Transcript International Finance

International Finance
EXCHANGE RATES & BALANCE OF PAYMENTS
CHAPTER 36
UNIT 8B, DAY 1
Today’s Agenda
1st
• 2 Closed Economies
• Market Day in Beantown & Pastaland
2nd
• Open Economies
• Currency Markets
3rd
• Open Economies
• Market Day in Beantown & Pastaland
4th
• Debriefing and Exchange Rate Activity
Simulation Objective:
EXPLAIN HOW MONEY AND PRICES ARE
RELATED THROUGH MARKETS.
2 Countries, 2 Currencies
Beantown
Pastaland
 Currency: Beans
 Currency: Macaroni
 Money Supply: 200
 Money Supply: 100
Beans
 Products:
1.
2.
3.
4.
1 pass for a skipped
discussion reply
A spiffy sticker set
Pistachios
Hershey Kisses
Noodles
 Products
1.
2.
3.
4.
1 pass for guaranteed 2
pt EC on Unit 8 Quest
A spiffy sticker set
Candy Bar
Life Saver Mints
Closed Economy Auctions
Beantown
Pastaland
 Auction Items 1-3
 Auction Items 1-3
1.
2.
3.
1 pass for missed
discussion reply
A spiffy sticker set
Pistachios
Record prices for 1-3
 Distribute item 4:



1 piece to 6 beans
Collect remaining
currency
1.
2.
3.
1 pass for guaranteed 2 pt
EC on Unit 8B quest
A spiffy sticker set
Candy Bar
Record prices for 1-3
 Distribute item 4


1 piece to 3 noodles
 Collect remaining
currency
Auction 1 Debriefing
Pastaland
Beantown
Item
Price (beans)
Item
Discussion Reply
Extra Credit
Stickers
Stickers
Pistachios
Candy Bar
Price (noodles)
1. Why did the price for stickers differ in Beantown and
Pastaland?
2. Why did prices in Beantown and Pastaland differ overall?
3. Are the people in Beantown wealthier than those in
Pastaland?
Open Economy Auctions:
same goods BUT 1st trade for other country’s currency to buys its goods
 Trade beans for noodles to buy “foreign” goods
 5 minutes to trade: Report all exchanges to me
Transaction
1
2
3
4
5
6
7
8
9
10
Exchange Rate (Beans : Noodles)
Open Economy Auctions
Beantown
Pastaland
 Auction Items 1-3
 Auction Items 1-3
1.
2.
3.
1 pass for discussion reply
A spiffy sticker set
Pistachios
Record prices for 1-3
 Distribute item 4:



1 piece to 6 beans
Collect remaining
currency
1.
2.
3.
1 pass for guaranteed 2 pt
EC on Unit 8 Test
A spiffy sticker set
A chocolate bar
Record prices for 1-3
 Distribute item 4


1 piece to 3 noodles
 Collect remaining
currency
Auction 2 Debriefing
Pastaland
Beantown
Item
Price (beans)
Item
Discussion Reply
Extra Credit
Stickers
Stickers
Pistachios
Candy Bar
Price (noodles)
1. Why did the price for stickers differ in Beantown and
Pastaland?
2. Why did prices in Beantown and Pastaland differ overall?
3. Are the people in Beantown wealthier than those in
Pastaland?
Who has traveled abroad
recently?
HOW FAR DID YOUR DOLLARS GO?
Big Mac Index
What was the exchange rate today?
 Beans to Noodles?
 Noodles to Beans?
Why do people want currency from other nations?
 In the simulation?
 In real life?
Types of Exchange Rates
 Flexible (Floating) Rate

Currency value
determined by the supply
and demand for a
currency

Most currencies today are
fairly flexible and
fluctuate

Examples?
 Fixed Rates

Currency value
determined by a country’s
government

Simulation could be fixed
if rate of beans to noodle
set in advance

Examples?
Why do exchange rates fluctuate?
 Changes in preferences for foreign goods
 Changes in price level in different countries
 Changes in interest rates in different countries
 Changes in incomes in different countries
 Speculation
Working with Foreign Exchange Rates
 Converting US$ to foreign currency:
 Multiply the cost of the item in the US by the exchange rate

