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CHAPTER
CHAPTER
18
International trade and
finance
Chapter outline and
learning objectives
The international economy
Net exports, net funds outflow,
national income, production,
expenditure and saving
Balance of payments: current
account, financial account and
capital account
Nominal exchange rates
Real or price-adjusted exchange
rates
1
The international economy
In our discussion of domestic economies, we have mostly ignored the
international economy.
But especially in the 21st century, nations are integrated in an
international economy through
• buying and selling goods and services.
• buying and selling assets.
In this chapter, we discuss an abstract representation of these
exchanges, specific accounting rules for valuing these exchanges
and other ways to value these exchanges.
2
The international economy
Over the past several decades, international trade and finance have
become increasingly important due to
• more efficient transportation
• more efficient communication and computer networks
• changes in the composition of production: more lightweight, highvalue goods and services are produced today than in the past
• liberalization of trade and financial policies, including for economic
and monetary unions like the EU’s euro system.
3
Value of imports and exports as a fraction of total domestic
production by country, 1950-2011
160%
argentina
150%
canada
chile
140%
china
130%
germany
120%
spain
110%
france
100%
UK
india
90%
iran
80%
italy
70%
japan
60%
korea
50%
mexico
40%
netherlands
30%
poland
20%
russia
sweden
10%
1950
1951
1952
1953
1954
1955
1956
1957
1958
1959
1960
1961
1962
1963
1964
1965
1966
1967
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
thailand
0%
turkey
US
Source: Penn World Table, version 8.1, www.ggdc.net/pwt
4
The international economy
Before 1980, domestic institutions mostly acquired credit (ex., from
bonds) and capital (ex, from stock) from domestic institutions and
citizens.
• Likewise, domestic institutions and citizens rarely invested in
foreign bonds and stock.
In the 1980s and 1990s, restrictions on flows of funds in Europe were
removed, and international electronic transfers and communication
improved.
5
The international economy
By the 2000s, the
international flow of
funds had increased
significantly.
But during the international
financial crisis from 20082012, foreign purchases of
private bonds and stock
decreased,
• but purchases of US
government bonds
increased due to their
perceived safety.
© 2015 Pearson Education, Inc.
The flow of funds, 1995-2012
6
The international economy
For international finance of
credit and capital, the US relies
on Japan, China, the UK, other
European countries, Canada
and small countries like the
Cayman Islands that have
favorable tax and transfer
regulations.
Relying on the saved funds
from other countries allows US
institutions and individuals to
more easily and cheaply finance
(investment) expenditure.
But it also implies that crises
can be transmitted more easily
across borders.
© 2015 Pearson Education, Inc.
Foreign holdings of US stocks and bonds
by country, 2012
7
The flow of products: net exports
Nations have generally increased the quantity of both exports and
imports
• but some nations have increased imports more than exports, while
others have increased exports more than imports.
• Recall that net exports (NX) are the value of a nation’s exports
minus the value of its imports, which can be positive or negative.
