Download ch35

Chapter 35
Exchange Rates
and the Balance
of Payments
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
In this chapter you will learn to
1. Describe the components of the U.S. balance of payments and
explain why the balance of payments must always balance.
2. Describe the demand for and supply of foreign currency.
3. Describe the various factors that cause fluctuations in the
exchange rate.
4. Explain why a current account deficit is not necessarily
undesirable.
5. Describe the theory of purchasing power parity (PPP) and its
limitations.
6. Explain how flexible exchange rates can dampen the effects of
external shocks.
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
35-2
The Balance of Payments
The Current Account
• Records payments and receipts arising from international
trade in goods and services
- trade account
- capital-service account
Debit item = payment of money from the U.S.
Credit item = receipt of money for the U.S.
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
35-3
The Capital Account
• Records payments and receipts arising from trade in longterm and short-term assets
- foreign direct investment
- portfolio investment
- includes purchases of foreign currency by the
government or central bank
Debit item = purchase of assets by the U.S.
Credit item = sale of assets by the U.S.
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
35-4
Table 35.1 U.S. Balance of
Payments, 2006 (billions of dollars)
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
35-5
The Balance of Payments Must
Balance
Let CA be the current account balance, and KA be the
capital account balance:
Balance of Payments = CA + KA = 0
Consider a CA surplus:
 exports exceed imports
 the “extra” earnings must be used to acquire
foreign assets
 KA deficit (capital outflow)
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
35-6
The Balance of Payments Must
Balance
Consider a CA deficit:
 imports exceed exports
 the “extra” purchases can only be financed if we
sell assets to foreigners
 KA surplus (capital inflow)
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
35-7
A Balance of Payments Deficit?
The term balance of payments deficit (or surplus) makes no
sense if taken literally.
Yet the terms are often used. So what do they mean?
A deficit usually refers to a situation where the government (or
central bank) is selling foreign-exchange reserves.
But in this case (as always) the balance of payments is
balanced.
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
35-8
Summary
1. The current account shows all transactions in goods and
services between the U.S. and the rest of the world.
2. The capital account shows all transactions in assets
between the U.S. and the rest of the world.
3. All transactions involving a payment from the U.S.
appear as a debit item. All transactions involving a
receipt to the U.S. appear as a credit item.
4. The balance of payments-the sum of the current account
and the capital account must, by definition, always be
zero.
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
35-9
Balance of Payments
APPLYING ECONOMIC CONCEPTS 35.1
A Student’s Balance of Payments with
the Rest of the World
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
35-10
The Foreign-Exchange Market
Trade between countries normally requires the exchange of
one currency for another.
The exchange rate is the number of units of domestic
currency required to purchase one unit of foreign currency.
For example, the current Canadian-US exchange rate is
approximately 1.32 — it takes $1.32 Canadian to purchase
one U.S. dollar.
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
35-11
The Foreign-Exchange Market
An appreciation of the domestic currency is a fall in the
exchange rate:
- it takes fewer units of domestic currency to purchase
one unit of foreign currency
A depreciation of the domestic currency is a rise in the
exchange rate:
- it takes more units of domestic currency to purchase
one unit of foreign currency
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
35-12
The Foreign-Exchange Market
A demand for foreign currency implies a supply of U.S. dollars
to the FX market.
Conversely, a supply of foreign currency implies a demand for
U.S. dollars in the FX market.
In the model that follows, we think about the U.S.-dollar price
of the euro as the exchange rate.
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
35-13
Figure 35.1 The ForeignExchange Market
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
35-14
The Demand for Foreign Exchange
A depreciation of the U.S. dollar reduces the quantity of
foreign currency demanded. Why?
Foreign goods, services and assets become more expensive
to Americans when the U.S. dollar depreciates:
 Americans reduce their foreign purchases and
thus reduce their demand for foreign currency
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
35-15
The Demand Curve for Foreign
Exchange
The demand curve for foreign exchange is negatively sloped
when it is plotted against the exchange rate:
- an appreciation of the U.S. dollar
increases the quantity of foreign
exchange demanded
- a depreciation of the U.S. dollar
decreases the quantity of foreign
exchange demanded
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
35-16
The Determination of Exchange
Rates
Perfectly flexible exchange rates are determined solely by
market forces, without interventions by central banks.
A central bank may attempt to fix or peg the exchange rate at
a particular value:
- it must intervene to buy or sell foreign currency
Managed floats and adjustable pegs are intermediate cases.
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
35-17
Figure 35.2 Fixed and Flexible
Exchange Rates
In the absence of
intervention by the
central bank, the
exchange rate
adjusts to clear
the foreignexchange market.
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
35-18
Fixed Exchange Rates
Central banks must intervene in the foreign-exchange market
if they wish to fix the exchange rate:
- if excess demand for FX, then the central bank must
sell from its reserves
- if excess supply of FX, then the central bank must
accumulate more reserves
APPLYING ECONOMIC CONCEPTS 35.2
China’s Pegged Exchange Rate
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
35-19
Figure 35.3 Changes in
Exchange Rates
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
35-20
Changes in Exchange Rates
Two specific changes to consider in foreign exchange:
1. Changes in Import or Domestic Prices
- If the price level in one country is rising relative to the
price level in another country, the equilibrium value of its
currency will be falling relative to that of the other
country.
2. Capital Movements
- A movement of financial capital appreciates the
currency of the capital-importing country and
depreciates the currency of the capital-exporting country.
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
35-21
Structural Changes
Structural changes in the economy can affect the exchange
rate.
