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1. THE ROLE AND NATURE OF
INVESTMENT
Learning Objectives
1. Discuss the main arguments economists make in support
of free trade.
2. Explain the determinants of net exports and tell how each
affects aggregate demand.
•
International finance is the field that
examines the macroeconomic
consequences of the financial flows
associated with international trade.
1.1 The Case for Trade
•
•
A tariff is a tax imposed on imported
goods and services.
A quota is a ceiling on the quantity of
specific goods and services that can be
imported, which reduces world living
standards.
1.2 The Rising Importance of
International Trade
1.3 Net Exports and the
Economy
• Determinants of net exports
–
–
–
–
–
–
Income
Relative prices
The exchange rate
Trade policies
Preferences and technology
Net exports and aggregate demand
1.3 Net Exports and the
Economy
Changes in Net Exports and
Aggregate Demand
Effect of initial
increase in net
exports without
multiplier
Multiplier times
the initial
increase in net
exports
Multiplier times
the initial
decrease in net
exports
Price level
Price level
Effect of initial
decrease in net
exports without
multiplier
AD1
Real GDP per year
AD2
AD2
AD1
Real GDP per year
2. INTERNATIONAL FINANCE
Learning Objectives
1. Define a country’s balance of payments, and explain what
is included on the current and capital accounts.
2. Assuming that the market for a country’s currency is in
equilibrium, explain why the current account balance will
always be the negative of the capital account balance.
3. Summarize the economic arguments per se against public
opposition to a current account deficit and a capital
account surplus.
•
Balance of payments is the balance
between spending flowing into a country
and spending flowing out.
2. INTERNATIONAL FINANCE
EQUATION 2.1
Qua
of
cur
dem

qu
of
cu
s
•
•
Quantity of currency demanded is from two sources
–
Exports
–
Rest of world purchases of domestic assets
Quantity of currency supplied is from two sources
–
Imports
–
Domestic purchases of rest of world assets
EQUATION 2.2
Exp

(res

of

wo
pur
of
do
as

Im

(d
p
o
r

o

w
a
2.1 Accounting for
International Payments
•
•
•
•
The current account is an accounting statement
that includes all spending flows across a nation’s
border except those that represent purchases of
assets.
The balance on current account refers to
spending flowing into an economy from the rest of
the world on current account less spending flowing
from the nation to the rest of the world on current
account.
A current account surplus is a situation that
occurs when spending flowing in for the purchase of
goods and services exceeds spending that flows out.
A current account deficit is a situation that occurs
when spending for goods and services that flows out
of the country exceeds spending that flows in.
2.1 Accounting for
International Payments
•
•
•
•
The capital account is an accounting
statement of spending flows into and out of the
country during a particular period for purchases
of assets.
The balance on capital account refers to the
balance between rest of world purchases of
domestic assets and domestic purchases of rest
of world assets.
A capital account surplus is a positive
balance on capital account.
A capital account deficit is a negative balance
on capital account.
2.1 Accounting for
International Payments
EQUATION 2.3
Exp
Imp

[(re
of
wo
pu
of
do
as
(d
p
o
r
o
w
a
EQUATION 2.4
Curr
acco
bala


(ca
acc
ba
2.2 Deficits and Surpluses:
Good or Bad?
•
For consumers neither surplus nor deficit seem to
pose a problem.
Public opinion appears to regard surpluses and
deficits as undesirable.
•
–
–
•
Foreign income from U.S. assets
Loss of sovereignty
There is no economic justification for viewing any
particular current account balance as a good or bad
thing.
3. EXCHANGE RATE SYSTEMS
Learning Objectives
1. Define the various types of exchange rate systems.
2. Discuss some of the pros and cons of different exchange
rate systems.
3.1 Free-Floating Systems
•
A free floating exchange rate system
is a system in which governments and
central banks do not participate in the
market for foreign exchange.
3.2 Managed Float Systems
•
A managed float involves government
or central bank participation in a floating
exchange rate system.
3.3 Fixed Exchange Rates
•
•
•
A fixed exchange rate system is a system in
which the exchange rate between two
currencies is set by government policy.
A commodity standard system is a system in
which countries fix the value of their respective
currencies relative to a certain commodity or
group of commodities.
Currency board arrangements are fixed
exchange rate systems in which there is an
explicit legislative commitment to exchange
domestic currency for a specified foreign
currency at a fixed rate.
Maintaining a Fixed Exchange
Rate Through Intervention
S2
Price per pound (dollars)
S1
Fixed
rate
$4
3
D1
Quantity of British pounds per period
D2
Anatomy of a Currency
Collapse: Thai Baht
Thailand’s central bank
buys baht, increasing
demand
Thai asset holders sell
baht fearing the central
bank might give up its
efforts
Weakness in the Japan
economy causes the
baht demand to fall
Price of baht in U.S. dollars
S1
$0.0
4
S2
In July 1997 the central bank
gave up efforts to prop the
currency. By the end of the
year the value of the baht
had fallen to about $0.02
$0.0
2
D2
Quantity of baht per period
D1