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)



II.                Current Accounts in the Balance of Payments


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 U.S. imports – debit (U.S. residents pay for imports.)


Value of exports > Value of imports à Trade surplus

Value of exports < Value of imports à 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 Ireland enters policy information for an U.S. insurance company (debit – imported service, paid for by U.S. company)



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 à capital outflow (- debit)

Foreign purchases of U.S. assets à capital inflow (+ credit)



1917-1982 U.S. net capital exporter à capital outflow (- debit) à U.S. purchased foreign assets à money earned on those assets improved current account balance (see ** above)


1983 high interest rates à net inflow of capital (+ credit) à Foreign purchase of U.S. assets à Shows up as a surplus on the capital account à Americans owe foreigners more and more à 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 U.S. residents

-        flow of funds from U.S. residents to foreign residents


The current account is in deficit à U.S. imports and unilateral transfers to foreigners exceeds the amount spent by foreigners on our exports and sent as unilateral transfers to us à 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.


In the U.S., the deficit in the current account has been offset by an inflow of capital from abroad. As a result of the net inflow of capital, foreigners are acquiring more claims on U.S. financial assets.


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.)


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

-         Whenever U.S. residents need euros, they must go to the foreign exchange market and pay for them in dollars.

-         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 U.S. goods cheaper for euro zone residents. If prices of U.S. goods are cheaper, Europeans will demand more, and the supply of euros will increase.



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.

Example: U.S. incomes increase. What happens to the equilibrium exchange rate?



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.


Example: If the price of a euro is $1.00 in New York and $1.01 in Frankfurt, an arbitrageur can purchase $10,000,000 euros in New York and sell them in Frankfurt for $10,100,000 (profit 100,000 minus trading costs). The arbitrageur increases the demand for euros in N.Y. and increases the supply of euros in Frankfurt, eliminating the difference in price.



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


à 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).


Example: Suppose a basket of goods sells for $11,000 in the U.S. sells for 10,000 euro in euro zone. According to PPP theory, the exchange rate should be $1.10 per euro. If it were not, (suppose the exchange rate was $1.00 per euro) you could buy the basket in the euro zone for 10,000 euro and sell it for $11,000 in the U.S. You could then exchange the $11,000 for 11,000 euro for a profit of 1,000 euro. Selling dollars and buying euros drives up the price of the euro.



** 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?

1.      Devaluation


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.



1.      inflationary

2.      volatile


- The ideal system would foster international trade, lower inflation, and promote a more stable economy.