For example, the discovery of exportable oil or natural gas will
increase exports and appreciate the domestic currency.
Anything that changes the patterns of trade will generally also
change exchange rates.
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
35-22
The Volatility of Exchange Rates
Exchange rates are one of the most volatile of all
macroeconomic variables, in large part because of heavy
speculation and reaction to news.
Is this a sign of efficient markets, or inefficient ones?
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
35-23
Three Policy Issues
1. Are current account deficits “bad” and surpluses “good”?
2. Is there a “correct” value for the U.S. dollar?
3. Should countries fix their exchange rates?
APPLYING ECONOMIC CONCEPTS 35.3
News and the Exchange Rate
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
35-24
Current Account Deficits and
Surpluses
Consider a country with a current account deficit:
- it is either borrowing from the rest of the world
- or it is selling other assets to foreigners
This is not necessarily undesirable.
LESSONS FROM HISTORY 35.1
Mercantilism, Then and Now
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
35-25
Figure 35.4 U.S. Current
Account Balance, 1960–2005
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
35-26
Causes of a Current Account Deficit
To see this, recall from Chapter 20 that GDP is equal to :
GDP = Ca + Ia + Ga + NXa
where the subscript “a” denotes actual (rather than desired)
expenditure.
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
35-27
Causes of a Current Account Deficit
GNP is equal to GDP plus R, the net investment income
received from abroad:
GNP = GDP + R
= Ca + Ia + Ga + NXa + R
The current account balance (CA) is simply NXa + R.
We therefore get:
GNP = Ca + Ia + Ga + CAa
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
35-28
Causes of a Current Account Deficit
Now consider that we have a given amount of GNP that can
be consumed, saved, or paid in taxes:
GNP = Ca + Sa + Ta
By equating the last two equations and omitting the subscripts
for simplicity, we get:
C + I + G + CA = C + S + T

CA = S + (T - G) - I
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
35-29
Causes of a Current Account Deficit
This equation says that the current account in any year is
exactly equal to the excess of national saving over domestic
investment.
We can rearrange the equation slightly to get:
CA = (S – I) + (T – G)
which says that the CA is equal to the government budget
surplus plus the excess of private saving over investment.
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
35-30
Is It Undesirable to Have a Current
Account Deficit?
Consider a few possible causes:
- an increase investment
- a decrease in domestic saving
- an increase in the government’s budget deficit
Whether the rise in the current account deficit is desirable
depends on its underlying cause.
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
35-31
Is There a “Correct” Value for the
U.S. Dollar?
With a flexible exchange rate, market forces determine the
value of the exchange rate.
The free-market equilibrium exchange rate is the “correct”
exchange rate:
- in the sense that it accurately represents the market
value of the dollar
- this in turn reflects its scarcity on FX markets
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
35-32
Purchasing Power Parity
But some economists argue that the U.S. dollar is
sometimes “overvalued” and sometimes “undervalued.”
What do they mean?
Purchasing Power Parity (PPP):
- a theory that the exchange rate is equal to relative
price levels
If PU and PJ are the price levels of the U.S. and Japan, and e
is the U.S.-dollar price of yen, then the theory of PPP predicts
that:
PU = e  PJ
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
35-33
Does This Theory Work Empirically?
The PPP exchange rate is the value of e that makes the
previous equation hold:
ePPP  PU / PJ
If the PPP theory is supported by the data, we should
observe that the actual e and ePPP move closely together.
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
35-34
Figure 35.5 Actual and PPP
Exchange Rates, 1980-2006
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
35-35
Why Doesn’t PPP Appear to Hold?
1. Nontraded Goods
 PPP will not generally hold when applied to large
baskets of goods (like the CPI or GDP deflator)
2. Different Baskets and Relative Price Changes
 PPP will not hold if countries’ baskets of goods
differ and there are changes in relative prices
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
35-36
Why Doesn’t PPP Appear to Hold?
But if PPP does not hold, it is difficult to justify the idea
that a particular currency is “overvalued” or “undervalued”:
- the “right” value is the value produced by the
free, competitive FX market
None of this suggests that today’s “right” value will be
unchanged tomorrow:
- due to shocks of various kinds, the “right” value for
the exchange rate will be constantly adjusting
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
35-37
Flexible versus Fixed Exchange Rate
What are the benefits of having a fixed exchange rate?
What are the benefits of having a flexible exchange rate?
Benefits of Fixed Exchange Rates
- exchange-rate risk is eliminated
 more international trade?
 more economic “gains from trade”?
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
35-38
Flexible versus Fixed Exchange Rate
Surprisingly, it is difficult to find much evidence of this effect
in the data.
Benefits of Flexible Exchange Rates
- the exchange rate can act as a “shock absorber”
 dampening the effects on output and employment
Example: Consider a reduction in the world’s demand for
U.S. exports — say computer chips.
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
35-39
Figure 35.6 Flexible Exchange
Rates as a Shock Absorber
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
35-40
Flexible versus Fixed Exchange Rate
With either exchange-rate regime, there will be a negative
AD shock, and thus a short-run decline in real GDP.
But with flexible exchange rates, the depreciation of the dollar
will dampen the effect of the shock (net exports will fall by
less), thus reducing the shift of the AD curve.
This is the sense in which flexible exchange rates act like
“shock absorbers.”
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
35-41
Summing Up
Advocates of a fixed exchange rate emphasize the
uncertainty faced by U.S. exporters and importers.
Advocates of a flexible exchange rate emphasize the shockabsorption benefits.
EXTENSIONS IN THEORY 35.1
Optimal Currency Areas
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
35-42