Download 19. The World of International Finance

Economics
NINTH EDITION
Chapter 19
The World of
International Finance
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Learning Objectives
19.1 Discuss how the price of foreign exchange is
determined by demand and supply.
19.2 Distinguish between the nominal exchange rate and the
real exchange rate.
19.3 Explain how the current account, financial account, and
capital account are all related to one another.
19.4 List the benefits and costs of a system of fixed
exchange rates compared to a system of flexible exchange
rates.
19.5 Discuss how international financial crisis can emerge.
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19.1 HOW EXCHANGE RATES ARE
DETERMINED (1 of 5)
What Are Exchange Rates?
• Exchange rate
The price at which currencies trade for one another in the market.
• Euro
The common currency in Europe.
An increase in the value of a currency relative to the currency of another nation is called an
appreciation of a currency.
A decrease in the value of a currency relative to the currency of another nation is called a
depreciation of a currency.
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19.1 HOW EXCHANGE RATES ARE
DETERMINED (2 of 5)
How Demand and Supply
Determine Exchange Rates
Market equilibrium occurs where
the demand for U.S. dollars equals
the supply.
•
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19.1 HOW EXCHANGE RATES ARE
DETERMINED (3 of 5)
Changes in Demand or
Supply
An increase in the demand for
dollars will increase (appreciate)
the dollar’s exchange rate.
Higher U.S. interest rates or lower
U.S. prices will increase the
demand for dollars.
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19.1 HOW EXCHANGE RATES ARE
DETERMINED (4 of 5)
Changes in Demand or
Supply
An increase in the supply of dollars
will decrease (depreciate) the dollar
exchange rate.
Higher European interest rates or
lower European prices will increase
the supply of dollars.
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19.1 HOW EXCHANGE RATES ARE
DETERMINED (5 of 5)
Changes in Demand or Supply
Let’s summarize the key facts about the foreign exchange market, using euros as our
example:
• The demand curve for dollars represents the demand for dollars in exchange for euros.
The curve slopes downward. As the dollar depreciates, there will be an increase in the
quantity of dollars demanded in exchange for euros.
• 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.
• 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.
• 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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19.2 REAL EXCHANGE RATES AND
PURCHASING POWER PARITY (1 of 3)
REAL-NOMINAL PRINCIPLE
What matters to people is the real value of money or income—its purchasing
power—not the face value of money or income.
• Real exchange rate
The price of U.S. goods and services relative to foreign goods and services, expressed
in a common currency.
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19.2 REAL EXCHANGE RATES AND
PURCHASING POWER PARITY (2 of 3)
The figure shows the real
exchange rate for the United
States compared to its net exports
as a share of GDP.
Insert Figure 19.4
Notice that, in general, when the
real (multilateral) exchange rate
increased, U.S. net exports fell.
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19.2 REAL EXCHANGE RATES AND
PURCHASING POWER PARITY (3 of 3)
• Law of one price
The theory that goods easily tradable across countries should sell at the same price
expressed in a common currency.
• Purchasing power parity
A theory of exchange rates whereby a unit of any given currency should be able to buy
the same quantity of goods in all countries.
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APPLICATION 1
BIG MACS IN SWITZERLAND
APPLYING THE CONCEPTS #1: How can the price of a Big Mac in Switzerland shed light
on the Swiss - U.S. exchange rate?
• Looking at the price of hamburgers across the world can actually provide insights into the behavior of
currency markets.
• Economist magazine checks the price of Big Macs around the world and determines the appropriate
exchange rate based on the differences in prices.
Insert Table 19.1
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19.3 THE CURRENT ACCOUNT, THE
FINANCIAL ACCOUNT, AND THE CAPITAL
ACCOUNT (1 of 5)
• Balance of payments
A system of accounts that measures transactions 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 account
The sum of net exports (exports minus imports) plus net income received from abroad
plus net transfers from abroad.
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19.3 THE CURRENT ACCOUNT, THE
FINANCIAL ACCOUNT, AND THE CAPITAL
ACCOUNT (2 of 5)
• Financial account
The value of a country’s net sales (sales minus purchases) of assets.
• Capital account
The value of capital transfer and transaction in nonproduced, nonfinancial assets in the
international accounts.
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19.3 THE CURRENT ACCOUNT, THE
FINANCIAL ACCOUNT, AND THE CAPITAL
ACCOUNT (3 of 5)
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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19.3 THE CURRENT ACCOUNT, THE
FINANCIAL ACCOUNT, AND THE CAPITAL
ACCOUNT (4 of 5)
Rules for Calculating the Current, Financial, and Capital Accounts
Insert Table 19.2
SOURCE: Economic Report of the President (Washington, D.C.: U.S. Government Pricing Office, 2015).
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19.3 THE CURRENT ACCOUNT, THE
FINANCIAL ACCOUNT, AND THE CAPITAL
ACCOUNT (5 of 5)
Rules for Calculating the Current, Financial, and Capital Accounts
• Net international investment position
Domestic holding of foreign assets minus foreign holdings of domestic assets.
• Sovereign investment fund
Assets accumulated by foreign governments that are invested abroad.
