Download Principles of Economics Third Edition by Fred Gottheil

Chapter 32
Exchange Rates, Balance of
Payments, and International Debt
© 2002 South-Western
Economic Principles
• Exchange Rates
• Foreign Exchange Markets
• Appreciation and Depreciation
of Currencies
2
Economic Principles
• Floating and Fixed Exchange
Rates
• Arbitrage
• Devaluation
3
Economic Principles
• Balance of Payments
• International Debt and Debt
Service
4
The Foreign Exchange Market:
The Buying and Selling of
Currencies
Foreign exchange market
A market in which currencies of
different nations are bought and
sold.
5
The Foreign Exchange Market:
The Buying and Selling of
Currencies
Exchange rate
The number of units of foreign
currency that can be purchased
with one unit of domestic
currency.
6
The Foreign Exchange Market:
The Buying and Selling of
Currencies
1. Suppose that a kite costs 40
pesos, and the exchange rate is 10
pesos to the dollar. What is the
dollar price of the kite?
• 40 pesos/10 = 4 dollars.
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EXHIBIT 1 FOREIGN EXCHANGE MARKET
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Exhibit 1: Foreign Exchange
Market
At $2 per yap, is the foreign
exchange market in Exhibit 1 in
equilibrium, or is there an excess
demand or excess supply of yaps?
• Since the equilibrium price is $3 per
yap, at $2 per yap there would be an
excess demand for yaps.
9
Exhibit 1: Foreign Exchange
Market
At $4 per yap, is the foreign
exchange market in Exhibit 1 in
equilibrium, or is there an excess
demand or excess supply of yaps?
• Since the equilibrium price is $3 per
yap, at $4 per yap there would be an
excess supply of yaps.
10
The Foreign Exchange Market:
The Buying and Selling of
Currencies
2. Why is the demand curve for
foreign currency downwardsloping?
• When the price of a foreign currency
declines, the quantity of that foreign
currency demanded increases.
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The Foreign Exchange Market:
The Buying and Selling of
Currencies
2. Why is the demand curve for
foreign currency downwardsloping?
• For example, if a dollar can buy more
Mexican pesos than before, then a dollar
can also buy more Mexican goods and
services than before.
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The Foreign Exchange Market:
The Buying and Selling of
Currencies
2. Why is the demand curve for
foreign currency downwardsloping?
• As a result, Americans wish to exchange
dollars for more pesos in order to buy
more Mexican goods, increasing the
quantity of pesos demanded in the foreign
exchange market.
13
The Foreign Exchange Market:
The Buying and Selling of
Currencies
3. Why is the supply curve for
foreign currency upwardsloping?
• When the price of a foreign currency
rises, then the purchasing power of the
foreign currency rises when it comes to
buying imported goods and services.
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The Foreign Exchange Market:
The Buying and Selling of
Currencies
3. Why is the supply curve for
foreign currency upwardsloping?
• For example, if it takes more dollars to
buy a Mexican peso, then it takes fewer
pesos to buy a dollar, and so the price of
American goods are cheaper for Mexicans.15
The Foreign Exchange Market:
The Buying and Selling of
Currencies
3. Why is the supply curve for
foreign currency upwardsloping?
• As a result, Mexicans wish to exchange
more pesos for dollars in order to buy
more American goods, increasing the
quantity of pesos supplied in the foreign
exchange market.
16
The Foreign Exchange Market:
The Buying and Selling of
Currencies
4. Which of the following will cause an
increase in the demand for Mexican
pesos?
a. Decreasing American incomes.
b. Increasing Mexican interest rates.
c. Increasing American interest rates.
17
The Foreign Exchange Market:
The Buying and Selling of
Currencies
4. Which of the following will cause an
increase in the demand for Mexican
pesos?
b. Increasing Mexican interest rates.
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EXHIBIT 2 EFFECT OF AN INCREASE IN THE DEMAND
FOR YAPS ON THE DOLLARS-FOR-YAPS
RATE OF EXCHANGE
19
Exhibit 2: Effect of an Increase in the
Demand for Yaps on the Dollars-for-Yaps
Rate of Exchange
1. After the increase in demand from D1 to
D2, Is there excess supply, excess demand,
or equilibrium at an exchange rate of $3
per yap?
• There is excess demand of (70-30) = 40
thousand yaps.
20
Exhibit 2: Effect of an Increase in the
Demand for Yaps on the Dollars-for-Yaps
Rate of Exchange
2. After the increase in demand from D1 to
D2, what is the new equilibrium exchange
rate?
• The new equilibrium exchange rate is $5
per yap.
21
The Foreign Exchange Market:
The Buying and Selling of
Currencies
5. Which of the following will cause a
decrease in the supply of Mexican pesos?
a. Decreasing American tastes for
Mexican goods.
b. Decreasing Mexican interest rates.
c. Decreasing Mexican incomes.
22
The Foreign Exchange Market:
The Buying and Selling of
Currencies
5. Which of the following will cause a
decrease in the supply of Mexican pesos?
c. Decreasing Mexican incomes.
