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Chapter 18 International Finance and the Foreign Exchange Market Slides to Accompany “Economics: Public and Private Choice 9th ed.” James Gwartney, Richard Stroup, and Russell Sobel Next page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 1. Foreign Exchange Market Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Foreign Exchange Market The market where one currency is traded for another. The exchange rate enables people in one country to translate the prices of foreign goods into units of their own currency. An appreciation of a nation’s currency will make foreign goods cheaper. A depreciation will make foreign goods more expensive. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 2. Determinants of the Exchange Rate Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Determinants of the Exchange Rate Under a flexible rate system, the exchange rate is determined by supply and demand. The dollar demand for foreign exchange originates from the demand of Americans for foreign goods, services, and assets (either real or financial). The supply of foreign exchange originates from sales of goods, services, and assets from Americans to foreigners. The foreign exchange market will bring the quantity demanded and quantity supplied into balance. As it does so, it will also bring the purchases by Americans from foreigners into equality with the sales of Americans to foreigners. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Equilibrium in the Foreign Exchange Market • The dollar price of the pound is measured on the vertical axis. The horizontal axis indicates the flow of pounds to the foreign exchange market. • Where the demand and supply of pounds are in equilibrium, the exchange rate is $1.50 = 1 pound. • At this equilibrium price, the quantity demanded equals the quantity supplied to the market. • A higher price of pounds (such as $1.80 = 1 pound), would lead to an excess supply of pounds ... causing the dollar price of the pound to fall (depreciate). • A lower price of pounds (such as $1.20 = 1 pound), would lead to an excess demand for pounds … causing the dollar price of the pound to rise (appreciate). $ Price of foreign exchange Supply (sales to foreigners) (for pounds) Excess supply of pounds $1.80 $1.50 e $1.20 Excess demand for pounds Demand (purchases from foreigners) Quantity of Q Jump to first page foreign exchange (pounds) Copyright (c) 2000 by Harcourt Inc. All rights reserved. Changes in the Exchange Rate The following factors will cause a currency to depreciate: A rapid growth of income (relative to trading partners) that stimulates imports relative to exports. A higher rate of inflation than one's trading partners. A reduction in domestic real interest rates (relative to rates abroad). Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Growth of Income and Growth of Imports $ Price of foreign exchange S (for pounds) • Other things constant, if incomes increase in the United States, U.S. imports will grow. • The increase in imports will increase the demand for pounds b $1.80 $1.50 a (in the foreign exchange market) . . . causing the dollar price of the pound to rise from $1.50 to $1.80. D2 D1 Quantity of Q1 Jump to first page Q2 foreign exchange (pounds) Copyright (c) 2000 by Harcourt Inc. All rights reserved. Inflation With Flexible Exchange Rates S2 $ Price of foreign exchange S1 (for pounds) • If prices were stable in Britain while the price level in the U.S. increased by 50 percent . . . the U.S. demand for British goods (and pounds) would increase . . . as U.S. exports to Britain would be relatively more expensive they would decline and thereby cause the supply of pounds to fall. • These forces would cause the dollar to depreciate relative to the pound. $2.25 b $1.50 a D1 D2 Quantity of Q1 Jump to first page foreign exchange (pounds) Copyright (c) 2000 by Harcourt Inc. All rights reserved. Changes in the Exchange Rate The following factor will cause a currency to appreciate: A slower growth rate relative to one’s trading partners. A lower inflation than one's trading partners. An increase in domestic real interest rates (relative to rates abroad). Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Question for Thought: 1. If the exchange rate between the U.S. dollar and Mexican peso fluctuates freely, indicate which of the following will cause the dollar to appreciate (or depreciate) relative to the peso. (a) An increase in the quantity of drilling equipment purchased in the U.S. by Pemex (the Mexican oil company) as a result of a Mexican oil discovery? (b) An increase in the U.S. purchase of crude from Mexico as a result of development of Mexican oil fields? (c) Higher real interest rates in Mexico, inducing U.S. citizens to move their financial investments from U.S. to Mexican banks? (d) Lower real interest rates in the U.S., inducing Mexican investors to borrow dollars and then exchange them for pesos? (e) Inflation in the United States and stable prices in Mexico? (f ) An increase in the inflation rate from 2% to 10% in both the U.S. and Mexico? (g) An economic boom in Mexico, inducing Mexicans to buy more U.S.–made automobiles, trucks, appliances, and TV sets? (h) Attractive investment opportunities, inducing U.S. investors to buy stock in Mexican firms? Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 3. Balance of Payments Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Balance of Payments Any transaction that creates a demand for foreign currency (and a supply of the domestic currency) in the foreign exchange market is recorded as a debit, or minus, item. Example: Imports Transactions that create a supply of foreign currency (and demand for the domestic currency) on the foreign exchange market are recorded as a credit, or plus, item. Example: Exports Under a pure flexible system, the quantity demanded will equal the quantity supplied in the foreign exchange market. Thus, in the balance of payments accounts: total debits = total credits Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Balance of Payments Current Account Transactions: Current Account: -- All payments (and gifts) related to the purchase or sale of goods and services and income flows during the current period. The 4 categories of current account transactions are: Merchandise trade -- import and export of goods Service trade -- import and export of services Income from investments Unilateral transfers -- gifts to and from foreigners Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Balance of Payments Capital Account Transactions: Capital Account: -- Transactions that involve changes in the ownership of real and financial assets. The Capital Account includes both Direct investments by foreigners in the U.S. and by Americans abroad, and, Loans to and from foreigners. Under a pure flexible-rate system, official reserve transactions are zero; therefore: a current-account deficit implies a capital-account surplus. a current-account surplus implies a capital-account deficit. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. U.S. Balance of Payments, 1997* Debits Credits Balance: Deficit (-) or Surplus (+) Current account: 1. U.S. Merchandise exports 2. U.S. Merchandise imports 3. Balance of merchandise + trade (1+2) 4. U.S. Service exports 5. U.S. Service imports 6. Balance on service + trade (4+5) +679.3 -877.3 -198.0 +258.3 -170.5 -87.8 7. Balance on goods and services (3 +6) 8. U.S. Investment income on U.S. Assets abroad 9. Foreign income on foreign assets in the U.S. 10. Net investment income (8+ 9) 11. Net unilateral transfers 12. Balance on current account (7 + 10 + 11) -110.2 +241.8 -247.1 -5.3 -39.7 -39.7 -155.2 Capital account 13. Foreign investment in the U.S. (Capital inflow) 14. U.S. Investment abroad (capital outflow) 15. Balance on capital account (13+14) +717.6 -577.2 16. Official reserve account balance +140.4 +14.8 17. Total (12+15+16) 0.0 Source: Survey of Current Business, U.S. Dept. of Commerce, October 1998 Jump to first page * Figures are in Billions of Dollars Copyright (c) 2000 by Harcourt Inc. All rights reserved. 4. Macroeconomic Policy in an Open Economy Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Macroeconomic Policy in an Open Economy Monetary Policy and the Exchange Rate An unanticipated shift to a more restrictive monetary policy will: raise the real interest rate, reduce the rate of inflation, and, at least temporarily, reduce aggregate demand and the growth of income. These factors will all cause the nation’s currency to appreciate. In turn, the currency appreciation along with the inflow of capital will result in a current account deficit. In contrast, the effects of a more expansionary monetary policy will be just the opposite: lower interest rates, and, an outflow of capital. These factors lead to currency depreciation, and, a shift toward a current account surplus. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Macroeconomic Policy in an Open Economy Fiscal Policy and the Exchange Rate An unanticipated shift to a more expansionary fiscal policy will tend to: an increase in real interest rates, an inflow of capital, and, these factors will cause the nation’s current account to shift toward a deficit. In contrast, the effects of a more restrictive fiscal policy will be just the opposite: lower interest rates, and, an outflow of capital. These factors move the economy toward a current account surplus. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 5. Macroeconomic Policy, Exchange Rates, Capital Flows, and Current Account Deficits Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. The Exchange Rate, Current-Account Balance, and Net Foreign Investment Real Exchange Rate trade-weighted value of the $ (March 1973=100) 130 • A more restrictive monetary policy coupled with expansionary fiscal policy – will cause: • higher real interest rates, • an inflow of capital, • currency appreciation, • and a current account deficit. • This policy combination was followed in the early 1980’s. • Note: - the appreciation of the $ (top) - the increase in the current account deficit (middle), and, - the net inflow of foreign capital (bottom). 120 110 100 90 80 1973 Year 1978 1983 1988 1993 1998 1978 1983 1988 1993 1998 1978 1983 1988 1993 1998 Current - Account as a share of GDP surplus (+) or deficit (-) 1 0 -1 -2 -3 -4 1973 Year Net Foreign Investment as a share of GDP surplus (+) or deficit (-) 3 2 1 0 -1 -2 1973 Year Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 6. How Do Current Account Deficits Affect the Economy? Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. How do Current Account Deficits Affect the Economy? Under a flexible exchange rate system, an inflow of capital implies a current account deficit. An outflow of capital implies a current account surplus. A trade deficit is not necessarily bad. Rapid growth will stimulate imports. A healthy growing economy that offers attractive investment opportunities will often generate an inflow of capital. These factors are not bad. However, both are likely to cause a current account trade deficit. A nation’s trade deficit or surplus is an aggregation of the voluntary choices of businesses and individuals. In contrast with a budget deficit of an individual, business, or government, there is no legal entity that is responsible for the trade deficit. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 7. International Finance and Exchange Rate Regimes Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Exchange Rate Regimes There are 3 major types of exchange rate regimes: flexible rates, fixed- rate (unified currency), and, pegged exchange rates. Examples of a Fixed Rate (Unified) System: Nations of the European Union have recent adopted a unified currency system. Countries can also use a currency board to unify their currency with another. The currencies of Hong Kong, Argentina, and Panama are unified with the U.S. dollar. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Exchange Rate Regimes Pegged Rate Systems: A nation can either follow an independent monetary policy and allow its exchange rate to fluctuate, or, tie its monetary policy to the maintenance of the fixed exchange rate. It cannot, however, maintain the convertibility of its currency at the fixed exchange rate while following a monetary policy more expansionary than that of the country to which the domestic currency is tied. Attempts to peg rates and follow a monetary policy that is too expansionary have lead to several recent financial crises—a situation where falling foreign currency reserves eventually force the country to forego the pegged exchange rate. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Questions for Thought: 1. Explain why a current account balance and a capital account balance must sum to zero under a pure flexible-rate system. 2. Will a flexible exchange rate lead to a balance between merchandise exports and imports? Why or why not? What exactly is a trade deficit? Is it necessarily bad? Why or why not? 3. Several politicians have suggested that the federal government should run a sizeable budget surplus during the next decade in order to "save social security." If the federal government does run a large surplus, what is the expected impact on interest rates, the inflow of capital, the current account deficit, and the foreign exchange value of the dollar? Explain. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. End Chapter 18 Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved.