International Finance International Finance .

International Finance

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International Finance








2Learning Objectives

• Explain how international trade is financed

• Describe a country’s balance of payments accounts

• Explain what determines the amount of international borrowing and lending

3Learning Objectives (cont.)

• Explain why the United States changed from being a lender to being a borrower in the mid-1980s

• Explain how the foreign exchange value of the dollar is determined

• Explain why the foreign exchange value of the dollar fluctuates

5Financing International Trade

Balance of Payments Accounts

Balance of payments accounts record a country’s international trading, borrowing, and lending.

6Balance of Payments: Credits

• Credits, + (receipts from foreigners)

• Exports of goods and services

• Income receipts

• Unilateral current transfers to the US

• Financial inflows

• ““Dollars in”Dollars in”

7Balance of Payments: Debits

• Debits, - (payment to foreigners)

• Imports of goods and services

• Income payments

• Unilateral current transfers to foreigners

• Financial outflows

• ““Dollars out”Dollars out”

8Balance of Payments Paired Transactions

• Every international transaction enters the balance of payments twice, once as a credit and once as a debit

• If you buy something from a foreigner, you must pay her. She must then spend or store your payment.

9Examples of Paired Transactions

Credit Debit

JD buys an Italian bike (Masi) (current account)

Sale of bank deposit by Chase Bank (Financial account)


Credit Debit

Julia buys meal at l’Escargot d’Or (current account)

Sale of claim on BofA card (Financial account)


Credit Debit

TJ buys 1 share of Shell (Dutch)(Financial account)

Shell deposits in US bank (Financial account)

15Credits to the Current Account


• Exports of goods and services

• income receipts

• unilateral current transfers to the US

16Debits to the Current Account


• Imports of goods and services

• Income payments

• Unilateral current transfers to foreigners

17Credits to the Financial Account


• Financial inflows• Increase in foreign-owned assets (U.S. liabilities)

• Decrease in U.S.-owned assets (U.S. claims).

18Debits to the Financial Account


• Financial outflows

• Decrease in foreign-owned assets (U.S. liabilities)

• Increase in U.S.-owned assets (U.S. claims)


The balance of payments accounts include:

1) Current account•Exports of goods and services + US income receipts

•Imports of goods and services+US income payments

•Unilateral current transfers, net•US receipts – US payments

•“Net interest income” = US income receipts –US income payments

transfers Net income interestNetNXCAB



2) Financial account*

• Records changes in foreign assets in the United States minus changes US assets abroad

* Prior to 1997, the Financial account was known as the Capital account



3) Official settlements account• Records the change in official U.S. reserves.

• Official U.S reserves -- mainly the government’s holdings of foreign currency.

• If official reserves increase, the official settlements accounts balance is negative.

Part of the Financial account & it’s small!


Fundamental balance of payments accounts identity:

Current account + Financial account = 0

23

Current account (billion $)Import of goods and services -940Exports of goods and services +830Net interest income –10Net transfers –40Current account balance –160

Financial account (increases in ...)Foreign investment in the United States +430U.S. investment abroad -240Statistical discrepancy –40Financial account balance +150

Official settlements accountDecrease in official U.S. reserves +10

U.S. Balance of Payments Accounts in 1996

24

Current account (billion $)Import of goods and services -1,120Exports of goods and services +910Net interest income +20Net transfers –40Current account balance –230

Financial account (increases in ...)Foreign investment in the United States +540U.S. investment abroad -310Statistical discrepancy –40Financial account balance +230

Official settlements account Increase in official U.S. reserves -

U.S. Balance of Payments Accounts in 1998

28U.S. Balance of Payments

• Let’s visit the Bureau of Economic Analysis

http://www.bea.doc.gov/bea/di1.htm

http://www.bea.doc.gov/bea/di1.htm

29The Balance of Payments:

1975-1998


Borrowers and Lenders, Debtors and Creditors

• A net borrower is a country that is borrowing more from the rest of the world than it is lending.

• A net lender is a country that is lending more than it is borrowing.



• Debtor nations are countries that during their entire history have borrowed more from the rest of the world than they have lent to it.

• Creditor nations are countries that have invested more in the rest of the world than other countries have invested in it.



• The United States is both a net borrower and a debtor nation.

• We became a borrower as a result of a string of current account deficits.

Is there any reason to be concerned?


No — if the borrowing is financing investment that is generating economic growth and higher income.

Yes — if the money is being used to finance consumption.