23
EXHIBIT 3 EFFECT OF AN INCREASE IN THE SUPPLY OF
YAPS ON THE DOLLARS-FOR-YAPS RATE OF
EXCHANGE
24
Exhibit 3: Effect of an Increase in the
Supply of Yaps on the Dollars-for-Yaps
Rate of Exchange
1. After the increase in supply from S1 to
S2, is there excess supply, excess demand,
or equilibrium at an exchange rate of $3
per yap?
• There is an excess supply of (50-30) = 20
thousand yaps.
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Exhibit 3: Effect of an Increase in the
Supply of Yaps on the Dollars-for-Yaps
Rate of Exchange
1. After the increase in supply from S1 to
S2, what is the new equilibrium exchange
rate?
• The new equilibrium exchange rate is $2
per yap.
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Floating Exchange Rates
Floating exchange rate
An exchange rate determined
strictly by the demands and
supplies for a nation’s currency.
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Floating Exchange Rates
Appreciation
A rise in the price of a nation’s
currency relative to foreign
currencies.
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Floating Exchange Rates
Depreciation
A fall in the price of a nation’s
currency relative to foreign
currencies.
29
Floating Exchange Rates
1. Complete the sentence:
When journalists say that the
dollar has “weakened,” they
mean that the dollar has _____ in
value.
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Floating Exchange Rates
1. Complete the sentence:
When journalists say that the
dollar has “weakened,” they
mean that the dollar has
depreciated in value.
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Floating Exchange Rates
2. If the dollar has appreciated in value
relative to the Mexican peso, then which
of the following is true:
a. The exchange rate has more pesos per
dollar than before.
b. The exchange rate has fewer pesos per
dollar than before.
32
Floating Exchange Rates
2. If the dollar has appreciated in value
relative to the Mexican peso, then which
of the following is true:
a. The exchange rate has more pesos per
dollar than before.
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Tourists at the Mall
Has the U.S. dollar appreciated
or depreciated in value relative to
the Japanese yen between 1960
and 1996?
• Depreciated in value.
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Tourists at the Mall
Has the U.S. dollar appreciated
or depreciated in value relative to
the Japanese yen between 1960
and 1996?
• In 1960 the exchange rate was 358 yen
per dollar. By 1996 there were only 131
yen per dollar.
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Floating Exchange Rates
Arbitrage
The practice of buying a foreign
currency in one market at a low
price and selling it in another at a
higher price.
36
Floating Exchange Rates
3. How might floating exchange
rates make international trade
riskier?
• Suppose that the price of an
internationally traded good changes
during the time between when a purchase
is negotiated and the product is delivered.
37
Floating Exchange Rates
3. How might floating exchange
rates make international trade
riskier?
• Then the change in exchange rates is like
an unforeseen change in the price of the
good, which redistributes the gains from
trade in an unforeseen way.
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Floating Exchange Rates
Fixed exchange rate
A rate determined by government
and then maintained through the
process of buying and selling
quantities of its own currency on
the foreign exchange market.
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EXHIBIT 4A TRADE UNDER FREE AND FIXED EXCHANGE
RATES
40
EXHIBIT 4B TRADE UNDER FREE AND FIXED EXCHANGE
RATES
41
Exhibit 4: Trade Under Free
and Fixed Exchange Rates
1. If there is a system of free or floating
exchange rates, then what happens if the
demand for a foreign currency increases?
• The exchange rate (dollars per unit of
foreign currency) increases and there is
neither excess demand nor excess supply
of the foreign currency.
42
Exhibit 4: Trade Under Free
and Fixed Exchange Rates
2. If there is a system of fixed exchange
rates, then what happens if the demand
for a foreign currency increases?
• Since the exchange rate cannot change,
an increase in demand will create excess
demand for the foreign currency.
43
Exhibit 4: Trade Under Free
and Fixed Exchange Rates
3. If there is excess demand for Mexican
pesos under a system of fixed exchange
rates, what will the Mexican government
need to do to eliminate the excess demand
for the peso?
• Mexico will need to exchange some of its
own pesos for dollars on the foreign
44
exchange market.
Exhibit 4: Trade Under Free
and Fixed Exchange Rates
3. If there is excess demand for Mexican
pesos under a system of fixed exchange
rates, what will the Mexican government
need to do to eliminate the excess demand
for the peso?
• This will increase the supply of pesos on
the foreign exchange market and
eliminate the excess demand.
45
Exhibit 4: Trade Under Free
and Fixed Exchange Rates
3. If there is excess demand for Mexican
pesos under a system of fixed exchange
rates, what will the Mexican government
need to do to eliminate the excess demand
for the peso?
• In order for Mexico to do this, it must
have sufficient stock of pesos to exchange
for dollars.
46
Exhibit 4: Trade Under Free
and Fixed Exchange Rates
4. Continuing the Mexican peso example,
what might Mexico be forced to do if it
did not have a sufficient quantity of pesos
on reserve to eliminate the excess
demand?
