Chapter 18 International Finance
I. Balance of Payments
A country’s balance of payments summarizes all economic transactions that occur during a given time period between residents of a country and residents of other countries. (Residents are firms, households, and governments)
A. International Economic Transactions
- Balance of payments statements measure a flow because they summarize transactions in a given time period (year).
- Transactions that don’t involve money are included. (Example: Food sent by non-profit world hunger organizations would be included.)
- Accounts are maintained according to double-entry book keeping. (Debits- payments to the rest of the world, Credits – inflow of receipts from the rest of the world)
A. Merchandise Trade Balance
Merchandise Trade Balance – Value of merchandise exported minus the value of merchandise imported
(trade in tangible products)
Value of U.S. exports – credit
Value of exports > Value of imports ŕ Trade surplus
Value of exports < Value of imports ŕ Trade deficit
- In 1998, the trade deficit exceeded $300 billion
B. Balance on Goods and Services
Balance on Goods and Services – The section of a country’s balance of payments account that measures the difference in value between a country’s exports of goods and services and its imports of goods and services.
Services are intangibles (transportation, insurance, banking, etc.)
**Includes income earned from foreign assets owned by Americans minus income earned from U.S. assets owned abroad.
Example: Irish tourist visits New York City (credit – exported service)
Computer service in
C. Unilateral Transfers
Unilateral Transfers – government transfers to foreign residents, foreign aid, personal gifts to friends and relatives abroad
Net Unilateral Transfers – The unilateral transfers (gifts and grants) received from abroad by residents of a country minus the unilateral transfers residents send abroad
- U.S. net transfers have been negative since WWII, except 1991 when U.S. government received transfers from foreign governments to support the Persian Gulf War.
Balance on current account – The section of a country’s balance-of-payments account that measures the sum of the country’s net unilateral transfers and its balance on goods and services (all transactions in currently produced goods and services plus net unilateral transfers)
D. Capital Account
Capital account – The record of a country’s international transactions involving purchases or sales of financial and real assets (borrowing, lending, and investments).
Americans purchase foreign assets ŕ capital outflow (- debit)
Foreign purchases of U.S. assets ŕ capital inflow (+ credit)
1917-1982 U.S. net capital exporter ŕ capital outflow (- debit) ŕ U.S. purchased foreign assets ŕ money earned on those assets improved current account balance (see ** above)
1983 high interest rates ŕ net inflow of capital (+ credit) ŕ Foreign purchase of U.S. assets ŕ Shows up as a surplus on the capital account ŕ Americans owe foreigners more and more ŕ The U.S. is now the largest net debtor nation.
Foreign investment adds to the capital and productivity of U.S. and promotes employment, but the return on foreign held assets flows to foreigners, not Americans.
Official reserve transactions account – The section of a country’s balance-of-payments account that reflects the flow of gold, Special Drawing Rights, and currencies among central banks
E. Statistical Discrepancy
Despite efforts to capture all international transactions, some go unreported.
Debits must equal credits.
A residual account called the statistical discrepancy was created to ensure that debits = credits.
The statistical discrepancy is a measure of net error and a way to satisfy the requirements of double-entry bookkeeping.
F. Deficits and Surpluses
Like households, nations operate under the following constraint: Expenditures cannot exceed income plus cash on hand and borrowed funds.
Current transactions – income and expenditure from imports, exports, and unilateral transfers
Capital transactions – international investments and borrowing
Because of the above constraint: Any surplus or deficit in one account must be balanced by other changes in the balance of payments account.
U.S. Balance of Payments 1998
+ flow of funds
from foreign residents to
flow of funds from
The current account is in deficit ŕ U.S. imports and unilateral transfers to foreigners exceeds the amount spent by foreigners on our exports and sent as unilateral transfers to us ŕ The deficit in the current account is offset by a surplus in the capital account.
Example: pg. 415, Exhibit 2
A deficit in a particular account should not necessarily be viewed as a source of concern, nor should a surplus be a source of satisfaction.
I. Foreign Exchange Rates and Markets
A. Foreign Exchange
Foreign exchange – foreign currency needed to carry out international transactions
Exchange rate – The price of one country’s currency measured in terms of another country’s currency
Currency depreciation – With respect to the dollar, an increase in the number of dollars needed to purchase 1 unit of foreign currency
Currency appreciation – With respect to the dollar, a decrease in the number of dollars needed to purchase 1 unit of foreign currency
B. Demand for Foreign Exchange
Example: Dollars and euros (Since January 1999, the official currency of 11 European countries, known collectively as the euro zone.)
- There is an inverse relationship between the dollar price of euros and the quantity demanded.
- A drop in the dollar price of the euro means it takes fewer dollars to purchase the euros needed to buy products made in the euro zone. (These products become cheaper.)
C. Supply of Foreign Exchange
- The supply of the euro is generated by the desire of euro zone citizens to acquire dollars.
An increase in the dollar-per-euro exchange rate makes
D. Determining the Exchange Rate
The exchange rate equates the quantity of euros demanded with the quantity supplied.
If the exchange rate is allowed to float, the market will clear continually.
E. Arbitrageurs and Speculators
Arbitrageur – A person who takes advantage of temporary geographic differences in the exchange rate by simultaneously purchasing a currency in one market and selling it in another market (There is little risk because they buy and sell simultaneously.)
Because of arbitrageurs, the exchange rates between specific currencies are nearly identical at any given time in the different markets around the world.
If the price of a euro is $1.00 in
Speculator – a person who buys or sells foreign exchange in hopes of profiting from fluctuations in the exchange rate over time (By taking risks, they try to make profit from market fluctuations.)
F. Purchasing Power Parity
Purchasing power parity (PPP) theory – The theory that exchange rates between two countries will adjust in the long run to reflect price level differences between the countries
ŕ A given basket of internationally traded goods should therefore sell for similar amounts around the world (except for differences reflecting transportation costs and the like).
Suppose a basket of goods sells for $11,000 in the
** The PPP theory does not usually explain exchange rates at any particular point in time because of trade barriers, central bank interventions, etc. But is a valuable long-run predictor.
- A country’s currency generally appreciates during periods when its inflation rate is lower than the rest of the world.
- A country’s currency generally appreciates when real interest rates are higher than in the rest of the world.
G. Flexible and Fixed Exchange Rates
Flexible exchange rates – Rates determined by the forces of supply and demand without government intervention
Fixed exchange rates – Rates pegged within a narrow range of values by central banks’ ongoing purchases and sales of currencies
- European Central Bank selects the rate of exchange they want between the euro and the dollar. It attempts to “peg” the rate within a narrow range around a particular value.
- If the value of the euro drops below the minimum acceptable exchange rate, monetary authorities sell dollars (decrease the value) and buy euros (increase the value).
** If the monetary authority has to keep selling foreign exchange to keep within the range of values they have chosen, they may run out of foreign currency reserves. What will they do then?
2. Attempt to reduce domestic demand for $ by imposing restrictions on imports etc.
3. Adopt contractionary fiscal/monetary policy to reduce income levels and decrease demand for foreign currency.
We will not cover the bottom of pg. 423 to the middle of pg. 425
II. The Current System: Managed Float- An exchange rate system that combines features of freely floating rates with intervention by central banks (to moderate fluctuations in exchange rates).
- Most countries peg their rates to a major currency.
- The ideal system would foster international trade, lower inflation, and promote a more stable economy.