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International Finance

Chapter 33

© 2006 Thomson/South-Western

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Balance of Payments

A country’s balance of payments summarizes all economic transactions that occur during a given period between residents (people, firms, and governments) of that country and residents of other countries

Balance of payments measures a flow, or the balance of economic transactions

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Balance of Payments

Balance-of-payments accounts are maintained according to the principles of double-entry bookkeeping, in which entries on one side of the ledger are called credits, and entries on the other side are called debits.

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Merchandise Trade Balance

Equals the value of merchandise exports minus the value of merchandise imports

Reflects trade in goods, or tangible products, and is often referred to as the trade balanceIf the value of merchandise exports exceeds

the value of merchandise imports, there is a trade surplus

If the value of merchandise imports exceeds the value of merchandise exports, there is a trade deficit

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Exhibit 1: Relative to GDP, U.S. Imports Have Topped Exports Since 1976, and the Trade

Deficit Has Widened

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Exhibit 2: U.S. Trade Deficits in 2003 by Country or Region

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Balance on Goods and Services

Balance on goods and services: the portion of a country’s balance-of-payments account that measures the value of a country’s exports of goods and services minus the value of its imports of goods and services (net exports)

Merchandise trade balance focuses on the flow of goods, but services (intangibles) are also traded internationally

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Unilateral Transfers

Unilateral transfers consist of government transfers to foreign residents: foreign aid, personal gifts to individuals abroad, etc.

Net unilateral transfers equal the unilateral transfers received from abroad by U.S. residents minus unilateral transfers sent to foreign residents by U.S. residents

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Balance on Current Account

The portion of a country’s balance-of-payments account that measures that country’s balance on goods and services plus its net unilateral transfers

Can be negative = current account deficit

Can be positive = current account surplus

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Capital Account

The record of a country’s international transactions involving purchases or sales of financial and real assets

Between 1917 and 1982, the United States ran a deficit in the capital accountU.S. residents purchased more foreign assets

than foreigners purchased assets in the U.S.This reversed itself in 1983, and since then

foreigners have purchased more U.S. assets than the other way around

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U.S. Balance of Payments 2003(billions of dollars)

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U.S. Balance of Payments 2003(billions of dollars)

All transactions requiring payments from foreigners to U.S. residents are entered as credits, indicated by a plus sign (+), because they result in an inflow of funds from foreign residents to U.S. residents.All transactions requiring payments to foreigners from U.S. residents are entered as debits, indicated by a minus sign (), because they result in an outflow of funds from U.S. residents to foreign residents. As you can see, a surplus in the capital account of $579.0 billion more than offsets a current account deficit of $541.8 billion.

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U.S. Balance of Payments

The statistical discrepancy that balances payments is a negative $37.2 billion

Statistical discrepancy: the official “fudge factor” that:measures the error in the balance-of-

paymentssatisfies the double-entry bookkeeping

requirement that total debits equal total credits

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Foreign Exchange and Exchange Rates

Foreign exchange: foreign money needed to carry out international transactions

Exchange rate: the price measured in the currency of one country that is needed to purchase one unit of another country’s currency

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The Euro and Exchange Rates

The euro is now the common currency of the euro area

The price, or exchange rate, of the euro in terms of the dollar is the number of dollars required to purchase one euro

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Foreign Exchange

Currency depreciation: with respect to the dollar, an increase in the number of dollars needed to purchase 1 unit of foreign exchange in a flexible rate system

Currency appreciation: With respect to the dollar, a decrease in the number of dollars needed to purchase 1 unit of foreign exchange in a flexible rate system

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Demand for Foreign Exchange

U.S. residents need euros to pay for goods and services produced in the euro area

The demand curve for euros the inverse relationship between the dollar price of the euro and the quantity of euros demanded, other things constantIncomes and preferences of U.S. consumersThe expected inflation rates in the U.S. and the euro

areaThe euro price of goods in the euro areaInterest rates in the U.S. and the euro area

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Demand for Foreign Exchange

In the aggregate, the lower the dollar price of foreign exchange, other things constant, the greater the quantity demanded

A drop in the dollar price of foreign exchange, in this case the euro, means that fewer dollars are required to purchase each euro: prices of euro goods become cheaper

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Supply of Foreign Exchange

The supply of foreign exchange is generated by the desire of foreign residents to acquire dollars

The positive relationship between the dollar-per-euro exchange rate and the quantity of euros supplied in the foreign exchange market implies an upward-sloping supply curve

Assumed constant are: euro area incomes and preferencesexpectations about the rates of inflation in the euro

area and the United Statesinterest rates in the euro area and the United States

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Exhibit 4: The Foreign Exchange Market

1.10

0

D

S

Foreign exchange(millions of euros)800 820

Exc

han

ge

rate

(d

olla

rs p

er e

uro

)Initial equilibrium exchange rate is $1.10If the exchange rate is allowed to adjust freely, or to float in response to market forces, the market will clear continually

