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21 The Balance of Payments, Exchange Rates, and Trade Deficits McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. International Transactions • International trade • Buy/sell current goods or services • Imports and exports • International asset transactions • Buy/sell real or financial assets • Buy stock • Sell your house to a foreigner • Requires currency exchange LO1 21-2 Balance of Payments • Sum of international financial • LO2 transactions Current account • Balance on goods and services • Net investment income • Net transfers • Balance on current account 21-3 Balance of Payments • Capital and financial account • Capital account • Financial account • Balance of payments accounts sum • • LO2 to zero Current account deficits generate asset transfers to foreigners Official reserves 21-4 Balance of Payments LO2 21-5 Official Reserves • Foreign currencies, certain reserves • • LO2 with the IMF, and stocks of gold Owned by government or central bank Used as balancing mechanism in balance of payments 21-6 U.S. Trade Balances LO2 21-7 Flexible Exchange Rates • Demand for pounds • Supply of pounds • Market equilibrium • Increase in dollar price of pounds • Dollar depreciates • Pound appreciates • Decrease in dollar price of pounds • Dollar appreciates • Pound depreciates LO3 21-8 Flexible Exchange Rates The Market for Foreign Currency (Pounds) P Dollar Price of 1 Pound S1 $3 $2 Dollar Depreciates (Pound Appreciates) Exchange Rate: $2 = £1 Dollar Appreciates (Pound Depreciates) $1 D1 0 Q1 Q Quantity of Pounds LO3 21-9 Flexible Exchange Rates • Determinants of exchange rates • Factors that shift demand/supply • Changes in tastes • Relative income changes • Relative price-level changes • Purchasing-power-parity theory • Relative interest rates • Relative expected returns on assets • Speculation LO3 21-10 Flexible Exchange Rates The Market for Foreign Currency (Pounds) P Dollar Price of 1 Pound S1 c $3 a x Exchange Rate: $3 = £1 Balance Of Payments Deficit $2 b D 2 Exchange Rate: $2 = £1 $1 D1 0 Q1 Q2 Q Quantity of Pounds LO3 21-11 Flexible Exchange Rates • Eliminate balance of payments • LO4 deficit or surplus Disadvantages of flexible exchange rates • Volatility • Uncertainty and diminished trade • Terms-of-trade changes • Instability 21-12 Flexible Exchange Rates LO4 21-13 Fixed Exchange Rates • Government intervention • Use of reserves • Trade policies • Exchange controls and rationing • Distorted trade • Favoritism • Restricted choice • Black markets • Macroeconomic adjustments LO4 21-14 The Managed Float • Gold standard 1879-1934 • Fixed exchange rate system • Bretton Woods 1944-1971 • Fixed exchange rate system • LO4 indirectly tied to gold Managed float 1971-present 21-15 The Managed Float • Dependence on foreign exchange • • • LO4 markets Occasional intervention In support of managed float Concerns with managed float 21-16 U.S. Trade Deficit • Large and persistent • Causes of trade deficits • High U.S. growth (relatively) • China • Price of oil • Low U.S. saving rate • Implications of trade deficits • Increased current consumption • Increased indebtedness LO5 21-17 Billions of Dollars U.S. Trade Deficits 0 -50 -100 -150 -200 -250 -300 -350 -400 -450 -500 -550 -600 -650 -700 -750 -800 -850 -900 Goods and Services Balance of Trade Goods Billions of Dollars 2001 2003 2004 2005 2006 2007 2008 2009 0 -50 -100 -150 -200 -250 -300 -350 -400 -450 -500 -550 -600 -650 -700 -750 -800 -850 -900 Balance on Current Account 2001 LO5 2002 2002 2003 2004 2005 2006 2007 2008 2009 21-18 Speculation in Currency Markets • Positive or negative influence? • Contributes to currency market • • • • • LO5 fluctuations Self-fulfilling expectations Smoothing short-term fluctuations Absorbing risk Futures market at work Positive role played overall 21-19
