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Exploring Economics
Second Edition
by Robert L. Sexton
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Copyright © 2002 by Thomson Learning, Inc.
Chapter 27
International Finance
Copyright © 2002 by Thomson Learning, Inc.
27.1 The Balance of Payments


The record of all of the international
financial transactions of a nation over a
year is called the balance of
payments.
It records all the exchanges those in a
nation engaged in that required an
outflow of funds to other nations or an
inflow of funds from other nations, and
provides information about a nation’s
world trade position.
Copyright © 2002 by Thomson Learning, Inc.
27.1 The Balance of Payments

The balance of payments is divided into
three main sections:




the current account,
the capital account, and
official reserve assets.
The current account is a record of a
country’s imports and exports of goods
and services, net investment income ,
and net transfers.
Copyright © 2002 by Thomson Learning, Inc.
27.1 The Balance of Payments

Because the U.S. gains claims over
foreign buyers by obtaining foreign
currency in exchange for the dollars
needed to buy U.S. exports, all exports
of U.S. goods abroad are considered a
credit or plus item in the U.S. balance of
payments.
Copyright © 2002 by Thomson Learning, Inc.
27.1 The Balance of Payments


When a U.S. consumer buys an
imported item, the reverse is true.
U.S. imports are considered a debit item
in the balance of payment because the
dollars sold to buy the necessary
foreign currency add to foreign claims
against U.S. buyers.
Copyright © 2002 by Thomson Learning, Inc.
27.1 The Balance of Payments



Our imports provide the means by
which foreigners can buy our exports.
Nations import and export services,
such as tourism, as well as the largest
component of the balance of payments,
merchandise (goods).
Private and government grants and gifts
to foreigners also count as a debit item
in a country’s balance of payments, and
grants and gifts from foreigners count
as a credit item.
Copyright © 2002 by Thomson Learning, Inc.
27.1 The Balance of Payments


The balance on current account is the
net amount of debits or credits after
adding up all transactions of goods,
services, and fund transfers.
If the sum of credits exceeds the sum of
debits, a nation is said to have a
balance of payments surplus on current
account.
Copyright © 2002 by Thomson Learning, Inc.
27.1 The Balance of Payments


If debits exceed credits, it is running a
balance of payments deficit on current
account.
The merchandise import/export
relationship is often called the balance
of trade, which is different from the
balance on current account.
Copyright © 2002 by Thomson Learning, Inc.
U.S. Balance of Payments, 1999
Type of Transaction
Current Account
1.
2.
3.
Exports of goods
$772.0
Imports of goods
–1224.0
Balance of trade (lines 1 + 2)
4.
5.
6.
Service exports
Service imports
Balance on goods and
services (lines 3 + 4 + 5)
Unilateral transfers (net)
Unilateral income (net)
Current account balance
lines 6 + 7 + 8)
7.
8.
9.
– 452.0
294.0
–291.0
–315.0
–15
–54
SOURCE: Survey of Current Business, July 2001.
Copyright © 2002 by Thomson Learning, Inc.
Capital Account
–444.0
10. U.S.-owned assets abroad
$581.0
11. Foreign owned assets in the –1024.0
United States
12. Capital Account Balance
– 443.0 (lines 10
+ 11)
13. Statistical discrepancy
1
14. Net Balance
$444
(lines 9 + 12 + 13)
U.S. Balance of Trade
50
Balance on Goods and
Services, and Income
Billions of dollars
25
$0
– 25
– 50 Balance on Current Account
– 75
– 100
Merchandise Trade Balance
– 125
– 150
– 175
1960
1965
1970
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1975
1980 1985
Year
1990
1995
2000
27.1 The Balance of Payments


A deficit on current account is settled by
movements of financial, or capital,
assets.
Therefore, a current account deficit
would be financed by a capital account
surplus, and a current account surplus
would be financed by a capital account
deficit.
Copyright © 2002 by Thomson Learning, Inc.
27.1 The Balance of Payments