8
billions of US$
100
2
0
1
-100
1947/01
1948/01
1949/01
1950/01
1951/01
1952/01
1953/01
1954/01
1955/01
1956/01
1957/01
1958/01
1959/01
1960/01
1961/01
1962/01
1963/01
1964/01
1965/01
1966/01
1967/01
1968/01
1969/01
1970/01
1971/01
1972/01
1973/01
1974/01
1975/01
1976/01
1977/01
1978/01
1979/01
1980/01
1981/01
1982/01
1983/01
1984/01
1985/01
1986/01
1987/01
1988/01
1989/01
1990/01
1991/01
1992/01
1993/01
1994/01
1995/01
1996/01
1997/01
1998/01
1999/01
2000/01
2001/01
2002/01
2003/01
2004/01
2005/01
2006/01
2007/01
2008/01
2009/01
2010/01
2011/01
2012/01
2013/01
2014/01
-300
-600
-800
billions of US$ (left scale)
0
-200
-1
-400
-2
-500
-3
-4
-700
-5
-900
-6
-1000
-7
percent of total domestic production
The flow of products: net exports
Value of net exports (current account transactions) for the US, 1947-2014
percent of total domestic production (right scale)
Source: St. Louis Federal Reserve Economic Data, http://research.stlouisfed.org/fred2/
9
The flow of products: net exports
The value of exports, imports and net exports relative to the value of domestic
production in Korea, 1953-2014
exports
imports
net exports
60%
55%
50%
45%
40%
35%
30%
25%
20%
15%
10%
5%
-5%
1953
1954
1955
1956
1957
1958
1959
1960
1961
1962
1963
1964
1965
1966
1967
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
0%
-10%
-15%
-20%
Source: Bank of Korea, http://ecos.bok.or.kr/
10
The flow of products: net exports
Factors that affect exports relative to imports
• preferences of domestic products v. foreign products
• prices of domestic products v. foreign products
• value of domestic currency v. foreign currency
• trade policies: government taxes on imports and subsidies on
exports
• expenditure (and saving) by domestic residents v. foreign residents
•
•
more expenditure and less saving in general implies more expenditure on
imports in particular
more saving in general implies more saving to buy foreign assets in particular
11
The flow of funds: net funds outflow
Buying and selling of assets is associated with the exchange of funds:
money, credit and financial capital.
Net funds outflow refers to domestic funds to purchase foreign
assets minus foreign funds to purchase domestic assets.
• Outflows of funds are associated with purchases of foreign assets
by domestic citizens.
• Inflows of funds are associated with purchases of domestic assets
by foreign citizens.
• Net funds outflow represents net investment in foreign economies,
and is sometimes called net foreign investment.
• Because funds are saved before they are invested, net funds
outflow is directly related to domestic (national) saving and
inversely related to domestic expenditure.
12
The flow of funds: net funds outflow
When a US resident uses his funds to buy stock in a Korean
company, US net funds outflow increases.
When a Japanese resident buys a US government bond, the
purchase decreases US net funds outflow and increases net funds
inflow.
13
The flow of funds: net funds outflow
Factors that affect net funds outflow
• Expectations about interest (on deposits and loans), yield (on
bonds) and return (on stock and other sellable assets) rates on
foreign assets v. rates on domestic assets, which can be affected
by expectations about
•
•
the value of domestic currency v. foreign currency
the risks of (negative returns on) domestic assets v. foreign assets
• Government policies that affect foreign ownership of domestic
assets and domestic ownership of foreign assets
14
The flow of funds: net funds outflow
An international transaction that involves an exchange of goods and
services also involves an exchange of money.
Money from an international transaction is either saved or spent:
• If it is saved, it is invested in an asset—domestic or foreign asset—
allowing domestic (investment) expenditure or net funds outflow to
increase.
• If it is spent, it is spent on goods and services—domestic or foreign
goods and services—increasing expenditure on domestic goods
and services or decreasing net exports.
15
Net exports and net funds outflow
foreign country
Flows of goods and services: imports
(recorded in current account)
domestic
country
corresponding flows of funds
corresponding flows of
funds: funds inflow
Flows of financial assets (recorded in
the financial account)
foreign institution
or individual
domestic
institution or
individual
16
Net exports and net funds outflow
foreign country
Flows of goods and services: exports
(recorded in current account)
domestic
country
corresponding flows of funds
corresponding flows of
funds: funds outflow
Flows of financial assets (recorded in
the financial account)
foreign institution
or individual
domestic
institution or
individual
17
Net exports, net funds outflow, national income, production,
expenditure and saving
An international economy can
• spend more than it earns from production by borrowing from
foreigners.
• spend less than it earns from production and save by transferring
funds to foreigners.
As a result, in an international economy,
• spending need not equal income from production.
• national saving need not equal domestic investment expenditure.