•Mexico might be forced to borrow pesos
from another country, or even agree to
increase the exchange rate ($ per peso).
47
Floating Exchange Rates
Foreign exchange reserves
The stock of foreign currencies a
government holds.
48
Floating Exchange Rates
Devaluation
Government policy that lowers
the nation’s exchange rate; its
currency instantly is worth less in
the foreign exchange market.
49
Floating Exchange Rates
4. In which of the following circumstances
would a country most likely be forced into
a devaluation of its currency:
a. The excess supply of its currency in the
foreign exchange market exceeds its
foreign exchange reserves.
b. The excess demand for its currency in
the foreign exchange market exceeds its
foreign exchange reserves.
50
Floating Exchange Rates
4. In which of the following circumstances
would a country most likely be forced into
a devaluation of its currency:
a. The excess supply of its currency in the
foreign exchange market exceeds its
foreign exchange reserves.
51
Floating Exchange Rates
Import controls
Tariffs and quotas used by
government to limit a nation’s
imports.
52
Floating Exchange Rates
Exchange controls
A system in which government, as
the sole depository of foreign
currencies, exercises complete
control over how these currencies
can be used.
53
Floating Exchange Rates
International Monetary Fund
(IMF)
An international organization
formed to make loans of foreign
currencies to countries facing
balance of payments problems.
54
Balance of Payments
Balance of payments
An itemized account of a nation’s
foreign economic transactions.
55
Balance of Payments
Balance on current account
A category that itemizes a
nation’s imports and exports of
goods and services, income
receipts and payments on
investment, and unilateral
transfers.
56
EXHIBIT 5 THE U.S. BALANCE OF PAYMENTS ACCOUNT:
1999 ($ BILLIONS)
Source: Survey of Current Business (Washington, D.C.: U.S. Department of Commerce, January 2001), p. 56.
57
Exhibit 5: The U.S. Balance of
Payments Account: 1999 ($
Billions)
In which of the following categories of the
U.S. balance of payments did the U.S. run
a surplus in 1999?
a. Balance of trade.
b. Balance on current account.
c. Balance on capital account.
58
Exhibit 5: The U.S. Balance of
Payments Account: 1999 ($
Billions)
In which of the following categories of the
U.S. balance of payments did the U.S. run
a surplus in 1999?
c. Balance on capital account.
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EXHIBIT 6 U.S. BALANCE OF TRADE: 1950–2000
60
Exhibit 6: U.S. Balance of
Trade: 1950-2000
What has been the overall trend in the
U.S. balance of trade since the mid-1970s?
• Since the mid-1970s the U.S. balance of
trade has been in deficit.
61
Balance of Payments
What is an example of an export
of services?
• When a U.S. engineering firm provides
engineering design services for a project in
another country.
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Balance of Payments
Unilateral transfers
Transfers of currency made by
individuals, businesses, or
government of one nation to
individuals, businesses, or
governments in other nations,
with no designated return.
63
Balance of Payments
Balance on capital account
A category that itemizes changes
in the foreign asset holdings of a
nation and that nation’s asset
holdings abroad.
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What is a Balance of
Payments Problem?
Do trade imbalances always
create problems?
• No. For example, a country may have a
balance of trade deficit because it is
importing capital equipment necessary for
it to produce valuable exports in the
future.
65
How Deficits on Current
Account Develop
If foreigners make huge investments in
U.S. stocks and bonds, how might this
affect the current account?
• Foreign purchases of U.S. stocks and
bonds increases the demand for U.S.
dollars.
66
How Deficits on Current
Account Develop
If foreigners make huge investments in
U.S. stocks and bonds, how might this
affect the current account?
• Increased demand for the U.S. dollar
increases the value of the dollar relative to
other currencies.
67
How Deficits on Current
Account Develop
If foreigners make huge investments in
U.S. stocks and bonds, how might this
affect the current account?
• A high-valued dollar makes imports
cheap for Americans, but makes
American exports expensive for foreigners
in other countries.
68
How Deficits on Current
Account Develop
If foreigners make huge investments in
U.S. stocks and bonds, how might this
affect the current account?
• Consequently imports increase and
exports decline, causing a current account
deficit.
69
International Debt
International debt
The total amount of outstanding
IOUs a nation is obligated to
repay other nations and
international organizations.
70
International Debt
Debt service
Interest payments on
international debt as a
percentage of a nation’s
merchandise exports.
71
EXHIBIT 7 DEBT SERVICE OF SELECTED COUNTRIES,
AS A PERCENTAGE OF EXPORTS: 1998
Source: The World Bank, World Development Indicators, 2000 (Washington, D.C.: World Bank, 2000).
72
Exhibit 7: Debt Service of Selected
Countries, as a Percentage of Exports: 1998
What causes countries such as Egypt and
Sudan to have such high debt service as a
percentage of their exports?
• The amount of international debt held by
these countries is quite large relative to the
value of their exports, making repayment
difficult.
73