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APPLICATION 2
TAX HAVENS AND GLOBAL IMPALANCES
APPLYING THE CONCEPTS #2: How does accounting for investments made in tax
havens help explain some puzzles in international finance?
Two major puzzles arise in the international financial statistics.
• First, there appears to be more investment income paid than receive each year. Since
every dollar paid must go to someone, this shows as a gap in the statistics.
• Second, According to international statistics, developed countries are lending to
developed countries.
Gabriel Zucman of the London School of Economics found that over 8 percent of all global
wealth is held through tax havens, such as the Cayman Islands and these assets go
unrecorded. Once accounted for, the puzzles are resolved.
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19.4 FIXED AND FLEXIBLE EXCHANGE
RATES (1 of 5)
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:
• The increased value of the exchange rate makes imports less expensive for the
residents of the country where the exchange rate appreciated.
• The increased value of the exchange rate makes U.S. goods more expensive on world
markets.
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19.4 FIXED AND FLEXIBLE EXCHANGE
RATES (2 of 5)
Fixing the Exchange Rate
• Foreign exchange market
intervention
The purchase or sale of currencies by
government to influence the market
exchange rate.
To increase the price of dollars, the U.S.
government sells Euros in exchange for
dollars.
This shifts the demand curve for dollars
to the right.
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19.4 FIXED AND FLEXIBLE EXCHANGE
RATES (3 of 5)
Fixed versus Flexible Exchange Rates
FLEXIBLE EXCHANGE RATE SYSTEM
• Flexible exchange rate system
A currency system in which exchange rates are determined by free markets.
FIXED EXCHANGE RATES
• Fixed exchange rate system
A system in which governments peg exchange rates to prevent their currencies from
fluctuating.
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19.4 FIXED AND FLEXIBLE EXCHANGE
RATES (4 of 5)
Fixed versus Flexible Exchange Rates
BALANCE OF PAYMENTS DEFICITS AND SURPLUSES
• Balance of payments deficit
Under a fixed exchange rate system, a situation in which the supply of a country’s
currency exceeds the demand for the currency at the current exchange rate.
• Balance of payments surplus
Under a fixed exchange rate system, a situation in which the demand of a country’s
currency exceeds the supply for the currency at the current exchange rate.
• Devaluation
A decrease in the exchange rate to which a currency is pegged under a fixed exchange
rate system.
• Revaluation
An increase in the exchange rate to which a currency is pegged under a fixed exchange
rate system.
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19.4 FIXED AND FLEXIBLE EXCHANGE
RATES (5 of 5)
The U.S. Experience with Fixed and Flexible Exchange Rates
Fixed exchange rate systems provide benefits, but they require countries to maintain
similar economic policies—especially to maintain similar inflation rates and interest rates.
Higher prices in the United States cause the U.S. real exchange rate to rise. This increase
in the real exchange rate over time causes a trade deficit to emerge.
Exchange Rate Systems Today
The flexible exchange rate system has worked well enough since the breakdown of Bretton
Woods.
Some economists believe that the world will eventually settle into three large currency
blocs: the euro, the dollar, and the yen.
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APPLICATION 3
A TROUBLED EURO
APPLYING THE CONCEPTS #3: What are the fundamental causes for the problems with
the Euro?
• When the euro was launched in 1999, the vision of its founders was to use the monetary union to further
unify Europe economically and politically. They envisioned a large economic market, comparable to the
United States. They believed that by moving to a single currency with agreements on a number of fiscal rules
that they could achieve economic stability and growth.
• Unfortunately, this vision proved to be naïve. Under the umbrella of the euro, financial investors throughout
the world poured funds into Spain and Ireland fueling an unsustainable housing boom and also lending
excessive amounts to the governments of Greece, Italy, and Portugal that faced severe budget challenges.
• When the housing boom collapsed and the worldwide recession of 2007 increased budgetary pressures, it
became clear that the banks and governments of these countries could not easily pay their debts.
Moreover, with a single currency for the euro area, countries could not make adjustments through
depreciation of their currency. The options facing Europe were bleak: either large-scale financial transfers
from Germany and other successful countries, or sharp cutbacks in budgets and prolonged unemployment to
reduce wage levels.
• What became apparent was that the United States did not just have a single currency; it also had a unified
fiscal system that provided transfers to states and regions in economic distress. Monetary union without a
corresponding fiscal system cannot be easily sustained.
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19.5 MANAGING FINANCIAL CRISES
• 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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APPLICATION 4
THE ARGENTINE FINANCIAL CRISIS
APPLYING THE CONCEPTS #4: What are the causes of financial collapses that occur
throughout the globe?
During the late 1980s, Argentina suffered from hyperinflation. As part of its financial
reforms, it 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 equivalent in
other hard currencies, on hand. Some economists believed this reform would bring stability
to the financial system. Unfortunately, they were 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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KEY TERMS
Balance of payments
Flexible exchange rate system
Balance of payments deficit
Foreign exchange market intervention
Balance of payments surplus
Law of one price
Capital account
Net international investment position
Current account
Purchasing power parity
Devaluation
Real exchange rate
Euro
Revaluation
Exchange rate
Sovereign investment funds
Financial account
Fixed exchange rate system
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