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Chapter 17
INTERNATIONAL FINANCE
Chapter in a Nutshell
1. The balance of payments is a record of a country’s international trading, borrowing, and
lending. In the balance of payments, inflows of funds from foreigners to the United States are
noted as receipts; outflows of funds from the United States to foreigners are noted as
payments.
2. The balance of payments has two components, the current account and the capital account.
The current account includes the dollar value of transactions in currently produced goods and
services, investment income, and unilateral transfers. If the monetary inflows on these
accounts are greater (less) than monetary outflows, the current account balance is a surplus
(deficit). The second component of the balance of payments is the capital account which
includes international purchases or sales of assets such as real estate, corporate stocks and
bonds, and government securities. The capital account balance is a surplus (deficit) if
domestic residents sell more (fewer) assets to foreigners than they purchase from foreigners.
Because the current account balance and capital account balance always equal each other, any
current account deficit (surplus) must be balanced by a capital account surplus (deficit).
3. In recent years, the United States has realized a deficit in its current account. Thus, foreigners
lend or give us the funds to make up the difference between our imports and our exports. It
would not be an overstatement to say that we borrow so much from foreigners to finance our
current account deficits that we sell them pieces of America. Those pieces consist primarily of
real estate and corporate stock. However, foreigners also lend us billions of dollars each year
in the form of purchases of government and corporate securities and other debt instruments.
4. The buying and selling of currencies generally takes place in the foreign exchange market.
This market does not involve sending large loads of currency from one country to another.
Typically it involves electronic balances. Dollar-denominated balances in computers in the
United States or other countries are traded for computer-housed balances around the world that
are denominated in yen, pounds, francs, and the like. In short, when currency is traded, paper
and metal are not the usual media of exchanges.
5. Most daily newspapers publish foreign exchange rates for major currencies. The exchange
rate is the price of one currency in terms of another. Currency depreciation (appreciation)
means that it takes more (fewer) units of a nation’s currency to purchase a unit of some foreign
currency. Among the major factors that determine the equilibrium exchange rate in a free
market are consumer tastes, relative incomes, relative prices, relative interest rates, and
expectations of future exchange rates.
6. Although exchange rates are determined by supply and demand, governments can affect
exchange rates in various ways. The extent and nature of government participation in foreign
exchange markets defines the various systems of exchange rates. These systems include
floating exchange rates, managed floating exchange rates, and fixed exchange rates.
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Chapter 17: International Finance
7. As part of its strategy for forming a regional economic bloc, the European Union has pursued
monetary integration. For participating nations, monetary integration implies a common
currency, a single exchange rate, a single monetary policy, and a single central bank to oversee
the monetary policy.
Chapter Objectives
After reading this chapter, you should be able to:
1. Explain what a current account deficit or surplus means.
2. Identify recent trends in the U.S. balance of payments.
3. Discuss the nature and operation of the foreign exchange market.
4. Understand the foreign exchange quotations as presented in major newspapers.
5. Identify the factors that determine the dollar’s exchange rate.
6. Discuss the features of the major exchange rate systems of the world.
Knowledge Check
Chapter 17: International Finance
Key Concept Quiz
1. current account
2. balance of trade
3. unilateral transfers
4. capital account balance
5. statistical discrepancy
6. exchange rates
171
_____ a. the amount of capital inflows minus capital outflows
_____ b. the most widely reported component of the current
account
_____ c. is reported in the capital account
_____ d. includes gifts for which nothing is given in exchange
_____ e. the price of one currency in terms of another
8. appreciation
_____ f. includes the dollar value of a country’s transactions in
currently produced goods and services, investment
income, and unilateral transfers
9. equilibrium exchange
rates
_____ g. when it takes more units of one nation’s currency to
purchase a unit of a foreign currency
10. floating exchange rate
system
_____ h. when it takes fewer units of a nation’s currency to
purchase a unit of some foreign currency
11. managed floating
exchange rates
_____ i. when governments and central banks do not
participate in the foreign exchange market
12. key currency
_____ j. one that is widely traded on the world money markets
and is relatively stable
7. depreciation
_____ k. is determined by the market forces of supply and
demand
_____ l. attempt to combine market determined exchange rates
with central bank intervention
Multiple Choice Questions
1. The current account balance is the sum of all of the following except
a.
