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Chapter 32 Exchange Rates, Balance of Payments, and International Debt © 2005 Thomson Economic Principles Exchange rates Foreign exchange markets Appreciation and depreciation of currencies Floating and fixed exchange rates Gottheil - Principles of Economics, 4e © 2005 Thomson 2 Economic Principles Arbitrage Devaluation Balance of payments International debt and debt service Gottheil - Principles of Economics, 4e © 2005 Thomson 3 The Foreign Exchange Market: The Buying and Selling of Currencies Foreign exchange market • A market in which currencies of different nations are bought and sold. Gottheil - Principles of Economics, 4e © 2005 Thomson 4 The Foreign Exchange Market: The Buying and Selling of Currencies Exchange rate • The number of units of foreign currency that can be purchased with one unit of domestic currency. Gottheil - Principles of Economics, 4e © 2005 Thomson 5 The Foreign Exchange Market: The Buying and Selling of Currencies 1. Suppose that a kite costs 40 yaps, and the exchange rate is 10 yaps to the dollar. What is the dollar price of the kite? • 40 yaps/10 = 4 dollars. Gottheil - Principles of Economics, 4e © 2005 Thomson 6 EXHIBIT 1 FOREIGN EXCHANGE MARKET Gottheil - Principles of Economics, 4e © 2005 Thomson 7 Exhibit 1: Foreign Exchange Market At $2 per yap, is the foreign exchange market in Exhibit 1 in equilibrium, or is there an excess demand or excess supply of yaps? • Since the equilibrium price is $3 per yap, at $2 per yap there would be an excess demand for yaps. Gottheil - Principles of Economics, 4e © 2005 Thomson 8 Exhibit 1: Foreign Exchange Market At $4 per yap, is the foreign exchange market in Exhibit 1 in equilibrium, or is there an excess demand or excess supply of yaps? • Since the equilibrium price is $3 per yap, at $4 per yap there would be an excess supply of yaps. Gottheil - Principles of Economics, 4e © 2005 Thomson 9 The Foreign Exchange Market: The Buying and Selling of Currencies 2. Why is the demand curve for foreign currency downward-sloping? • When the price of a foreign currency declines, the quantity of that foreign currency demanded increases. Gottheil - Principles of Economics, 4e © 2005 Thomson 10 The Foreign Exchange Market: The Buying and Selling of Currencies 2. Why is the demand curve for foreign currency downward-sloping? • For example, if a dollar can buy more yaps than before, then a dollar can also buy more yap-priced goods and services than before. Gottheil - Principles of Economics, 4e © 2005 Thomson 11 The Foreign Exchange Market: The Buying and Selling of Currencies 2. Why is the demand curve for foreign currency downward-sloping? • As a result, Americans wish to exchange dollars for more yaps in order to buy more yap-priced goods, increasing the quantity of yaps demanded in the foreign exchange market. Gottheil - Principles of Economics, 4e © 2005 Thomson 12 The Foreign Exchange Market: The Buying and Selling of Currencies 3. Why is the supply curve for foreign currency upward-sloping? • When the price of a foreign currency rises, then the purchasing power of the foreign currency rises when it comes to buying imported goods and services. Gottheil - Principles of Economics, 4e © 2005 Thomson 13 The Foreign Exchange Market: The Buying and Selling of Currencies 3. Why is the supply curve for foreign currency upward-sloping? • For example, if it takes more dollars to buy a yap, then it takes fewer yasps to buy a dollar, and so the price of American goods are cheaper for people who use the yap. Gottheil - Principles of Economics, 4e © 2005 Thomson 14 The Foreign Exchange Market: The Buying and Selling of Currencies 3. Why is the supply curve for foreign currency upward-sloping? • As a result, people who use yaps wish to exchange more yaps for dollars in order to buy more American goods, increasing the quantity of yaps supplied in the foreign exchange market. Gottheil - Principles of Economics, 4e © 2005 Thomson 15 The Foreign Exchange Market: The Buying and Selling of Currencies 4. Which of the following will cause an increase in the demand for yaps? a. Decreasing American incomes b. Increasing yap-priced interest rates c. Increasing American interest rates Gottheil - Principles of Economics, 4e © 2005 Thomson 16 The Foreign Exchange Market: The Buying and Selling of Currencies 4. Which of the following will cause an increase in the demand for yaps? a. Decreasing American incomes b. Increasing yap-priced interest rates c. Increasing American interest rates Gottheil - Principles of Economics, 4e © 2005 Thomson 17 EXHIBIT 2 EFFECT OF AN INCREASE IN THE DEMAND FOR YAPS ON THE DOLLARS-FOR-YAPS RATE OF EXCHANGE 18 © 2005 Thomson Exhibit 2: Effect of an Increase