Capital account transactions include
income from U.S. financial investments
in other countries and other foreign
income from investments in the U.S.,
which can be viewed as compensation
for the use of capital services.
Income from U.S. investments overseas
are a credit item in the U.S. balance of
payments, and income from foreign
investments in the U.S. are a debit item.
Copyright © 2002 by Thomson Learning, Inc.
27.1 The Balance of Payments


Due to the reciprocal aspect of trade,
the balance of payments must balance
so that credits and debits are equal.
However, errors and omissions mean
the official measures do not come out
equal.
The statistical discrepancy is included
so that the official balance of payments
do balance.
Copyright © 2002 by Thomson Learning, Inc.
27.1 The Balance of Payments


A useful analogy from personal financial
transactions can be made to the
balance of payments.
People earn income by exporting their
labor services, or receiving investment
income, and they import consumption
goods.
Copyright © 2002 by Thomson Learning, Inc.
27.1 The Balance of Payments


Both loans and fund transfers are
sometimes made.
Any deficit must be financed by
borrowing or selling assets; surpluses
allow new investment or additions to
reserves.
Copyright © 2002 by Thomson Learning, Inc.
27.2 Exchange Rates


U.S. consumers must first exchange
U.S. dollars for the seller’s currency in
order to pay for imported goods.
Similarly, foreigners buying U.S. goods
must sell their currencies to obtain U.S.
dollars in order to pay for exported
goods.
Copyright © 2002 by Thomson Learning, Inc.
27.2 Exchange Rates

The price of one unit of a country’s
currency in terms of another country’s
currency is called the exchange rate.
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27.2 Exchange Rates


Prices of goods in their own currencies
combine with exchange rates to
determine the domestic price of foreign
goods.
For instance, an increase in the eurodollar exchange rate from $1 per euro to
$2 per euro would increase the U.S.
price of German goods, reducing the
number of German goods that would be
demanded in the United States.
Copyright © 2002 by Thomson Learning, Inc.
27.2 Exchange Rates



The demand for foreign currencies is a
derived demand because it derives
directly from the demand for foreign
goods and services or for foreign
capital.
The more foreign goods demanded, the
more of that foreign currency that will be
needed to pay for those goods.
Such an increased demand for the
currency will push up the exchange
value of that currency relative to other
currencies.
Copyright © 2002 by Thomson Learning, Inc.
27.2 Exchange Rates


Similarly, the supply of foreign currency
is provide by foreigners who want to buy
the exports of a particular nation.
The more foreigners demand U.S.
products, the more of their currencies
they will supply in exchange for U.S.
dollars, which they use to buy our
products.
Copyright © 2002 by Thomson Learning, Inc.
27.2 Exchange Rates

Just as in the product market, the
supply of and demand for a foreign
currency determine the equilibrium price
(exchange rate) of that currency.
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27.2 Exchange Rates


The demand for a foreign currency is
downward sloping because, as the price
of the euro falls relative to the dollar,
European products become relatively
more inexpensive to U.S. consumers,
who therefore buy more European
goods.
To do so, the quantity of euros
demanded by U.S. consumers will
increase to buy more European goods
as the price of the euro falls.
Copyright © 2002 by Thomson Learning, Inc.
27.2 Exchange Rates


The supply curve of a foreign currency
is upward sloping because, as the price,
or value, of the euro increases relative
to the dollar, American products become
relatively more inexpensive to European
buyers and the quantity of dollars they
will demand will increase.
Europeans will, therefore, increase the
quantity of euros supplied to the U.S. by
buying more U.S. products (assuming
the European demand for U.S. products
is price elastic).
Copyright © 2002 by Thomson Learning, Inc.
27.2 Exchange Rates


Equilibrium in the foreign exchange
market is reached where the demand
and supply curves for a given currency
intersect.
If the dollar price of euros is higher than
the equilibrium price, there will be an
excess quantity of euros supplied at that
price (a surplus of euros), and
competition among euro sellers will
push the price of euros down toward
equilibrium.
Copyright © 2002 by Thomson Learning, Inc.
27.2 Exchange Rates