I.e. If a cup of coffee costs $3.00 in the US in 2002, it would
cost
ER Rate
Cost in Foreign Currency
Japanese ¥ per US $ 124.09
=124.09*3 =372.27¥
Canadian $ per US $ 1.54
=1.54*3
=4.62 C$
British £ per US $
=0.69*3
=2.07£
.69
Working with Foreign Exchange Rates
What were Molly’s expenditures for 3 goods in 1996?
1.
a)
b)
c)
How many yen would this cost?
How many Canadian dollars would this cost?
How many British pounds would this cost?
In 2002, US prices haven’t changed, but…
2.
a)
b)
c)
How many yen would this cost?
How many Canadian dollars would this cost?
How many British pounds would this cost?
What happened to prices for each country from 1996 to
2002?
4. What happened to Japanese prices over the period?
3.
International Finance
EXCHANGE RATES
CHAPTER 36
UNIT 8B, DAY 2
Big Ideas from Yesterday
 Why do people trade currency?
 People trade currency to buy goods from other countries.
 What sets the exchange rate among 2 currencies?
 Most currencies are FLEXIBLE & change relative to S & D
 If exchange rate set arbitrarily, then considers FIXED
 How do changes in the exchange rate impact prices?
 Changes in exchange rate cause the prices of imports to change
(even when prices in the home country have not)
Agenda for 1/7
 Currency Markets & Exchange Rates Overview (15 min)
 Practice with Calculating Exchange Rates (15 min)
 Market Fluctuations & Exchange Rates Intro (15 min)
 Practice with Graphing Market Fluctuations (30 min)
 Exchange Rate Headlines (15 min)
Exchange Rates
 Def: price of one country’s currency expressed in
terms of another’s
 Example: 1 dollar=.73 euros and 1 euro=1.36 dollars
 Other currencies?
Foreign Exchange Markets
 Big Idea: Money is a commodity that facilitates
exchange
 Implications of the Idea:
 Exchange Rate=Price of Money
 Price of money set by forces of Supply and Demand
Value of a Dollar
 When you buy Euro denominated good…
Dollar Price of Good = Euro Price of Good X Dollar Price of Euros
Value of a Dollar
 So…
 If a Uggs Cost $131 Australian Dollars and 1 US dollar will buy
you 1.1 Australian dollars
 Then, Americans should be able to buy Uggs for….


$119.09 US
What if 1 US could now only buy 0.5 Australian dollars?

$262 US
 As the price of a foreign currency rises, demand for
that currency (and the imports it buys) will decline
Sources of Foreign Demand for US Money

Foreign demand for American exports.


Foreign demand for American investments.


British citizens want to buy a Ford (need Dollars not Pounds)
Dubai decides to buy a stake in U.S. shipping companies & ports
Speculation.

Citizens of Yemen decide to transfer their money into dollars
because their money is losing value
The Demand Curve
 Downward sloping
 Why? The demand for dollars arises from the foreign demand
for U.S. exports and investments.
 As dollars become cheaper, all American exports
effectively fall in price.
LO1
Sources of Foreign Supply of US Money

American demand for imports.


American investments in foreign countries.


You decide to visit Cancun on Senior Week & need Pesos
Ford decides to open a new plant in China & needs Yuan
Speculation.

Americans worry our currency is losing value (and will continue to
do so)convert Dollars to Euros perceived as safer
The Supply Curve for Dollars
 Upward sloping
 Why? The supply of dollars arises from the US demand for imports
and investments abroad.
 If the value of the dollar rises, Americans can buy
more Euros (therefore, we will supply more dollars).

LO1
Buy more Euro denominated goods
Foreign-Exchange Market
EURO PRICE OF DOLLAR
(euros per dollar)
3.0
LO2
2.5
2.0
Supply of dollars
1.5
0.90
0.5
0
Equilibrium
Demand for dollars
QUANTITY OF DOLLARS per time
period
Depreciation and Appreciation
 Appreciation refers to a rise in the price of one
currency relative to another.
 Depreciation (currency) refers to a fall in the
price of one currency relative to another.
 One country’s depreciation is offset by another’s
appreciation
LO2
Market Dynamics
 Foreign Exchange Market Equilibrium is unstable

Shifts in Supply/Demand Curves
Change in Exchange Rates
 Change in Balance of Payments

LO2
Market Forces
 Some of the more important reasons supply and/or
demand may shift:
Relative income changes.
Increase in Country A’s income relative to Country BA
demands more imports from B and increases supply of its
currency to ForEx Market Country A’s currency
depreciates relative to Country B
Relative price changes.
Changes in product availability.
Relative interest-rate changes.
Higher interest rates in country A lead investors in country
B to shift their deposits to A  higher demand for A’s
currency and A appreciates
LO2
Speculation.
A word about order…
 Different fluctuations impact foreign exchange
markets in the short, medium, and long run.

Short Run: Changes in Interest Rates


Medium Run: Changes in Economic Activity (X-M mix)


Higher rates lead to appreciation
Faster economic growth leads to depreciation
Long Run: Changes in Price Level

Lower inflation rates lead to appreciation
Practice
Problem #1
Draw foreign currency
markets for the Swiss
Franc and the French
Euro. If real incomes in
Switzerland rise at a
faster rate than those in
France, what will
happen to the exchange
rate between Euros and
Francs?
Practice
Problem #2
Draw foreign currency
markets for the Israeli
Shekel and South
African Rand. What
would happen interest
rates rose in Israel
relative to those in
South Africa?
Practice
Problem # 3
Draw foreign currency
markets for the Russian
Ruble and Brazilian
Real. What would
happen if the price level
in Russia rose relative
to the price level in the
Brazil?
Practice
Problem # 4
Draw foreign currency
markets for the US
Dollar and British
Pound. What would
happen in the short run
if the Fed bought
$600B in bonds while
the Bank of England
made no change to
monetary policy?
Headlines for Currency
Appreciation/Depreciation
 Create a fictitious scenario for one of the market
forces governing foreign exchange markets