18
Net exports, net funds outflow, national income, production,
expenditure and saving
National income earned from producing and selling domestic final
goods and services equals the expenditure on those goods and
services by different individuals institutions:
GDP = Y = C + I + G + NX
In particular, domestic final goods and services can be bought by
domestic individuals and institutions or bought by foreign individuals
and institutions:
Y – C – G – I = NX
19
Net exports, net funds outflow, national income, production,
expenditure and saving
Alternatively, national income earned from production can be spent in
non-productive ways, can be saved and invested in domestic
productive capacity or saved and invested in foreign assets:
Y – C – G = I + NFO
Recall that national saving (S) is the national income that remains
after paying for private and government consumption expenditure:
Y–C–G≡S
20
Net exports, net funds outflow, national income, production,
expenditure and saving
National saving, S,
• accumulated from national income from production in general and
income from net exports in particular,
can be invested in domestic productive capacity (I) or in foreign
assets (NFO):
S = I + NFO
Also, we showed that
S = I + NX
21
Net exports, net funds outflow, national income, production,
expenditure and saving
Let’s redefine net funds outflow as NFO ≡ S – I
net investment in
foreign assets
=
national
saving
–
domestic
investment
expenditure
22
Net exports, net funds outflow, national income, production,
expenditure and saving
If domestic residents earn a high income from selling more goods
than they buy from foreign residents (NX > 0), then income that is
saved and not invested in the domestic economy can be invested in
foreign assets (NFO > 0).
If domestic residents spend more than they earn by buying more
goods than they sell to foreign residents (NX < 0), then domestic
residents must borrow from foreign residents as foreigners invest in
domestic assets (NFO < 0).
In sum, funds earned from or paid for net exports can be saved in or
must be borrowed from foreign financial markets, so that
NX = NFO
23
Net exports, net funds outflow, national income, production,
expenditure and saving
In sum, there is a direct link among
• income that is earned from production, including income earned
from exports,
• saving
• domestic expenditure in general
• domestic investment expenditure (investment in domestic
productive capacity)
• funds (money, credit and financial capital) that are invested in
foreign economies.
24
Net exports, net funds outflow, national income, production,
expenditure and saving
The association may not always be exact because flows of goods and
services may differ somewhat from flows of money, other assets,
credit and financial capital.
But in general there is a close relationship in the accounting of flows
of goods and services, financial assets, income and other funds.
25
Balance of payments
The accounting of flows of goods and services, various kinds of
income and money, and various financial assets and liabilities are
recorded in a country’s balance of payments.
The name comes from the fact that the accounting of payments for
these items is supposed to balance.
26
Balance of payments
The balance of payments records payments between a country’s
residents and non-residents for
1. purchases/sales of goods and services (NX).
2. current income earned from assets (ex., interest, yield or return)
and from working (wages and salaries).
3. current transfers: money received/paid without a sale/purchase of
goods, services or assets.
4. purchases/sales of assets, which can earn income in the future,
and liabilities, which will be paid in the future.
5. purchases/sales of special assets that are difficult to value at
market prices and special transfers.
27
Balance of payments
(Current) purchases/sales of goods and services (net exports),
current income earned and current transfers (of money) are recorded
in the current account.
Purchases/sales of assets and liabilities, which involve future income
and expenses, are recorded in the financial account.
Purchases/sales of special assets that are difficult to value at market
prices and special transfers are recorded in the capital account.
28
Current account
The current account records the value of goods and services that are
(currently) bought and sold in various transactions between residents
and non-residents of a country:
• General merchandise: tangible final goods
• Goods for processing: intermediate goods that are sent to/from a
foreign economy for processing in the receiving economy and then
re-imported/re-exported
• Repairs on goods provided to or received from non-residents on
ships, aircraft and other forms of transportation
• Goods bought and sold in ports by international transporters
29
Current account
• Transportation services for passengers and freight transported
internationally
• Travel: goods and services purchased by non-resident travelers for
travel of less than one year
• Communication services—such as postal, courier and
telecommunications services
• Construction services
• Insurance services
• Financial services—such as lending, borrowing, leasing, currency
exchange
• Computer and information services
• Cultural and recreational services—such as payments for
production of television broadcasts, acting, operating museums
and playing sports
30
Current account
The current account records the value of current income, which refers
to income earned from/by non-residents for working or investing in
assets:
• Compensation of non-resident workers and compensation from
non-resident firms for providing labor services (ex., wages and
salaries).