This will result in higher interest payments and consumption will eventually have to be reduced.


Current Account Balance

The current account balance (CAB) equals:

transfers Net income interestNetNXCAB


Net Exports

• Largest part of the current account balance.

• Determined by the government budget and private saving and investment.


Net Exports

• Net exports is exports of goods and services minus imports of goods and services (X-M)

• A government sector surplus or deficit is net taxes minus government purchases of goods and services (T – G)

• A private sector surplus or deficit is saving minus investment (S – I)

38Net Exports, the Government

Budget, Saving, and Investment

Variables

Exports X 959

Imports M 1,110

Government purchases G 1,487

Net Taxes T 1,563

Investment I 1,367

Saving S 1,140

Symbols andequations

United Statesin 1998

(billions of dollars)



Net Exports X - M = 959 – 1,110 = – 151

Government sector T - G = 1,563 – 1,487 = 76

Private sector S - I = 1,140 – 1,367 = –227

Surpluses and deficits in 1998



National accounts Y = C + I + G + X – M

= C + S + T

Rearranging X – M = S – I + T – G

Net exports X – M –151

equals:

Government sector T – G 76

plus

Private sector S – I –227

Relationship among surpluses and deficits in 1998


The Twin Deficits

• The government sector balance (T-G) and the Current Account balance (X-M) tend to move in the same direction

• The US has frequently had a deficit on both

• Hence, they are known as the twin deficits.

45The Twin Deficits


Is U.S. Borrowing for Consumption or Investment

• Net exports were –$99 billion in 1996

• The government buys structures (e.g. highways, dams) that exceed $200 billion/year.

• The government spends on education and health care—increases human capital.


Is U.S. Borrowing for Consumption or Investment

Our borrowing is financing investment

49The Exchange Rate

• The foreign exchange market is the market in which the currency of one country is exchanged for the currency of another.

• The foreign exchange rate is the price at which one currency exchanges for another.

• In April 1997==>$1 = 123 Japanese yen

50The Exchange Rate

51The Exchange Rate

Currency depreciation is the fall in the value of one currency in terms of another.

• The dollar depreciates if in later months it will buy less yen than before (e.g. 90 yen as compared to 114).

Currency appreciation is the rise in the value of one currency in terms of another currency.

52The Exchange Rate

Demand in the Foreign Exchange Market

The quantity of dollars demanded in the foreign exchange market depends upon:

1) The exchange rate

2) Interest rates in the United States and other countries

3) The expected future exchange rate

53The Exchange Rate

The Law of Demand for Foreign Exchange

• The demand for dollars is a derived demand.• They (RoW) buy dollars in order to buy

U.S.-made goods and services.

• Holding other things the same, the higher the exchange rate, the less is the quantity of dollars demanded.

54

D

The Demand for Dollars

Quantity (trillions of dollars per day)

Exc

hang

e ra

te (

yen

per

dolla

r)

50

150

1.1 1.2 1.4 1.50 1.3

100

Other things remainingthe same, a rise in the exchange rate decreasesthe quantity of dollars demanded...

…and a fall in theexchange rateincreases the quantityof dollars demanded

55The Exchange Rate

Why do exchange rates influence the quantity of dollars demanded?

1) Exports Effect

2) Expected Profit Effect

56The Exchange Rate

Changes in the Demand for Dollars

A change in any other influence on the dollars that people plan to buy in the foreign exchange market:

• Changes the demand for dollars

• Shifts the demand curve for dollars

57The Exchange Rate

The other factors that change the demand for dollars are:


interest rate differential = US rate – other rate


58

D2

D1

Changes in the Demand for Dollars


Exc

hang

e ra

te (

yen

per

dolla

r)

50

100

150

1.1 1.2 1.3 1.4 1.50

D0

Increase in thedemand for dollars

Decreasein thedemand fordollars

59

The demand for dollarsincreases if:

The demand for dollarsdecreases if:

Changes in theDemand for Dollars

• The U.S interest rate differential increases

• The expected future exchange rate rises

• The U.S. interest rate differential decreases

• The expected future exchange rate falls

60The Exchange Rate

Supply in the Foreign Exchange Market

The quantity of dollars supplied in the foreign exchange market depends upon:

1) The exchange rate



61The Exchange Rate

The Law of Supply for Foreign Exchange

• U.S. residents supply dollars in the foreign exchange market when they buy imports.

• Holding other things the same, the higher the exchange rate, the higher is the quantity of dollars supplied.

