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A Lecture Presentation in PowerPoint to accompany Exploring Economics Second Edition by Robert L. Sexton Copyright © 2002 Thomson Learning, Inc. Thomson Learning™ is a trademark used herein under license. ALL RIGHTS RESERVED. Instructors of classes adopting EXPLORING ECONOMICS, Second Edition by Robert L. Sexton as an assigned textbook may reproduce material from this publication for classroom use or in a secure electronic network environment that prevents downloading or reproducing the copyrighted material. Otherwise, no part of this work covered by the copyright hereon may be reproduced or used in any form or by any means—graphic, electronic, or mechanical, including, but not limited to, photocopying, recording, taping, Web distribution, information networks, or information storage and retrieval systems—without the written permission of the publisher. Printed in the United States of America ISBN 0030342333 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 Copyright © 2002 by Thomson Learning, Inc. 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. Copyright © 2002 by Thomson Learning, Inc. 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. Copyright © 2002 by Thomson Learning, Inc. 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. Copyright © 2002 by Thomson Learning, Inc. 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. Copyright © 2002 by Thomson Learning, Inc. 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. Copyright © 2002 by Thomson Learning, Inc. 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. Copyright © 2002 by Thomson Learning, Inc. 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. Copyright © 2002 by Thomson Learning, Inc. 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. Copyright © 2002 by Thomson Learning, Inc. 27.4 Flexible Exchange Rates Since the advent of flexible exchange rates, world trade has expanded. Copyright © 2002 by Thomson Learning, Inc. 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. Copyright © 2002 by Thomson Learning, Inc. 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. Copyright © 2002 by Thomson Learning, Inc. 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. Copyright © 2002 by Thomson Learning, Inc. 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. Copyright © 2002 by Thomson Learning, Inc. 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. Copyright © 2002 by Thomson Learning, Inc. 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. Copyright © 2002 by Thomson Learning, Inc. 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. Copyright © 2002 by Thomson Learning, Inc. 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. Copyright © 2002 by Thomson Learning, Inc. 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.