If the dollar price of euros is lower than
the equilibrium price, there will be an
excess quantity of euros demanded at
that price (a shortage of euros), and
competition among euro buyers will
push the price of euros up toward
equilibrium.
Copyright © 2002 by Thomson Learning, Inc.
Dollar Price of Euros
Equilibrium in the Foreign Exchange Market
Excess supply
for euros
$1.40
Supply for euros
(U.S. sales
of goods
and services
to Europeans)
$1.20
$1.00
Excess demand
for euros
0
Copyright © 2002 by Thomson Learning, Inc.
Demand for euros
(U.S. purchase of
European goods
and services)
Quantity of Euros
27.3 Equilibrium Changes in the
Foreign Exchange Market


Any force that shifts either the demand
for or supply of a currency will shift the
equilibrium in the foreign exchange
market, leading to a new exchange rate.
An increased demand for euros will
result in a higher equilibrium price
(exchange value) for euros, while a
decreased demand for euros will result
in a lower equilibrium price (exchange
value) for euros.
Copyright © 2002 by Thomson Learning, Inc.
27.3 Equilibrium Changes in the
Foreign Exchange Market

Changes in a currency’s exchange rate
can be caused by





changes in tastes for goods,
changes in income,
changes in relative real interest rates,
changes in relative inflation rates, and
speculation.
Copyright © 2002 by Thomson Learning, Inc.
27.3 Equilibrium Changes in the
Foreign Exchange Market

Demand for foreign currencies is
derived from demand for foreign goods
so shifts in the foreign goods demand
curve will shift the foreign currency
demand curve in the same direction.


U.S. taste for European goods increases,
the demand for euros increases, increasing
the equilibrium price of euros
U.S. taste for European goods decreases,
the demand for euros decreases,
decreasing the equilibrium price of euros.
Copyright © 2002 by Thomson Learning, Inc.
27.3 Equilibrium Changes in the
Foreign Exchange Market


An increase in U.S. incomes would
increase the amount of European imports
purchased by Americans, which would
increase the demand for euros, resulting in
a higher exchange rate for euros.
A decrease in U.S. incomes would
decrease the amount of European imports
purchased by Americans, which would
decrease the demand for euros, resulting
in a lower exchange rate for euros.
Copyright © 2002 by Thomson Learning, Inc.
27.3 Equilibrium Changes in the
Foreign Exchange Market

A decrease in U.S. tariffs on European
goods would tend to have the same
effect as an increase in U.S. incomes,
by making imports more affordable,
increasing the U.S. demand for
European goods and increasing the
exchange rate for euros.
Copyright © 2002 by Thomson Learning, Inc.
Dollar Price of Euros
Impact of U.S. Taste or Income Increase, of Tariff
Decrease, in the Foreign Exchange Market
E1
$1.50
$1.00
E0
D1
D0
0
Quantity of Euros
Copyright © 2002 by Thomson Learning, Inc.
27.3 Equilibrium Changes in the
Foreign Exchange Market

If European incomes rose, European
tariffs on U.S. goods increased, or their
tastes for American goods increased,
Europeans would demand more U.S.
goods, leading them to increase their
supply of euros to obtain the added
dollars necessary to make those
purchases, leading to a new lower
exchange rate for euros.
Copyright © 2002 by Thomson Learning, Inc.
Impact of European Taste of Income, or Tariff
Decrease, on the Foreign Exchange Market
Dollar Price of Euros
S0
S1
E0
$1.50
$1.00
E1
D
0
Quantity of Euros
Copyright © 2002 by Thomson Learning, Inc.
27.3 Equilibrium Changes in the
Foreign Exchange Market


