar, a decrease in the number of dollars
needed to purchase 1 unit of foreign exchange
in a flexible rate system
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Demand for Foreign Exchange
U.S. residents need euros to pay for goods and
services produced in the euro area
The demand curve for euros the inverse
relationship between the dollar price of the
euro and the quantity of euros demanded, other
things constant
Incomes and preferences of U.S. consumers
The expected inflation rates in the U.S. and the euro
area
The euro price of goods in the euro area
Interest rates in the U.S. and the euro area
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Demand for Foreign Exchange
In the aggregate, the lower the dollar price of
foreign exchange, other things constant, the
greater the quantity demanded
A drop in the dollar price of foreign exchange,
in this case the euro, means that fewer dollars
are required to purchase each euro: prices of
euro goods become cheaper
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Supply of Foreign Exchange
The supply of foreign exchange is generated by
the desire of foreign residents to acquire dollars
The positive relationship between the dollarper-euro exchange rate and the quantity of
euros supplied in the foreign exchange market
implies an upward-sloping supply curve
Assumed constant are:
euro area incomes and preferences
expectations about the rates of inflation in the euro
area and the United States
interest rates in the euro area and the United States
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Initial
equilibrium
exchange rate is
$1.10
If the exchange
rate is allowed to
adjust freely, or to
float in response to
market forces, the
market will clear
continually
Exchange rate (dollars per euro)
Exhibit 4: The Foreign Exchange Market
S
1.20
1.10
1.00
D
0
800
820
Foreign exchange
(millions of euros)
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Exhibit 5: Effect on the Foreign Exchange Market
of an Increased Demand for Euros
S
Exchange rate (dollars per euro)
Suppose an increase
in U.S. incomes causes
Americans to increase
their demand for all
normal goods,
including those from
the euro area: demand
curve shifts from D to
D'
The shift of the
demand curve leads to
an increase in the
exchange rate from
$1.10 to $1.12 per euro
The euro
appreciates and the
dollar depreciates:
euro area people
purchase more
American products
$1.12
1.10
D'
D
0
800
820
Foreign exchange
(millions of euros)
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Arbitrageurs
Dealers who take advantage of temporary
geographic differences in exchange rates by
simultaneously buying a currency in one
market and selling it in another
 If
one euro costs $0.89 in New York and $0.90 in
Frankfurt, the arbitrageur would buy euros in New
York and at the same time sell them in Frankfurt
Demand for euros in New York would increase
Supply of euros in Frankfurt would increase
Price differential would be eliminated
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Speculators
Speculators buy or sell foreign exchange in
hopes of profiting from fluctuations in the
exchange rate over time
 trading
the currency at a more favorable exchange
rate later
By taking risks, speculators aim to profit from
market fluctuations by trying to buy low now
and sell high later
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Purchasing Power Parity
Purchasing power parity theory (PPP):
predicts the exchange rate between two
currencies will adjust in the long run to
reflect price-level differences between the
two currency regions
This is true as long as trade across borders
is unrestricted and exchange rates are
allowed to adjust freely
PPP is generally a long-run indicator
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Purchasing Power Parity
A given basket of internationally traded
goods should therefore sell for about the
same around the world after adjusting for
transportation costs and the like
Big Mac Index
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Exhibit 6:
In May
2004, the
U.S. Price
of a Big
Mac
Exceeded
Prices in
Most
Other
Countries
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Flexible Exchange Rates
Exchange rate determined by the forces
of demand and supply without
government intervention
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Fixed Exchange Rates
Fixed exchange rates: rate of exchange between
currencies pegged within a narrow range and
maintained by the central bank’s ongoing
purchases and sales of currencies
Suppose the European Central Bank selects
what it thinks is an appropriate rate of
exchange between the dollar and the euro: it
attempts to fix, or peg, the exchange rate within
a narrow band around the particular value
selected
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Fixed Exchange Rates
If the value of the euro threatens to climb
above the maximum acceptable exchange
rate, monetary authorities
Sell euros and buy dollars keeping the dollar
price of the euro down
If the value of the euro threatens to drop
below the minimum acceptable exchange
rate, monetary authorities
Sell dollars and buy euros in foreign
exchange markets
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Fixed Exchange Rates
If monetary officials must keep selling foreign
exchange to maintain the pegged rate, they risk
running out of foreign exchange reserves
The government has several options
The pegged exchange rate can be increased:
devaluation of the domestic currency
The pegged exchange rate can be decreased:
revaluation of the domestic currency
The government can attempt to reduce the domestic
demand for foreign exchange directly by imposing
restrictions on imports or capital flows
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Fixed Exchange Rates
The government can adopt contractionary
fiscal or monetary policies to reduce the
country’s income level, increase interest rates,
or reduce inflation relative to that of the
country’s trading partners
Finally, the government can allow the
disequilibrium to persist and ration the
available foreign reserves through some form
of foreign exchange control
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Development of the International
Monetary System
From 1879 to 1914, the international
financial system operated under a gold
standard
The gold standard provided a fixed,
predictable exchange rate that did not
vary as long as currencies could be
redeemed for gold at the announced rate
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Bretton Woods Agreement
Because the U.S. had a strong economy, the
dollar was selected as the key reserve currency
Created the International Monetary Fund
(IMF) to
Set rules for maintaining the international monetary
system
Standardize financial reporting for international
trade
Make loans to countries with temporary balance of
payments problems
Establish a revolving fund to lend money to troubled
economies
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Demise of the Bretton Woods System
During the latter part of the 1960s, inflation in
the U.S. caused the dollar to become
overvalued at the official exchange rate
The gold value of the dollar exceeded the exchange
value of the dollar
The result was that in August 1971, the U.S.
stopped exchanging gold for dollars
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Demise of the Bretton Woods System
The dollar was devalued with the hope that this
would put the dollar on firmer footing and
would save the dollar standard
With prices rising at different rates, an
international monetary system based on fixed
exchanged rates was doomed and the Bretton
Woods system collapsed
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Current System: Managed Float
Managed float system: combines features of a
freely floating exchange rate with sporadic
intervention by central banks as a way of
moderating exchange rate fluctuations among
the world’s major currencies
Most smaller countries still peg their currencies
to one of the major currencies or to a basket of
major currencies
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Managed Float
Major criticisms of flexible exchange rates:
They are inflationary because they free monetary
authorities to pursue expansionary policies
They have often been volatile, especially since the
late 1970s
This volatility creates uncertainty and risks for
importers and exporters and can lead to wrenching
changes in the competitiveness of a country’s export
sector
Policymakers’ ideal is a system that will foster
international trade, lower inflation, and
promote a more stable world economy
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