in the Demand for Yaps on the Dollars-for-Yaps Rate of Exchange 1. After the increase in demand from D1 to D2, Is there excess supply, excess demand, or equilibrium at an exchange rate of $3 per yap? • There is excess demand of (70 - 30) = 40 thousand yaps. Gottheil - Principles of Economics, 4e © 2005 Thomson 19 Exhibit 2: Effect of an Increase in the Demand for Yaps on the Dollars-for-Yaps Rate of Exchange 2. After the increase in demand from D1 to D2, what is the new equilibrium exchange rate? • The new equilibrium exchange rate is $5 per yap. Gottheil - Principles of Economics, 4e © 2005 Thomson 20 The Foreign Exchange Market: The Buying and Selling of Currencies 5. Which of the following will cause a decrease in the supply of yaps? a. Decreasing American tastes for yappriced goods b. Decreasing yap-priced interest rates c. Decreasing yap-priced incomes Gottheil - Principles of Economics, 4e © 2005 Thomson 21 The Foreign Exchange Market: The Buying and Selling of Currencies 5. Which of the following will cause a decrease in the supply of yaps? a. Decreasing American tastes for yappriced goods b. Decreasing yap-priced interest rates c. Decreasing yap-priced incomes Gottheil - Principles of Economics, 4e © 2005 Thomson 22 EXHIBIT 3 EFFECT OF AN INCREASE IN THE SUPPLY OF YAPS ON THE DOLLARS-FOR-YAPS RATE OF EXCHANGE 23 © 2005 Thomson Exhibit 3: Effect of an Increase in the Supply of Yaps on the Dollars-for-Yaps Rate of Exchange 1. After the increase in supply from S1 to S2, is there excess supply, excess demand, or equilibrium at an exchange rate of $3 per yap? • There is an excess supply of (50 - 30) = 20 thousand yaps. Gottheil - Principles of Economics, 4e © 2005 Thomson 24 Exhibit 3: Effect of an Increase in the Supply of Yaps on the Dollars-for-Yaps Rate of Exchange 2. After the increase in supply from S1 to S2, what is the new equilibrium exchange rate? • The new equilibrium exchange rate is $2 per yap. Gottheil - Principles of Economics, 4e © 2005 Thomson 25 Floating Exchange Rates Floating exchange rate • An exchange rate determined strictly by the demands and supplies for a nation’s currency. Gottheil - Principles of Economics, 4e © 2005 Thomson 26 Floating Exchange Rates Appreciation • A rise in the price of a nation’s currency relative to foreign currencies. Gottheil - Principles of Economics, 4e © 2005 Thomson 27 Floating Exchange Rates Depreciation • A fall in the price of a nation’s currency relative to foreign currencies. Gottheil - Principles of Economics, 4e © 2005 Thomson 28 Floating Exchange Rates 1. Complete the sentence: When journalists say that the dollar has “weakened,” they mean that the dollar has _____ in value. Gottheil - Principles of Economics, 4e © 2005 Thomson 29 Floating Exchange Rates 1. Complete the sentence: When journalists say that the dollar has “weakened,” they mean that the dollar has depreciated in value. Gottheil - Principles of Economics, 4e © 2005 Thomson 30 Floating Exchange Rates 2. If the dollar has appreciated in value relative to the yap, then which of the following is true: a. The exchange rate has more yaps per dollar than before. b. The exchange rate has fewer yaps per dollar than before. Gottheil - Principles of Economics, 4e © 2005 Thomson 31 Floating Exchange Rates 2. If the dollar has appreciated in value relative to the yap, then which of the following is true: a. The exchange rate has more yaps per dollar than before. b. The exchange rate has fewer yaps per dollar than before. Gottheil - Principles of Economics, 4e © 2005 Thomson 32 Tourists at the Mall Has the U.S. dollar appreciated or depreciated in value relative to the Japanese yen between 1960 and 1996? • Depreciated in value. Gottheil - Principles of Economics, 4e © 2005 Thomson 33 Tourists at the Mall Has the U.S. dollar appreciated or depreciated in value relative to the Japanese yen between 1960 and 1996? • In 1960 the exchange rate was 358 yen per dollar. By 1996 there were only 131 yen per dollar. Gottheil - Principles of Economics, 4e © 2005 Thomson 34 Floating Exchange Rates Arbitrage • The practice of buying a foreign currency in one market at a low price and selling it in another at a higher price. Gottheil - Principles of Economics, 4e © 2005 Thomson 35 Floating Exchange Rates 3. How might floating exchange rates make international trade riskier? • Suppose that the price of an internationally traded good changes during the time between when a purchase is negotiated and the product is delivered. Gottheil - Principles of Economics, 4e © 2005 Thomson 36 Floating Exchange Rates 3. How might floating exchange rates make international trade riskier? • Then the change in exchange rates is like an unforeseen change in the price of the good, which