b.
c.
d.
trade balance
foreign exchange balance
services balance
net unilateral transfers
2. When for all merchandise exports exceed imports,
a.
b.
c.
d.
the trade balance is in surplus
the current account is in surplus
the capital account is in surplus
the balance of payments is in surplus
3. When an Italian sends a gift of $10,000 to his German Internet café friend, the gift is
a. considered to be an unilateral transfer
b. not included in the capital account
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Chapter 17: International Finance
c. included in the current account
d. all of the above
4. The capital account balance
a.
b.
c.
d.
refers to positive capital inflows
equals capital inflows minus capital outflows
implies that capital outflows equal capital inflows
imply that the current account is negative
5. A current account deficit implies
a.
b.
c.
d.
a capital account surplus
a capital account deficit
that capital inflows are less than capital outflows
a foreign currency shortage
6. The buying and selling of currencies takes place
a.
b.
c.
d.
in the foreign exchange market
only with the approval of the Federal Reserve Bank
only with the approval of the U.S. Treasury Department
in the stock market
7. The exchange rate is
a.
b.
c.
d.
the price of one currency in terms of another
determined in the United States by the Federal Reserve Bank
fixed by the U.S. Treasury Department
determined at the New York Stock Exchange a the beginning of the trading day
8. When the dollar price of pounds increases
a.
b.
c.
d.
the dollar depreciates relative to the pound
the pound appreciates relative to the dollar
it takes more dollars to buy a pound
all of the above
9. When the dollar is stronger
a.
b.
c.
d.
the prices of foreign goods and services decrease for U.S. consumers
U.S, exporters benefit
U.S. current account surpluses increase
all of the above
10. All of the following are direct determinants of the exchange rates except
a.
b.
c.
d.
relative incomes
relative prices
relative interest rates
U.S. budget deficits and surpluses
11. To offset a depreciation of the dollar against the yen, the Federal Reserve would
a. use its holdings of yen to buy dollars on the foreign exchange market
Chapter 17: International Finance
173
b. use its holding of dollars to buy yen on the foreign exchange market
c. adopt an expansionary monetary policy that decreases interest rates
d. adopt a contractionary monetary policy that decreases interest rates
12. Which of the following is not true for the International Monetary Fund?
a.
b.
c.
d.
it attempts to promote trade and development in the international economy
it makes loans to member nations that have weak economies and large debts
it monitors the economies of weak member nations
it primarily loans money to member nations to finance the building of roads, dams, and
bridges
13. If the U.S. dollar depreciates on the foreign exchange market
a.
b.
c.
d.
U.S. exporters find it more difficult to sell goods in foreign markets
U.S. consumers realize lower prices on foreign goods
U.S. capital markets become less attractive to foreign investors
higher prices on foreign goods contribute to inflation in the United States
14. If the U.S. dollar appreciates on the foreign exchange market
a.
b.
c.
d.
U.S. consumers see lower prices on foreign goods
U.S. investors must pay higher prices for foreign stocks and bonds
U.S. residents pay more when they travel to foreign countries
higher prices on foreign goods intensify the rate of inflation in the United States
15. With floating exchange rates, if economic growth in Canada exceeds economic growth in
Mexico, the
a.
b.
c.
e.
dollar will appreciate against the peso
dollar will depreciate against the peso
peso will depreciate against the dollar
dollar will hold steady against the peso
16. Transactions on the U.S. balance of payments would include all of the following except
a.
b.
c.
d.