• Investment income currently paid to and earned from nonresidents: interest, yield, return, as well as principal at maturity
• due to previous acquisitions of assets, liabilities or capital by non-residents or
in foreign economies.
31
Current account
The current account records the value of current transfers, which
refer to transfers of money or other assets without a corresponding
purchase/sale of a good, service or another asset:
• Taxes paid from non-residents to the domestic government and
from residents to foreign governments
• Non-resident workers remitting wages/salaries to their home
country and resident workers remitting wages/salaries to foreign
countries.
• Claims on non-life insurance by non-residents
• Claims on pensions by non-residents after retirement
32
Current account
Current account values for China, Germany, Japan, Korea and US, 1970-2015
500
400
300
200
100
2015
2014
2013
2012
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
1984
1983
1982
1981
1980
1979
1978
1977
1976
1975
1974
1973
1972
1971
-100
1970
billions of US$
0
-200
-300
-400
-500
-600
-700
-800
-900
China
Germany
Japan
Korea
US
Source: International Monetary Fund, http://www.imf.org/
33
Current account
Current account values for Australia, Brazil, India, Russia and UK, 1970-2015
500
400
300
200
100
billions of US$
-100
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
0
-200
-300
-400
-500
-600
-700
-800
-900
Australia
Brazil
India
Russia
UK
Source: International Monetary Fund, http://www.imf.org/
34
Financial account
The financial account records the value of financial and real assets,
liabilities and capital purchased from/sold to non-residents.
• Funds recorded in financial account correspond to NFO. They
can be separated into:
• Direct investment:
1.
2.
3.
purchases/sales of stock/equity/ownership shares (called capital) of at least
10% of the total.
reinvested earnings (dividend payments) from non-residents who satisfy
condition 1.
other payments to/from non-residents who satisfy condition 1.
35
Financial account
• Portfolio investment:
1.
2.
3.
4.
5.
6.
7.
8.
purchases/sales of stock/equity/ownership shares (called capital) of less
than 10% of the total.
purchases/sales of various types of bonds (a type of credit or debt).
purchases/sales of various types of derivative assets and liabilities: assets
and liabilities whose values are depend on or are derived from other assets
and liabilities.
loans (a type of credit or debt)
deposits and currency
financial leases: contracts to rent goods, services and assets
repurchase agreements: purchases/sales of securities with an agreement to
sell/purchase them later.
trade credits and debits: temporary loans or adjustments in deposits to
finance trade of goods and services
36
Financial account
Because financial flows are usually fiduciary (legally private between
two parties)
• distinguishing “domestic” saving/investment from “foreign”
investment might be difficult because it is not clear who the
savers/lenders or borrowers/spenders are.
• tracking the many kinds of funds (money, credit, capital, derivative
assets…), especially rapidly moving electronic funds, might be
difficult in international finance.
•
Also, international banks have internal/private transfers between offices in
different countries, so tracking transfers of funds might be difficult.
Therefore, accurate data for the financial account may be hard to find
or calculate.
37
Financial account
To reduce the need for calculating the value of individual
transactions, accountants may use net values for portfolio investment
between institutions and countries instead of outflows and inflows
separately.
• However, when gross values are available, accountants might use
them instead.
38
Financial account
In either case of net or gross accounting,
• increases in foreign assets and decreases in foreign liabilities for
residents are recorded as a debit because cash is paid to nonresidents when residents buy (acquire) foreign assets and sell
(dispose of) foreign liabilities.
• decreases in domestic assets and increases in domestic liabilities
for non-residents are recorded as a debit because cash is paid to
non-residents when non-residents sell (dispose of) domestic
assets and buy (acquire) domestic liabilities.
These are outflows of funds.