1.20

1.00

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Exhibit 5: Effect on the Foreign Exchange Market of an Increased Demand for Euros

1.10

0

D

S

Foreign exchange(millions of euros)

800

$1.12

820

Suppose an increase in U.S. incomes causes Americans to increase their demand for all normal goods, including those from the euro area: demand curve shifts from D to D'The shift of the demand curve leads to an increase in the exchange rate from $1.10 to $1.12 per euroThe euro appreciates and the dollar depreciates: euro area people purchase more American products

Exc

han

ge

rate

(d

olla

rs p

er e

uro

)

D'

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Arbitrageurs

Dealers who take advantage of temporary geographic differences in exchange rates by simultaneously buying a currency in one market and selling it in anotherIf one euro costs $0.89 in New York and $0.90 in

Frankfurt, the arbitrageur would buy euros in New York and at the same time sell them in Frankfurt Demand for euros in New York would increase Supply of euros in Frankfurt would increase Price differential would be eliminated

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Speculators

Speculators buy or sell foreign exchange in hopes of profiting from fluctuations in the exchange rate over timetrading the currency at a more favorable exchange

rate later

By taking risks, speculators aim to profit from market fluctuations by trying to buy low now and sell high later

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Purchasing Power Parity

Purchasing power parity theory (PPP): predicts the exchange rate between two currencies will adjust in the long run to reflect price-level differences between the two currency regions

This is true as long as trade across borders is unrestricted and exchange rates are allowed to adjust freely

PPP is generally a long-run indicator

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Purchasing Power Parity

A given basket of internationally traded goods should therefore sell for about the same around the world after adjusting for transportation costs and the like

Big Mac Index

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Exhibit 6: In May

2004, the U.S.

Price of a Big Mac

Exceeded Prices in Most Other

Countries

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Flexible Exchange Rates

Exchange rate determined by the forces of demand and supply without government intervention

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Fixed Exchange Rates

Fixed exchange rates: rate of exchange between currencies pegged within a narrow range and maintained by the central bank’s ongoing purchases and sales of currencies

Suppose the European Central Bank selects what it thinks is an appropriate rate of exchange between the dollar and the euro: it attempts to fix, or peg, the exchange rate within a narrow band around the particular value selected

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Fixed Exchange Rates

If the value of the euro threatens to climb above the maximum acceptable exchange rate, monetary authorities Sell euros and buy dollars keeping the dollar

price of the euro downIf the value of the euro threatens to drop

below the minimum acceptable exchange rate, monetary authorities Sell dollars and buy euros in foreign

exchange markets

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Fixed Exchange Rates

If monetary officials must keep selling foreign exchange to maintain the pegged rate, they risk running out of foreign exchange reserves

The government has several optionsThe pegged exchange rate can be increased:

devaluation of the domestic currency The pegged exchange rate can be decreased:

revaluation of the domestic currencyThe government can attempt to reduce the domestic

demand for foreign exchange directly by imposing restrictions on imports or capital flows

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Fixed Exchange Rates

The government can adopt contractionary fiscal or monetary policies to reduce the country’s income level, increase interest rates, or reduce inflation relative to that of the country’s trading partners

Finally, the government can allow the disequilibrium to persist and ration the available foreign reserves through some form of foreign exchange control

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Development of the International Monetary System

From 1879 to 1914, the international financial system operated under a gold standard

The gold standard provided a fixed, predictable exchange rate that did not vary as long as currencies could be redeemed for gold at the announced rate

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Bretton Woods Agreement

Because the U.S. had a strong economy, the dollar was selected as the key reserve currency

Created the International Monetary Fund (IMF) to Set rules for maintaining the international monetary

systemStandardize financial reporting for international

tradeMake loans to countries with temporary balance of

payments problemsEstablish a revolving fund to lend money to troubled

economies

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Demise of the Bretton Woods System

During the latter part of the 1960s, inflation in the U.S. caused the dollar to become overvalued at the official exchange rate The gold value of the dollar exceeded the exchange

value of the dollar

The result was that in August 1971, the U.S. stopped exchanging gold for dollars

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Demise of the Bretton Woods System

The dollar was devalued with the hope that this would put the dollar on firmer footing and would save the dollar standard

With prices rising at different rates, an international monetary system based on fixed exchanged rates was doomed and the Bretton Woods system collapsed

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Current System: Managed Float

Managed float system: combines features of a freely floating exchange rate with sporadic intervention by central banks as a way of moderating exchange rate fluctuations among the world’s major currencies

Most smaller countries still peg their currencies to one of the major currencies or to a basket of major currencies

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Managed Float

Major criticisms of flexible exchange rates:They are inflationary because they free monetary

authorities to pursue expansionary policiesThey have often been volatile, especially since the

late 1970sThis volatility creates uncertainty and risks for

importers and exporters and can lead to wrenching changes in the competitiveness of a country’s export sector

Policymakers’ ideal is a system that will foster international trade, lower inflation, and promote a more stable world economy