Sears importing shirts and trousers from Hong Kong
Holiday Inn supplying rooms to German tourists visiting Chicago
Ayako Ozawa, a student at Stanford, receiving gifts from her family in Seattle
George Thomas, who lives in Hartford, purchasing radios from Sony of Japan
17. If the broadest context, the United States becomes a net demander of funds from the rest of
the world when it realizes a
a.
b.
c.
d.
deficit in its current account balance
surplus in its current account balance
deficit in its merchandise trade balance
surplus in its merchandise trade balance
18. Concerning the balance of payments, in the past two deceased the United States has
persistently realized deficits in all of the following except its
a. merchandise trade balance
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Chapter 17: International Finance
b. services balance
c. unilateral transfers balance
d. current account balance
19. For a country’s balance of payments, the ____provides the broadest measure of a country’s
international payments position
a.
b.
c.
d.
goods and services balance
merchandise trade balance
unilateral transfers balance
current account balance
20. Concerning the United States, suppose that its current account has a deficit of $20 trillion, its
merchandise trade account has a deficit of $15 trillion, its income flow account has a surplus
of $5 trillion, and its unilateral transfers account has a deficit of $10 trillion. The services
account of the United States
a.
b.
c.
d.
has a deficit of $5 trillion
has a deficit of $10 trillion
has a surplus of $5 trillion
is in balance
21. Suppose the exchange rate between the currencies of the United States and Great Britain is $2
per pound. A shirt that cost $20 in the United States would cost ______in Great Britain.
a.
b.
c.
d.
5 pounds
10 pounds
25 pounds
40 pounds
True-False Questions
1.
T
F
Monetary integration for the European union members implies that a
single central bank will oversee a single monetary policy.
2.
T
F
Foreign currencies are typically traded on the trading floors of the
foreign currency exchanges.
3.
T
F
Currency appreciation implies that it takes more units of a nation’s
currency to purchase a unit of some foreign currency.
4.
T
F
Because exchange rates are determined by supply and demand,
governments have very little control over them.
5.
T
F
In recent years, the United States has experienced a deficit in its current
account.
6.
T
F
When the current account is in deficit, the capital account must be in
surplus.
7.
T
F
The capital account balance is in surplus when domestic residents sell
fewer assets to foreigners than they purchase from foreigners.
8.
T
F
When U.S. imports exceed U.S. exports, capital flows into the U.S.
Chapter 17: International Finance
175
9.
T
F
Foreigners lend us billions of dollars in the form of purchases of
governmental corporate securities.
10.
T
F
The balance of payments refers to a surplus in the current account.
11.
T
F
The current account only includes the value of transactions in currently
produced goods and services.
12.
T
F
Investment income is always included in the capital account.
13.
T
F
The balance of trade excludes trade in services.
14.
T
F
Unilateral transfers refer to private transfers and gifts only.
15.
T
F
A strong dollar benefits all U.S businesses.
16.
T
F
Changes in consumer tastes can affect the equilibrium exchange rate.
17.
T
F
When Japanese incomes increase, the U.S. dollar tends to appreciate
relative to the Japanese yen.
18.
T
F
If the Federal Reserve Bank increases interest rates, the dollar tends to
appreciate.
19.
T
F
Central banks never intervene directly in foreign currency markets to
manage exchange rates.
20.
T
F
Fixed exchange rates are used primarily by large developed nations with
stable currencies.
21.
T
F
Concerning the United States and Argentina, if it takes $0.32 to purchase
one peso then it takes about 3.12 pesos to purchase $1.
22.
T
F
A depreciation of the dollar against the euro will make Ford autos less
competitive on European markets.
23.
T
F
A weak euro makes it less expensive for American tourists who visit
Europe.
24.
T
F
A rise in labor productivity in the United States tends to cause the dollar
to appreciate on the foreign exchange market.
25.
T
F
The euro is the common currency for members of the European
Monetary Union.
26.
T
F
Dollarization of the Mexican economy would occur if the U.S. dollar
replaced the peso as the official medium of exchange.
27.
T
F
28.
T
F
Long-run determinants of exchange rates include relative prices, relative
productivity levels, and relative interest rates.