39
Financial account
Transaction
Cash flow to/from
domestic economy
Financial account
entry: debit
Residents increase (acquire
or buy) assets of (from) nonresidents
–
–
Residents decrease (dispose
or sell) liabilities (ex., debt) to
non-residents
–
–
Non-residents decrease
(dispose or sell) assets of (to)
residents
–
–
Non-residents increase
(acquire or buy) liabilities (ex.,
debt) to residents
–
–
40
Financial account
In either case of net or gross accounting,
• decreases in foreign assets and increases in foreign liabilities for
residents are recorded as a credit because cash is received from
non-residents when residents sell (dispose of) foreign assets and
buy (acquire) foreign liabilities.
• increases in domestic assets and decreases in domestic liabilities
for non-residents are recorded as a credit because cash is received
from non-residents when non-residents buy (acquire) domestic
assets and sell (dispose of) domestic liabilities.
These are inflows of funds.
41
Financial account
Transaction
Cash flow to/from
domestic economy
Financial account
entry: credit
Residents decrease (dispose
or sell) assets of (to) nonresidents
+
+
Residents increase (acquire
or buy) liabilities (ex., debt) to
non-residents
+
+
Non-residents increase
(acquire or buy) assets of
(from) residents
+
+
Non-residents decrease
(dispose or sell) liabilities (ex.,
debt) to residents
+
+
42
Financial account
The financial account also records the value of official international
reserves, financial and real assets at central banks to make
international transactions:
• Monetary gold
• Foreign exchange: foreign currency, foreign-currency deposits,
foreign-currency liquid bonds and other securities
• Special drawing rights (SDRs): the right for a central bank or
government to borrow foreign currencies from the IMF
• Reserve position: deposits of foreign currencies at the IMF made
by a central bank or government
43
Capital account
The capital account records the value of special transfers between
residents and non-residents, called capital transfers:
• Transfers made by governments to non-residents to acquire fixed
assets, such as land, underground resources or equipment
• Transfers of fixed assets when individuals/institutions migrate from
one country to another
• Forgiveness of debt by governments and private institutions for
non-residents
44
Capital account
The capital account also records the value of the purchase/sale of
special assets between residents and non-residents:
• Acquisition/disposal of non-produced, non-financial assets:
1. the value of tangible assets such as land, underground resources
or equipment bought/sold by governments from/to non-residents
•
This value offsets the value of capital transfers made by governments, so that
the balance of payments balances.
2. intangible assets such as patents, copyrights, trademarks,
franchises, leases or other transferable contracts bought by/sold
to non-residents
Warning: the capital account does not record the value of capital paid
in (stock/equity/shares), which is recorded in the financial account.
45
The Prices of International Transactions: Nominal and Real
Exchange Rates
International transactions refer to flows of goods and services or flows
of assets.
We can consider the price, cost or value of exchanging goods,
services and assets
• in nominal terms: in monetary or currency units
• in real terms: in terms of other goods and services
46
Nominal exchange rates
The nominal exchange rate is the rate at which one currency can be
exchanged for another currency.
Nominal exchange rates can be expressed as the amount of foreign
currency that can buy one unit of domestic currency.
• For example, if 1100 ₩ buys US$ 1, then the nominal exchange
rate could be expressed as 1100₩ /US$ 1.
•
•
One US$ could be exchanged for 1100 ₩.
1000 ₩ could be exchanged for US$ 1/1100₩ = US$ 0.91.
47
Nominal exchange rates
In today’s international finance, nominal exchange rates between
currencies can be determined by
1. supply and demand of millions of buyers and sellers, so that
exchange rates can change daily depending on the amount of
buying and selling.
2. central banks that occasionally buy or sell the domestic currency
so that its value remains fairly stable relative to a major currency.
3. central banks that set up a currency union, such as the euro or
the franc of the communauté financière d'Afrique (CFA).
4. central banks that buy or sell the domestic currency so that its
value remains fixed relative to a major currency like the US$ or
the euro.
