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Chapter 15
International and Balance of
Payments Issues
Exchange Rates
High exchange rates make exports
expensive and imports cheaper and result
in larger trade deficit
 Exchange rate (R) is defined

 No.
of units of foreign currency per one unit of
domestic currency
 1/r shows number of dollars per unit of foreign
currency
Exchange Rates



Currency Appreciation – when R goes up, domestic
currency appreciates When $ appreciates against Euro,
it implies that $ will buy more Euros
Similarly, currency depreciation implies that $ will buy
less Euros
Real Exchange Rate is defined as

Nominal Exchange Rate X domestic price level
foreign price level
Re = Rx Pd
Pf
Importance of Exchange Rates

For the managers, exchange rates
influence prices of firm’s inputs as well as
outputs. Firms also hedge against
currency risk. Details of currency risk
exposure are included in the annual
reports of the firms
Balance of Trade

Balance of trade is the relation between
exports and imports
exports > Imports  Trade Surplus
 If exports < Imports  Trade Deficit
 If

Appreciation of $ makes trade balance
more negative as exports and imports
Determinants of Exports and
Imports

Imports = f [level of income, R]
(+)

(+)
Exports = f [Yd, Yf, R]
(+)
(+)
(-)
Yd = domestic level of income
 Yf = foreign level of income

Capital Flows



Capital Outflows: occur when a country has a
trade surplus and its citizens purchase real and
financial assets from abroad
Capital Inflows occur when a country has a trade
deficit and its citizens sell real and financial
assets abroad
Net capital flow = capital inflows – capital outflow
 Net
capital flow matches trade balance (x-m) in an
accounting sense
Balance of Payments Accounting



Balance of Payments records all transactions
between residents of the country and the rest of
the world
It consists of Current Account and Capital
Account (refer to Table 15.4 pg 460)
Current Account includes Exports (+) and
Imports (-), Receipts on U.S. assets abroad (+),
Payments on foreign assets in the US(-)
Unilateral Transfers

Unilateral Transfers include flow of goods
and services and financial assets in which
nothing of significant economic value is
received in return
 Examples:
foreign aid, military transfers,
pensions, gifts
Capital Account

Capital Account includes
Change in U.S. holdings of foreign assets –
capital outflow
 Change in foreign holdings of U.S. assets
statistical discrepancy – capital inflow
 The difference represents Net Capital Flow

Foreign Exchange Market

Demand for $ =

f [R, Yf Relative interest rates]
R
S
(-) (+)

Supply of $ =

f [R, YD, Relative interest
rates]
(+) (+)
If interest rate in the US
increases relative to foreign
interest rate, there are higher
capital inflows to the U.S.
D for $ and S for $ increase
E
R*
D
Qd , Qs
0
Q*
Exchange Rate Systems



Flexible Exchange Rate System – exchange rates are
determined by the forces of D and S. There is no
intervention by the Central Bank
Fixed Exchange Rate System – a system where central
banks intervene to maintain or stabilize exchange rates
at a fixed value
Managed Float – A system where central banks
intervene in the foreign exchange markets to maintain or
stability of exchange rates within a range
Policy Analysis

US Economy (1995-2005)








US Income
D for imports
S of $
R
Interest rate
Capital Inflows
D for $
R
This was a period of ‘strong dollar’ (Try using IS-LM
Curves!)
Euro Market

After its introduction in 1999, value of Euro
declined
 Higher
interest rates in the US led to capital inflows in
the US


S of Euros
Value of Euros
 Relatively
faster growth in the US income led to
increase in the European investment. This led to an
increase in the capital inflows in the US
Euro Market

European Central Bank intervened to
increase the value of Euro.
 Why?
What are th consequences of “weak
euro”?
 How does it affect US companies?
 In 2002, Euro appreciated and dollar
depreciated. How would you analyze these
trends?
Asian Financial Crisis 1997



Initially, Thailand and South Korea experienced
a decline in their exchange rates
The crisis spread to other economies such as
Malaysia, Indonesia, Hong Kong, and
Philippines,
IMF provided ‘rescue packages’ and
recommended ‘macro economic policy
packages’
Chinese Yuan





China maintains an undervalued currency to
increase imports and lower imports
China is under US pressure to revalue its
currency
Recently, Yuan was revalued slightly and was
tied to a basket of currencies instead of dollar
The ‘slight’ revaluation is not enough
High trade deficit with China and high
investment in China are the causes of concern