redistributes the gains from trade in an unforeseen way. Gottheil - Principles of Economics, 4e © 2005 Thomson 37 Floating Exchange Rates Fixed exchange rate • A rate determined by government and then maintained through the process of buying and selling quantities of its own currency on the foreign exchange market. Gottheil - Principles of Economics, 4e © 2005 Thomson 38 EXHIBIT 4A TRADE UNDER FREE AND FIXED EXCHANGE RATES 39 © 2005 Thomson EXHIBIT 4B TRADE UNDER FREE AND FIXED EXCHANGE RATES 40 © 2005 Thomson Exhibit 4: Trade Under Free and Fixed Exchange Rates 1. If there is a system of free or floating exchange rates, then what happens if the demand for a foreign currency increases? • The exchange rate (dollars per unit of foreign currency) increases and there is neither excess demand nor excess supply of the foreign currency. Gottheil - Principles of Economics, 4e © 2005 Thomson 41 Exhibit 4: Trade Under Free and Fixed Exchange Rates 2. If there is a system of fixed exchange rates, then what happens if the demand for a foreign currency increases? • Since the exchange rate cannot change, an increase in demand will create excess demand for the foreign currency. Gottheil - Principles of Economics, 4e © 2005 Thomson 42 Exhibit 4: Trade Under Free and Fixed Exchange Rates 3. If there is excess demand for yaps under a system of fixed exchange rates, what will the yap government need to do to eliminate the excess demand for the yap? • The yap government will need to exchange some of its own yaps for dollars on the foreign exchange market. Gottheil - Principles of Economics, 4e © 2005 Thomson 43 Exhibit 4: Trade Under Free and Fixed Exchange Rates 3. If there is excess demand for yaps under a system of fixed exchange rates, what will the yap government need to do to eliminate the excess demand for the yap? • This will increase the supply of yaps on the foreign exchange market and eliminate the excess demand. Gottheil - Principles of Economics, 4e © 2005 Thomson 44 Exhibit 4: Trade Under Free and Fixed Exchange Rates 3. If there is excess demand for yaps under a system of fixed exchange rates, what will the yap government need to do to eliminate the excess demand for the yap? • In order for the yap government to do this, it must have sufficient stock of yaps to exchange for dollars. Gottheil - Principles of Economics, 4e © 2005 Thomson 45 Exhibit 4: Trade Under Free and Fixed Exchange Rates 4. Continuing the yap example, what might the yap government be forced to do if it did not have a sufficient quantity of yaps on reserve to eliminate the excess demand? • The yap government might be forced to borrow yaps from another country, or even agree to increase the exchange rate ($ per yap). Gottheil - Principles of Economics, 4e © 2005 Thomson 46 Floating Exchange Rates Foreign exchange reserves • The stock of foreign currencies a government holds. Gottheil - Principles of Economics, 4e © 2005 Thomson 47 Floating Exchange Rates Devaluation • Government policy that lowers the nation’s exchange rate; its currency instantly is worth less in the foreign exchange market. Gottheil - Principles of Economics, 4e © 2005 Thomson 48 Floating Exchange Rates 4. In which of the following circumstances would a country most likely be forced into a devaluation of its currency: a. The excess supply of its currency in the foreign exchange market exceeds its foreign exchange reserves. b. The excess demand for its currency in the foreign exchange market exceeds its foreign exchange reserves. Gottheil - Principles of Economics, 4e © 2005 Thomson 49 Floating Exchange Rates 4. In which of the following circumstances would a country most likely be forced into a devaluation of its currency: a. The excess supply of its currency in the foreign exchange market exceeds its foreign exchange reserves. b. The excess demand for its currency in the foreign exchange market exceeds its foreign exchange reserves. Gottheil - Principles of Economics, 4e © 2005 Thomson 50 Floating Exchange Rates Import controls • Tariffs and quotas used by government to limit a nation’s imports. Gottheil - Principles of Economics, 4e © 2005 Thomson 51 Floating Exchange Rates Exchange controls • A system in which government, as the sole depository of foreign currencies, exercises complete control over how these currencies can be used. Gottheil - Principles of Economics, 4e © 2005 Thomson 52 Floating Exchange Rates International Monetary Fund (IMF) • An international organization formed to make loans of foreign currencies to countries facing balance of payments problems. Gottheil - Principles of Economics, 4e © 2005 Thomson 53 Balance of Payments Balance of payments • An itemized account of a nation’s foreign economic transactions. Gottheil - Principles of Economics, 4e © 2005 Thomson 54 Balance of Payments Balance on current account • A category that itemizes a nation’s imports and exports of goods and services, income receipts and payments on investment, and unilateral transfers. Gottheil - Principles of Economics, 4e © 2005 Thomson 55 EXHIBIT 5 THE U.S. BALANCE OF PAYMENTS ACCOUNT: 2002 ($ BILLIONS) Source: Survey of Current Business (Washington, D.C.: U.S. Department of Commerce, February 2003). Gottheil - Principles of Economics, 4e © 2005 Thomson 56 Exhibit 5: The U.S. Balance of Payments Account: 2002 ($ billions) In which of the following categories of the U.S. balance of payments did the U.S. run a surplus in 2002? a. Balance of trade b. Balance on current account c. Balance on capital account Gottheil - Principles of Economics, 4e © 2005 Thomson 57 Exhibit 5: The U.S. Balance of Payments Account: 2002 ($ billions) In which of the following categories of the U.S. balance of payments did the U.S. run a surplus in 2002? a. Balance of trade b. Balance on current account c. Balance on capital account Gottheil - Principles of Economics, 4e © 2005 Thomson 58 EXHIBIT 6 U.S. BALANCE OF TRADE: 1950–2002 Gottheil - Principles of Economics, 4e © 2005 Thomson 59 Exhibit 6: U.S. Balance of Trade: 1950-2002 What has been the overall trend in the U.S. balance of trade since the mid-1970s? • Since the mid-1970s the U.S. balance of trade has been in deficit. Gottheil - Principles of Economics, 4e © 2005 Thomson 60 Balance of Payments What is an example of an export of services? • When a U.S. engineering firm provides engineering design services for a project in another country. Gottheil - Principles of Economics, 4e © 2005 Thomson 61 Balance of Payments Unilateral transfers • Transfers of currency made by individuals, businesses, or government of one nation to individuals, businesses, or governments in other nations, with no designated return. Gottheil - Principles of Economics, 4e © 2005 Thomson 62 Balance of Payments Balance on capital account • A category that itemizes changes in the foreign asset holdings of a nation and that nation’s asset holdings abroad. Gottheil - Principles of Economics, 4e © 2005 Thomson 63 What is a Balance of Payments Problem? Do trade imbalances always create problems? • No. For example, a country may have a balance of trade deficit because it is importing capital equipment necessary for it to produce valuable exports in the future. Gottheil - Principles of Economics, 4e © 2005 Thomson 64 How Deficits on Current Account Develop If foreigners make huge investments in U.S. stocks and bonds, how might this affect the current account? • Foreign purchases of U.S. stocks and bonds increases the demand for U.S. dollars. Gottheil - Principles of Economics, 4e © 2005 Thomson 65 How Deficits on Current Account Develop If foreigners make huge investments in U.S. stocks and bonds, how might this affect the current account? • Increased demand for the U.S. dollar increases the value of the dollar relative to other currencies. Gottheil - Principles of Economics, 4e © 2005 Thomson 66 How Deficits on Current Account Develop If foreigners make huge investments in U.S. stocks and bonds, how might this affect the current account? • A high-valued dollar makes imports cheap for Americans, but makes American exports expensive for foreigners in other countries. Gottheil - Principles of Economics, 4e © 2005 Thomson 67 How Deficits on Current Account Develop If foreigners make huge investments in U.S. stocks and bonds, how might this affect the current account? • Consequently imports increase and exports decline, causing a current account deficit. Gottheil - Principles of Economics, 4e © 2005 Thomson 68 International Debt International debt • The total amount of outstanding IOUs a nation is obligated to repay other nations and international organizations. Gottheil - Principles of Economics, 4e © 2005 Thomson 69 International Debt Debt service • Interest payments on international debt as a percentage of a nation’s merchandise exports. Gottheil - Principles of Economics, 4e © 2005 Thomson 70 EXHIBIT 7 DEBT SERVICE OF SELECTED COUNTRIES, AS A PERCENTAGE OF EXPORTS: 2001 Source: United Nations Development Programme, Human Development Report 2003 (New York: Oxford University Press, 2003). Gottheil - Principles of Economics, 4e © 2005 Thomson 71 Exhibit 7: Debt Service of Selected Countries, as a Percentage of Exports What causes countries such as Argentina to have such high debt service as a percentage of their exports? • The amount of international debt held by these countries is quite large relative to the value of their exports, making repayment difficult. Gottheil - Principles of Economics, 4e © 2005 Thomson 72