Chapter 36:International Finance

McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

13e

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International Finance

• Each country has its own currency (except in Europe, where many countries have adopted the euro).

• International trade therefore involves two currencies – that of the exporter (which needs to pay bills in its currency) and that of the buyer (which pays for items using its currency).

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International Finance

• The relative values of the two currencies will affect trade patterns and ultimately the answers to the questions of WHAT, HOW, and FOR WHOM to produce.

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Learning Objectives

• 36-01. Know the sources of foreign exchange demand and supply.

• 36-02. Know how exchange rates are established.

• 36-03. Know how changes in exchange rates affect prices, output, and trade flows.

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Exchange Rates

• Exchange rate: the price of one country's currency in terms of another’s; the domestic price of a foreign currency.

• If US$1.50 = 1 euro, then US$1 = 0.67 euro.• Exchange rates in terms of each other must

be reciprocals of each other.

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Foreign Exchange Markets• U.S. travelers to Europe have a demand for

euros and a supply of dollars. European visitors to Disney World have a demand for dollars and a supply of euros.

• U.S. exporters of goods to Europe get paid in euros. They have a supply of euros and a demand for dollars, which they need to pay their bills.

• European exporters of goods to the U.S. get paid in dollars. They have a supply of dollars and a demand for euros.

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Foreign Exchange Markets• The market demand for U.S. dollars originates

in– Foreign demand for American exports.– Foreign tourists in America.– Foreign demand for American investments.– Currency speculators.– Possible government intervention.

• The market demand for U.S. dollars represents a market supply of foreign currency.

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Foreign Exchange Markets• The market supply of U.S. dollars originates

in– American demand for imports.– American tourists abroad.– American investments abroad.– Currency speculators.– Possible government intervention.

• The market supply of U.S. dollars represents a market demand for foreign currency.

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The Value of the Dollar• The value of the dollar is indicated by its

purchasing power.• A BMW costing 30,000 euros must be priced in

dollars if it is to be sold in the United States.– If 1 euro = $1.50, then it will be priced at $45,000.– If the exchange rate changed to 1 euro = $1.60, then

the BMW’s price in the United States would rise to $48,000.

– At this higher price, the quantity of BMWs sold will decrease.

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The Value of the Dollar• At a high euro price

of the dollar, fewer will want to buy dollars and more will want to sell dollars. There will be a surplus of dollars, and the dollar’s euro price will fall.

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The Value of the Dollar• At a low euro price of

the dollar, more will want to buy dollars and fewer will want to sell dollars. There will be a shortage of dollars, and the dollar’s euro price will rise.

• The foreign exchange market will adjust to its equilibrium price.

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The Value of the Dollar

• Any increase in demand for the dollar or decrease in supply of the dollar will push the dollar price in euros up. The dollar appreciates in value.

• Any decrease in demand for the dollar or increase in supply of the dollar will push the dollar price in euros down. The dollar depreciates in value.

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The Value of the Dollar

• When the dollar appreciates against the euro, the euro depreciates in value relative to the dollar.

• When the dollar depreciates against the euro, the euro appreciates in value relative to the dollar.

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The Balance of Payments• The summary of all international money flows

is contained in the balance of payments.– Balance of payments: a summary record of a

country’s international economic transactions in a given period of time.

• The balance of payments is divided into three parts:– Current account balance (which includes the trade

balance).– Capital account balance.– Statistical discrepancy.

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The Balance of Payments• The current account balance includes– The trade balance:

• Merchandise exports and imports.• Service exports and imports.

– Other money flows:• Income inflows from U.S. investments abroad.• Income outflows for foreign-owned U.S. investments.• Net U.S. government grants to foreigners.• Net private transfers and pensions.

• There is a net dollar outflow in the current account.

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The Balance of Payments

• The capital account balance includes– Inflow due to foreign purchases of U.S. assets.– Outflow due to U.S. purchases of foreign assets.– Increase in U.S. official reserves.– Increase in foreign official assets in U.S.

• There is a net dollar inflow in the capital account.

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The Balance of Payments• If we had perfect accounting, the outflow in the

current account would be balanced by the inflow in the capital account.

• Because the accounting process has several time lags in collecting data, the third part of the balance of payments is the statistical discrepancy, which indeed balances the two accounts.

• Therefore, the balance of payments always must equal zero.

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Market Dynamics

• Review:– Depreciation: a fall in the price of one currency

relative to another.• Caused by a decrease in demand or an increase in

supply of the first currency.

– Appreciation: a rise in the price of one currency relative to another.• Caused by an increase in demand or a decrease in

supply of the first currency.

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Market Dynamics• What market forces could cause an increase in

demand for the dollar?– Foreign incomes rise faster than U.S. incomes.– Foreign prices rise faster than U.S. prices.– Foreigners have an increased need for U.S. goods. – U.S. interest rates become higher than in foreign

countries.• Vice versa, and there would be a decrease in

demand for the dollar.• Small changes like these occur all the time, and the

$4 trillion foreign exchange market adjusts to those changes.

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Do Exchange Rates Matter?

• Daily participants in international trade prefer stable exchange rates to reduce the uncertainty in planning.

• Any exchange rate change automatically alters the prices of exports and imports of that country, affecting many business decisions.

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Do Exchange Rates Matter?

• Trade deficits, caused by U.S. demand increase for foreign goods, essentially reduced American jobs as more products were made abroad.

• The returning capital inflow had foreigners buying U.S. assets, including government bonds. U.S. foreign debt and interest costs increased.

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Should the Government Control Exchange Rates?

• An intervention would be intended to achieve exchange rate stability.

• However, stable exchange rates can lead to other economic effects.

• The standard way to eliminate instability in exchange rates is to adopt fixed exchange rates.– All major trading countries agree to keep the

exchange rates between each currency fixed.

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Should the Government Control Exchange Rates?

• The easiest way to fix exchange rates is to define each currency’s value against a common standard, such as a gold standard.– Gold standard: an agreement by countries to fix the

price of their currencies in terms of gold.

• The problem with fixed exchange rates is that the demand for and the supply of each currency will continue to fluctuate, and a fixed exchange rate does not account for this.

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Fixed Exchange Rates• With fixed exchange

rates (at e2), the increase in demand for pounds generates a shortage of pounds.

• More dollars flow out than flow in, so it creates a balance of payments (BOP) deficit for the United States and a BOP surplus for Britain.

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Fixed Exchange Rates• What to do?• Let the exchange rate

rise (not acceptable), or the U.S. government intervenes by selling pounds it owns and buying dollars.

• Also, the U.S. could transfer gold to Britain for dollars.

• This can be done once or twice, but cannot be kept up forever.

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Fixed Exchange Rates• Alternatively, the United States could erect

protective barriers to eliminate the increased demand for British goods.

• Or the United States could increase taxes to reduce disposable income and thereby the demand for imports.

• Or interest rates could be raised to slow spending and to draw foreign currency to the United States.

• To do this, the policy focus would have to shift away from full employment or price stability.