•
•
The Chinese yuan is the major example of a currency whose value is (or
was) fixed relative to the US$.
But in previous decades, most major currencies had a fixed value relative to
the US$, although the fixed value or “peg” changed occasionally:
48
1957/01
1958/01
1959/01
1960/01
1961/01
1962/01
1963/01
1964/01
1965/01
1966/01
1967/01
1968/01
1969/01
1970/01
1971/01
1972/01
1973/01
1974/01
1975/01
1976/01
1977/01
1978/01
1979/01
1980/01
1981/01
1982/01
1983/01
1984/01
1985/01
1986/01
1987/01
1988/01
1989/01
1990/01
1991/01
1992/01
1993/01
1994/01
1995/01
1996/01
1997/01
1998/01
1999/01
2000/01
2001/01
2002/01
2003/01
2004/01
2005/01
2006/01
2007/01
2008/01
2009/01
2010/01
2011/01
2012/01
2013/01
2014/01
2015/01
2016/01
won/US$
Nominal exchange rates
Korean won/US$, 1957.01-2016.05
1800
1700
1600
1500
1400
1300
1200
1100
1000
900
800
700
600
500
400
300
200
100
0
Source: Bank of Korea, http://www.bok.or.kr/
49
-10
-5
-15
1958/01
1959/01
1960/01
1961/01
1962/01
1963/01
1964/01
1965/01
1966/01
1967/01
1968/01
1969/01
1970/01
1971/01
1972/01
1973/01
1974/01
1975/01
1976/01
1977/01
1978/01
1979/01
1980/01
1981/01
1982/01
1983/01
1984/01
1985/01
1986/01
1987/01
1988/01
1989/01
1990/01
1991/01
1992/01
1993/01
1994/01
1995/01
1996/01
1997/01
1998/01
1999/01
2000/01
2001/01
2002/01
2003/01
2004/01
2005/01
2006/01
2007/01
2008/01
2009/01
2010/01
2011/01
2012/01
2013/01
2014/01
2015/01
2016/01
percent
Nominal exchange rates
Annual percent change in the value of the US$ relative to other currencies,
1958.01-2016.05
105
100
95
90
85
80
75
70
65
60
55
50
45
won
40
yen
35
yuan
30
25
A$
20
NZ$
15
baht
10
5
0
-20
-25
-30
-35
Source: Bank of Korea, http://www.bok.or.kr/
50
-5
-10
-15
1958/01
1959/01
1960/01
1961/01
1962/01
1963/01
1964/01
1965/01
1966/01
1967/01
1968/01
1969/01
1970/01
1971/01
1972/01
1973/01
1974/01
1975/01
1976/01
1977/01
1978/01
1979/01
1980/01
1981/01
1982/01
1983/01
1984/01
1985/01
1986/01
1987/01
1988/01
1989/01
1990/01
1991/01
1992/01
1993/01
1994/01
1995/01
1996/01
1997/01
1998/01
1999/01
2000/01
2001/01
2002/01
2003/01
2004/01
2005/01
2006/01
2007/01
2008/01
2009/01
2010/01
2011/01
2012/01
2013/01
2014/01
2015/01
2016/01
percent
Nominal exchange rates
Annual percent change in the value of the US$ relative to other currencies,
1958.01-2016.05
105
100
95
90
85
80
75
70
65
60
55
50
45
40
euro
35
C$
30
SFr
25
UKpound
20
15
Skrona
10
5
0
-20
-25
-30
-35
Source: Bank of Korea, http://www.bok.or.kr/
51
Real or price-adjusted exchange rates
How cheap is a cotton shirt from Cambodia relative to a cotton shirt
from the US?
• The answer depends on the
1. cost or price of production or products in both countries, originally
denominated in Cambodian riels or US dollars.
2. cost, price or value of currencies in both countries (riel v. dollar).
52
Real or price-adjusted exchange rates
The real exchange rate accounts for cost, price or value of
1. (real) products traded/exchanged between two countries when
produced, sold or bought.