Economists widely agree that the U.S. current-account deficit has caused
sizable job losses for Americans in general.
29.
T
F
If the U.S. current account shows a deficit, the United States becomes a
net supplier of funds to the rest of the world.
176
30.
Chapter 17: International Finance
T
F
Economists widely agree that the United States can run current-account
deficits without limit because the dollar is universally accepted as a
means of international payment.
Application Questions
1. The following data represents Vegaland’s international transactions measured in vegas:
Merchandise exports
Change in foreign assets in Vegaland
150
120
Exports of services
70
Income receipts on investment
50
Merchandise imports
100
Change in assets abroad (rest of the world)
80
Import of services
50
Income payments on investment
Unilateral transfers
100
60
a. What is Vegaland’s balance of trade?
b. What is its balance on the current account?
c. What is its balance on the capital and financial account?
2. Consider the following data on demand and supply of U.S. dollars:
Quantity Demanded
(Billions of Dollars
per Day)
Quantity Supplied
(Billions of Dollars
per Day)
130
0.6
1.0
120
0.7
0.9
110
0.8
0.8
100
0.9
0.7
Exchange Rate
(Lira per Dollar)
Chapter 17: International Finance
90
1.0
177
0.6
a. Graph the supply and demand curves.
b. What is the equilibrium exchange rate?
c. If U.S. importers decide to buy $200 million more of Italian products, what changes
occur in the foreign exchange market? Illustrate your answer. Does the U.S. dollar
depreciate or appreciate? What is the exchange rate?
d. Now suppose that the Italian importers decide to reduce their purchase of U.S. products
by $200 million. What changes occur in this foreign exchange market? Is the Italian
lira appreciating or depreciating relative to the U.S. dollar?
Answers to Knowledge Check Questions
Key Concept Answers
1. f
4. a
2. b
5 c
3. d
6. e
7. g
8. h
9. k
10.
11.
12.
Multiple Choice Answers
1. b
6. a
2. a
7. a
3. d
8. d
4. b
9. a
5. b
10. d
11.
12.
13.
14.
15.
a
d
d
a
b
16.
17.
18.
19.
20.
c
a
b
d
c
21. b
True-False Answers
1. T
6. T
2. F
7. F
3. F
8. T
4. F
9. T
5. T
10. F
11.
12.
13.
14.
15.
F
F
T
F
F
16.
17.
18.
19.
20.
T
T
T
F
F
21.
22.
23.
24.
25.
i
l
j
T
F
T
T
T
26.
27.
28.
29.
30.
T
F
F
F
F
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Chapter 17: International Finance
Application Question Answers
1. a. Vegaland’s balance of trade is
Merchandise exports
Less merchandise imports
Balance of trade
150
(100)
50
Chapter 17: International Finance
b.
179
Vegaland’s current account is
Merchandise exports
Exports of services
Income from investments
Less merchandise exports
Less import of services
Less income payments on investments
Less unilateral transfers
150
70
50
(100)
(50)
(100)
(60)
Current account balance
(40)
Vegaland’s capital and financial account is
c.
Changes in foreign assets in Vegaland
Less Changes in Vegaland’s assets in foreign countries
Current account balance
120
80
40
Foreign Exchange Market for
U.S. Dollars
Exchange
Rate
(lira/$)
130
120
110
100
90
80
70
60
50
40
30
20
10
S
S'
D
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14
Quantity of Dollars per Day
(Billions)
2. a.
b.
The equilibrium exchange rate is 110 lira per dollar.
When the U.S. importers buy $200 million more of Italian products, the quantity of U.S.
dollars supplied increases by $200 million. So, the supply curve of U.S. dollars shifts to
the right by $200 million.
The U.S. dollar depreciates. The new exchange rate is 100 lire per year.
c.
The decrease in demand for U.S. imports decreases the demand for U.S. dollars by $200
million. The Italian lira appreciates because the U.S. dollar depreciates.