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International Finance and the Foreign Exchange Market introduction International trade involves two currencies. Because currency must be exchanged and the traditional goods and services market is utilized - two markets are in play: 1. market for currency 2. market for the product itself. It is very helpful to simplify international transactions into these two markets when analyzing the effect of our global economy on any given national economy. For example a transaction involving citizens of the United Sta tes and citizens of Japan involves two currencies. In the U. S. sellers want to receive dollars while purchasers in Japan have yen. Yen must be exchanged for dollars and given to the seller in the United States. In the Japan sellers want to receive yen while purchasers in the United in the United States have dollars. Dollars must be exchanged for yen and given to the seller in Japan. This exchange of one currency for another in order to facilitate international trade is organized in the foreign exchange market. foreign exchange market -- market in which the currencies of different countries are bought and sold Commercial banks and currency brokers organize this market. exchange rate -- the domestic price of one unit of foreign currency, the price of one national currency in terms of another national currency The exchange rate translates the price of foreign goods into term of the domestic currency. Notes: three exchange rate mechanisms 1. fixed exchange rates -- exchange rates are held steady by the central bank 2. managed exchange rates --exchange rates are influenced by the central bank 3. flexible (floating) exchange rates -- exchange rates that are determined by the market forces of supply and demand currency fluctuations and policy appreciation -- an increase in the value of a domestic currency relative to foreign currencies An appreciation means foreign goods are less expensive in the domestic country and domestic goods are more expensive in the foreign country, therefore the domestic nation will import more and export less -- move toward a trade deficit. So a strong dollar may actually hurt the home economy because it will cut into domestic aggregate demand as we sell less at home and buy more from abroad, depreciation -- a reduction in the value of a domestic currency relative to foreign countries A depreciation means foreign goods are more expensive in the domestic country and domestic goods are less expensive in the foreign country, therefore the domestic nation will import less and export more -- move toward a trade surplus. This is why we may at times follow a policy designed to cause the dollar to fall relative to other countries currencies. A "weak" dollar is consistent with a strong economy. A policy designed to cause the depreciation of the domestic currency (devalue the currency) may cause unemployment to increase in the foreign nation. This is known as an "export of unemployment" and "beggar-thy-neighbor" policy. market mechanics Assume a two country world: 1. United States -- domestic currency is the dollar 2. England -- domestic currency is the pound. Notes: If we assume a two country world the supply and demand for foreign currency (pounds) is the supply and demand for foreign exchange. demand The demand for pounds (which is the supply of dollars in the foreign exchange market in England) originates from the demand of United States citizens for British goods. We must exchange dollars for pounds, therefore for we demand pounds. We do not demand pounds for the sake of demanding pounds -- the demand for pounds is a derived demand. [This is not to say people who speculate in currencies do not demand particular currencies simply to earn a profit.] The basis for the demand for pounds comes from the demand to use the pounds, not from intrinsic value in the pound itself. demand for pounds -- lower dollar price of the pound (an appreciation of the dollar -- the dollar will buy more pounds) means that British goods are relatively cheap; therefore citizens of the United States desire a larger quantity of pounds and the demand curve hence evidences the standard negative slope. supply The supply of pounds (which is the demand for dolla rs in the foreign exchange market in England) comes from the demand of the British for items supplied by United States producers. As the British purchase United States' products they must exchange their pounds to obtain the dollars the producers in the United States want to receive. Notes: Notes: supply of pounds -- higher dollar price of pounds (a depreciation of the dollar -- the pound will buy more dollars) means goods produced in the United States are less expensive and the British will purchase more goods from the United States and will hence supply more pounds, the supply curve evidences the standard positive slope. equilibrium exchange rate determination The market clearing price equates the value of U.S. purchases on items produced by the British (U.S. imports) with the value of items sold by the United States to the British (U.S. exports). exchange rate fluctuation differential growth rates of income If domestic income increases faster than foreign income we will spend some fraction of the increase on goods purchased from foreign nations (imports). Because we are purchasing more goods from the British we will demand more pounds to use to buy the increased imports. This causes an appreciation of the pound and a depreciation of the dollar. Notes: If domestic income lags behind international growth rates the demand for pounds will fall as we import less. This causes a depreciation of the pound and an appreciation of the dollar. Notes: differential rates of inflation If domestic inflation increases faster than the foreign inflation rate citizens of the United States will purchase more from Britain (imports) because British goods cost less compared with commodities produced in the United States. Hence we will demand more pounds to finance our increased purchases of imports. Consumers in Great Britain will purchase less from the United States because of the relatively high cost of our products (U.S. exports). Hence the supply of pounds will fall. This causes an appreciation of the pound and a depreciation of the dollar. Notes: If domestic inflation increases slower than the foreign inflation rate citizens of the United States will purchase less from Britain (imports) because their goods cost more compared with commodities produced in the United States. Hence we will demand fewer pounds. Consumers in Great Britain will purchase more from the United States because of the relatively low cost of our products (U.S. exports). Hence the supply of pounds will rise. This causes a depreciation of the pound and an appreciation of the dollar. Notes: changes in the interest rate If domestic interest rates are high compared with global financial investment opportunities foreign investors will demand more dollars and hence supply more pounds. This causes a depreciation of the pound and an appreciation of the dollar. Notes: If domestic interest rates are low compared with global financial investment opportunities foreign investors will demand fewer dollars and hence supply fewer pounds. This causes an appreciation of the pound and a depreciation of the dollar. balance of payments balance of payments a summary of all economic transactions between a country and all other countries for a specified time period • • imports -- debit because monies flow out of the country exports -- credit because monies flow into the country current account current account -- the record of all transactions with foreign nations that involve the exchange of merchandise goods and services (imports and exports) and services or unilateral gifts balance on merchandise trade -- the difference between the value of exports and the value of imports Notes: Notes: When one hears the phrase "trade deficit" it is the balance on merchandise trade that is being referred to. balance on current account -- the import - export balance of goods and services plus net private and government transfers • • if: exports > imports + transfers the balance on current account is in surplus if: exports < imports + transfers the balance on current account is in deficit capital account capital account -- the record of all transactions with foreign nations that involve direct investment and foreign loans official settlements account official settlements account -- an account with the International Monetary Fund (IMF) also known as the official reserve account the account balance the aggregate balance of payments must balance (analogue of double entry bookkeeping), therefore: current account balance + capital account balance + official reserve account balance = 0 a deficit in one area implies a surplus in another area Changes in the official settlements account are effectively zero (because of flexible exchange rates). Hence, current account balance + capital account balance = 0 A deficit (surplus) an current account means a surplus (deficit) on capital account. Notes: If the United States is running a trade deficit, we are running a surplus on capital account. Foreigners find investment in the United States attractive. If the United States is viewed as a good place to invest globally, we will run a current account deficit. If investment opportunities in the United States were no longer attractive to foreigners, a current account deficit would be a problem. We would have difficulty financing the deficit. origin of current account deficit 1. favorable investment opportunities in the United States -good investment means a higher demand for dollars which will cause the dollar the appreciate which in turn will move us toward a current account deficit 2. high United States interest rates -- means a higher demand for dollars which will cause the dollar the appreciate which in turn will move us toward a current account deficit 3. federal government budgetary deficits -- high return on government securities means a higher demand for dollars which will cause the dollar the appreciate which in turn will move us toward a current account deficit