62The Exchange Rate

Why do exchange rates influence the quantity of dollars supplied?

1) Imports Effect

2) Expected Profit Effect

63

S

The Supply of Dollars


Exc

hang

e ra

te (

yen

per

dolla

r)

50

150

1.1 1.2 1.3 1.4 1.50

100

Other things remainingthe same, a rise in the exchange rate increasesthe quantity of dollars supplied...

…and a fall in theexchange ratedecreases the quantityof dollars supplied

64The Exchange Rate

Changes in the Supply of Dollars

A change in any other influence on the dollars that people plan to sell in the foreign exchange market:

• Changes the supply of dollars

• Shifts the supply curve of dollars

65The Exchange Rate

The other factors that change the supply of dollars are:



66

S2

S1

The Supply of Dollars


Exc

hang

e ra

te (

yen

per

dolla

r)

50

100

150

1.1 1.2 1.3 1.4 1.50

S0

Decrease in thesupply of dollars

Increase in thesupply of dollars

67

The supply of dollarsincreases if:

The supply of dollarsdecreases if:

Changes in theSupply of Dollars

• The U.S interest rate differential decreases

• The expected future exchange rate falls

• The U.S. interest rate differential increases

• The expected future exchange rate rises

68The Exchange Rate

Market Equilibrium

• If the exchange rate is too high, there is a surplus of dollars.

• If the exchange rate is too low, there is a shortage of dollars.

69The Exchange Rate

Market Equilibrium

At the equilibrium exchange rate, there is neither a shortage nor a surplus.

70Equilibrium Exchange Rate


Exc

hang

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yen

per

dolla

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50

100

150

1.1 1.2 1.3 1.4 1.50

S

D

Surplus at150 yen per dollar

Shortage at50 yen per dollar

Equilibrium at100 yen per dollar

72The Exchange Rate

Changes in the Exchange Rate

Why the Exchange Rate is Volatile

• Supply and demand are not independent of each other.

• A change in the expected future exchange rate or U.S. interest rate differential shifts both supply and demand.

73

S94

Exchange Rate Fluctuations


Exc

hang

e ra

te (

yen

per

dolla

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84

100

0 Q0

D94

S95

D95

1994 to 1995

74

S97

D97

Exchange Rate Fluctuations


Exc

hang

e ra

te (

yen

per

dolla

r)

84

0 Q0

S95

D95

123

1995 to 1997

75The Exchange Rate

Exchange Rate Expectations

Two expectations that effect the value of money are:

1) Purchasing power parity

2) Interest rate parity

76The Exchange Rate

Purchasing Power Parity

• Money is worth what it will buy.

• Purchasing power parity means equal value of money.

77The Exchange Rate

Purchasing Power Parity

• If prices increase in other countries but remain constant in the United States, people will generally expect that the value of the U.S. dollar is too low and will expect it to rise.

• Supply of and demand for dollars change

• The exchange rate changes

78The Exchange Rate

Interest Rate Parity

• Money is worth what it can earn.

• Interest rate parity means equal interest rates.

79The Exchange Rate

Interest Rate Parity

If the rate of return is higher in the United States than in another country, the demand for U.S. dollars rise and the exchange rate rises until expected interest rates are equal.

80The Exchange Rate

The Fed in the Foreign Exchange Market

• Since the Fed influences the supply of money, it also has an impact on the exchange rate

• The Fed can intervene in the foreign exchange market and smooth out fluctuations in the exchange rate

81

D2

Foreign ExchangeMarket Intervention


Exc

hang

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yen

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dolla

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120

0 1.3

S

D1

130

130

130

130

Target exchangerate

1.21.1 1.4 1.5

D0



4) Balance of official reserve transactions equals:• Net increase in foreign official reserve claims on the US

• less: the net increase in US official reserves

• Measures the degree to which monetary authorities in the US and abroad joined with other lenders to cover the US current account deficit• The bookkeeping offset to this is the official settlements

accounts balance


Official settlements accounts balance (a.k.a “the balance of payments”) equals:

• Current account balance

• plus: the non-reserve portion of the capital & financial account balance

• plus: the statistical discrepancy

• Measures the payments gap that official reserve transactions need to cover


Official settlements accounts balance (a.k.a “the balance of payments”)

• Played an important historical role as a measure of disequilibrium in international payments (still plays this role for many countries)

• Negative balance of payments (deficit) may signal a crisis – means a country is running down its foreign reserves (or borrowing foreign reserves)

International Finance International Finance .

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