2. currencies exchanged between two countries when buying and
selling the products.
• It is the rate at which goods and services of one country can be
sold/bought relative to the goods and services of another country.
•
If Cambodian shirts are 5 times as cheap as US shirts after accounting for the
cost of production/products and the value of currencies, then
•
•
1 US shirt can be purchased/exchanged for every 5 Cambodian shirts.
1 Cambodian shirt can be purchased/exchanged for 1/5 of a US shirt.
• It also measures a currency’s purchasing power of foreign goods
and services relative to its purchasing power of domestic goods
and services.
•
Suppose that $100 can buy 5 Cambodian shirts or 1 US shirt.
53
Real or price-adjusted exchange rates
Real exchange rate =
Foreign currency Prices of domestic products in domestic currency

Domestic currency
Prices of foreign products in foreign currency
quantity of foreign products that can be exchanged

for a quantity of domestic products
The real exchange rate expresses the prices of domestic and foreign
goods in the same currency, after using the nominal (currency)
exchange rate to convert foreign prices to domestic prices or vice
versa.
54
Real or price-adjusted exchange rates
A decrease in the real exchange rate means that domestic products
become less expensive relative to foreign products, either due to
• lower prices of products in the domestic economy and/or higher
prices of products in the foreign economy or
• lower cost/value of domestic currency and higher cost/value of
foreign currency.
This encourages domestic residents and foreign residents to buy
more domestic products and fewer foreign products.
• Therefore, exports increase and imports decrease.
55
Real or price-adjusted exchange rates
An increase in the real exchange rate means that domestic products
become more expensive relative to foreign products, either due to
• higher prices of products in the domestic economy and/or lower
prices of products in the foreign economy or
• higher cost/value of domestic currency and lower cost/value of
foreign currency.
This encourages domestic residents and foreign residents to buy
fewer domestic products and more foreign products.
• Therefore, exports decrease and imports increase.
56
Summary
1. Major economies have increased the value of their exports and
imports relative to the value of domestic production in the last few
decades because of
•
more efficient transportation, more efficient communication and computer
networks, more lightweight, high-value goods and services and liberalization
of liberalization of trade and financial policies
2. The US has increased the use of international finance in the last
few decades as restrictions on flows of funds were removed, and
international electronic transfers and communication improved.
3. Net exports are the value of domestic goods and services sold
abroad minus the value of foreign goods and services sold
domestically.
4. Net funds outflow is the acquisition of foreign assets by domestic
residents minus the acquisition of domestic assets by foreigners.
•
It represents the saved funds from the national economy that are not invested
in domestic productive capacity but are instead invested in foreign assets.
57
Summary
5. An economy’s net funds outflow equals its net exports by
construction.
6. An economy’s saving can be used to either finance domestic
investment expenditure or to buy assets in foreign economies.
7. An international economy can spend more than it earns from
production by borrowing from foreigners and can spend less than
it earns from production and save by transferring funds to
foreigners.
58
Summary
8. Net exports and flows of funds from financial assets and other
flows of funds are recorded in the balance of payments.
9. (Current) purchases/sales of goods and services (net exports),
current income earned and current transfers are recorded in the
current account.
10. Purchases/sales of assets and liabilities, which involve future
income and expenses, are recorded in the financial account.
• Increases in foreign assets and decreases in foreign liabilities for residents are
recorded as a debit because cash flows out of the domestic economy.
• Increases in domestic assets and decreases in domestic liabilities for nonresidents are recorded as a credit because cash flows into the domestic
economy.
11. Purchases/sales of special assets that are difficult to value at
market prices and special transfers are recorded in the capital
account.
59
Summary
12. The nominal exchange rate is the rate at which one currency can
be exchanged for another currency.
13. The real exchange rate is the price-adjusted exchange rate, using
prices of products from both the domestic country and a foreign
country, as well as the cost/value of the domestic and foreign
currencies.
• It is the rate at which goods and services of one country can be purchased
relative to the goods and services of another country.
60