If U.S. interest rates were to increase
relative to European interest rates, other
things equal, the rate of return on U.S.
investments would increase relative to
that on European investments,
increasing European’s demand for U.S.
investments.
It would increase the supply of euros to
obtain the added dollars to buy added
U.S. investments.
Copyright © 2002 by Thomson Learning, Inc.
27.3 Equilibrium Changes in the
Foreign Exchange Market


At the same time, U.S. investors would
also shift their investments away from
Europe, decreasing their demand for
euros.
The combination of the increased
supply of euros and the decreased
demand for euros will lead to a new
lower exchange rate for euros.
Copyright © 2002 by Thomson Learning, Inc.
Impact of U.S. Interest Rate Increase on the
Foreign Exchange Market
Dollar Price of Euros
S0
S1
$1.90
E0
$1.50
E1
D0
D1
0
Quantity of Euros
Copyright © 2002 by Thomson Learning, Inc.
27.3 Equilibrium Changes in the
Foreign Exchange Market

If Europe experienced a higher inflation
rate than the United States,



European products would become more
expensive to U.S. consumers,
decreasing the quantity of European
goods demanded by Americans, and
decreasing the demand for euros.
Copyright © 2002 by Thomson Learning, Inc.
27.3 Equilibrium Changes in the
Foreign Exchange Market


U.S. products would become less
expensive to European consumers,
increasing the quantity of U.S. goods
demanded by Europeans, and,
therefore, increasing the supply of
Euros.
The combination of the increased
supply of euros and the decreased
demand for euros will lead to a new
lower exchange rate for euros.
Copyright © 2002 by Thomson Learning, Inc.
27.3 Equilibrium Changes in the
Foreign Exchange Market

If currency speculators believe that the
United States was going to experience
more rapid inflation in the future than
Japan, they will believe that the value of
the dollar will soon be falling as a result.
That will increase the demand for yen,
so the yen will appreciate relative to the
dollar. The opposite will occur if
speculators expect less rapid inflation in
the United States.
Copyright © 2002 by Thomson Learning, Inc.
The Impact of European Inflation Rate Increase on
the Foreign Exchange Market
Dollar Price of Euros
S0
S1
$1.90
E0
$1.00
E1
D0
D1
0
Quantity of Euros
Copyright © 2002 by Thomson Learning, Inc.
27.4 Flexible Exchange Rates

Since 1973, the world has essentially
operated on a system of flexible
exchange rates, under which currency
prices are allowed to fluctuate with
changes in supply an demand, without
governments stepping in to prevent
those changes.
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27.4 Flexible Exchange Rates

Before 1973, governments operated
under what was called the Bretton
Woods fixed-exchange rate system, in
which they would maintain a stable
currency exchange rate by buying or
selling currencies or reserves to bring
demand and supply for their currencies
together at the fixed exchange rate.
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27.4 Flexible Exchange Rates

Governments were unable to agree to
an alternative fixed-rate exchange
system when the Bretton Woods system
collapsed, so nations simply let market
factors determine currency values.
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27.4 Flexible Exchange Rates

Governments are still sensitive to sharp
changes in the exchange value of their
currencies, and they do intervene from
time to time to prop up exchange values
considered to be too low or falling too
rapidly or depress exchange values
considered too high or rising too rapidly.
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27.4 Flexible Exchange Rates

Economists sometimes say the current
exchange rate system is a “dirty float”
system, where fluctuations in currency
values are partly determined by market
forces and partly determined by
government intervention.
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27.4 Flexible Exchange Rates


Government attempts to support
exchange rates have been insufficient
to dramatically change exchange rates
for long, and currency exchange rates
have changed dramatically.
When exchange rates change, they
effect not only the currency market, but
product markets as well.
Copyright © 2002 by Thomson Learning, Inc.
27.4 Flexible Exchange Rates

If the exchange value of the dollar
relative to the yen or pound fell, it would
increase the cost, and therefore
decrease the volume of U.S. imports,
and also decrease the cost, and
therefore increase the volume of
Japanese and British imports from the
United States.
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27.4 Flexible Exchange Rates

Since the advent of flexible exchange
rates, world trade has expanded.
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27.4 Flexible Exchange Rates

The most important advantage of the
flexible rate system is that the recurrent
crises that led to speculative rampages
and major currency revaluations under
the fixed Bretton Woods system have
significantly diminished


Prices changed infrequently.
When they changed, the changes were of
a large magnitude.
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27.4 Flexible Exchange Rates

Today, exchange rates change almost
constantly, but each change is much
smaller in magnitude, with major
changes typically occurring only over
periods of months or years.
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27.4 Flexible Exchange Rates

Perhaps the most significant problem
with fixed exchange rates is that they
can result in currency shortages, just as
domestic wage and price controls can
lead to shortages.
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27.4 Flexible Exchange Rates

For example, given a fixed euro-dollar
exchange rate, an increase in demand
for euros to buy more European goods
and services would not be allowed to
increase the euro exchange rate,
resulting in a shortage of euros—a
shortage that must be corrected in
some way.
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27.4 Flexible Exchange Rates

It could be dealt with in various ways,
such as by the U.S. government
borrowing euros or selling some of its
reserves of gold, but the ability to make
up a currency shortage (deficit) for long
is limited, particularly if the deficit
persists.
Copyright © 2002 by Thomson Learning, Inc.
27.4 Flexible Exchange Rates


Under flexible exchange rates, an
imbalance between debits and credits
arising from shifts in currency demand
and/or supply is accommodated by
changes in currency prices rather than
through the special financial borrowings
or reserve movements necessary with
fixed rates.
In a pure flexible-exchange rate system,
balance of payments deficits and
surpluses tend to disappear.
Copyright © 2002 by Thomson Learning, Inc.
Dollar Price of Euros
How Flexible Exchange Rates Work
S
$1.50
$1.00
Payment
deficit with fixed
exchange rate
D1
D0
0
Copyright © 2002 by Thomson Learning, Inc.
Q0 Q1
Quantity of Euros
27.4 Flexible Exchange Rates


Flexible exchange rates also alleviate
the need to use restrictive monetary
and/or fiscal policy to end a currency
imbalance, while maintaining fixed
exchange rates, imposing less of a
constraint on countries’ internal
macroeconomic policies.
Flexible exchange rates have not been
universally endorsed.
Copyright © 2002 by Thomson Learning, Inc.
27.4 Flexible Exchange Rates

Traditionally, the major objection to
flexible exchange rates was that the
resulting currency fluctuations introduce
considerable uncertainty into
international trade, potentially reducing
the volume of trade and reducing the
gains from international specialization.
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27.4 Flexible Exchange Rates

Flexible rate proponents have given
three answers:
The empirical evidence points to faster growth
of international trade after the adoption of
flexible exchange rates.
 One can, in effect, buy insurance against
exchange rate risk through the forward or
futures market in currencies.
 The alleged certainty of currency prices under
Bretton Woods was fictitious because countries
could, at a whim, drastically revalue their
currencies.

Copyright © 2002 by Thomson Learning, Inc.
27.4 Flexible Exchange Rates

A second, more valid, criticism of
flexible exchange rates is that they can
contribute to inflationary pressures by
reducing the discipline the fixed rate
approach provided governments to
constrain their domestic prices because
lower domestic prices increase the
attractiveness of their exported goods.
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27.4 Flexible Exchange Rates

Yet this criticism is not so clear, given
the inflationary potential in sudden
substantial currency devaluations under
the Bretton Woods system.
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27.4 Flexible Exchange Rates

Flexible exchange rate advocates argue
that flexible exchange rates do not
cause inflation; rather, it is caused by
the expansionary macroeconomic
policies of governments and central
banks.
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27.4 Flexible Exchange Rates

Flexible exchange rates give
government decision makers greater
freedom of action than fixed rates;
whether they act responsibly is not
determined by exchange rates, but
rather by domestic policies.
Copyright © 2002 by Thomson Learning, Inc.