How do the supply or demand curves shift? Why?
What currency appreciates in value?
What currency depreciates in value?
Graph your work to show original equilibrium & the new
equilibrium.
International Finance Wrap Up
BALANCE OF PAYMENTS
EXCHANGE RATES—FIXED OR FLOATING
UNIT 8B, DAY 3
Agenda for 1/8
 Overview of the Balance of Payments (10 min)
 Practice with the Balance of Payments (30 min)
 Exchange Rates: Fixed or Floating (20 min)
 Unit 8 Study Guide (30 min)
The Balance of Payments
 The balance of payments is a summary of a
country’s international economic transactions in a
given period of time.
 It is an accounting statement of all international
money flows in a given time period.
 Foreign Exchange Market Equilibrium:
 Equilibrium Price=Exchange Rate
 Equilibrium Quantity=Balance of Payments
Balance of Payments—Always Offset
Current Account (Deficit)
Capital Account (Surplus)
 Trade Balance =
 Assets bought and sold
exports-imports
 Plus
 Unilateral Transfers
(i.e. foreign
remittances)
across US borders
 Calculated as…
 Foreign Purchases of US
Assets (i.e. Treasury Bills)
 Minus
 US Purchases of Foreign
Assets
Capital-Account Balance
 The capital-account surplus must equal the current-
account deficit.
Net
balance of
payments
=
currentaccount
balance
–
capitalaccount
balance
= 0
•Why?
•We “finance” our current account deficit by running a
capital account surplus
•I.e. As long as China keeps buying U.S. Treasury Bills,
we can buy Chinese imports
U. S. Balance of Payments, 2006
Item
Amount (in billions)
1. Merchandise exports
$1,035
2. Merchandise imports
(1,880)
3. Service exports
431
4. Service imports
(349)
Trade Balance (items 1-4)
–763
5. Income from U.S. overseas investments
621
6. Income outflow for foreign U.S. investments
(630)
7. Net U.S. government grants
(28)
8. Net private transfers and pensions
(56)
Current-Account Balance (items 1-8)
–856
9. U.S. capital inflow
1,464
10. U.S. captial outflow
(1,043)
11. Increase in U.S. official reserves
12. Increase in foreign official assets in U.S.
Capital-Account Balance (items 9-12)
13. Statistical discrepancy
Net Balance (items 1-13)
(2)
300
723
133
0
Practice with Balance of
Payments
SECTION 1: 10 MINUTES
Balance of Payments—US and Germany
(current account)
US
Debit
US sells $1 M of steel to GER builder
US Bank pays $5M interest to GER
depositors
US citizens pay $3M for Mercedes
US firm get $2M dividend on GER
investments
GER tourists spend $3M in US, US
tourists spend $5M in GER
GER pays $1M to a US shipping line
US exchange students spend $8M for
tuition in Bonn, GER
GER govt buys $10M in US weapons
TOTAL
Germany
Credit
Debit
$1m
$1m
Credit
US Balance of Payments (Current & Capital)
Credits
Debits
Current Account
US goods exports
$+150
US goods imports
-200
Balance of Trade
_________________
US service exports
+75
US service imports
-60
Balance of Trade in G & S
_________________
Capital Account
Capital Inflows to US
+80
Capital Outflows from US
-55
Balance on Capital Acct
_________________
Current & Capital Balance
_________________
Official Reserves
_________________
$0
Fixed or Floating
RESISTANCES AND RESPONSE TO FIXED AND
FLOATING EXCHANGE RATES
Micro Interests
 People who trade or invest in world markets want a
solid basis for forecasting future costs, prices, and
profits.
 Fluctuating currency exchange rates are an
unwanted burden on trade.
LO3
Micro Interests
 A change in the price of a country’s money
automatically alters the price of all of its exports and
imports.
 If the Dollar Appreciates…


Foreign Imports to the U.S. cost LESS (foreigners win)
U.S. exports to the world cost MORE (foreigners win)
 Why are the Chinese resistant to allowing their
currency to appreciate?
LO3
Macro Interests
 A micro problem that becomes widespread enough
can turn into a macro one.
 The huge U.S. trade deficits of the 1980s effectively
exported jobs to foreign nations.

LO3
Leads to unemployment
U.S. a Net Debtor
 From 1914 to 1984, the United States was a net
creditor in the world economy.
 Since 1985, the United States has been a net debtor.
U.S. a Net Debtor
 U.S. debtor status can complicate domestic policy.
A sudden capital flight from U.S.
assets could severely weaken the
dollar and disrupt the domestic
economy.
Exchange-Rate Intervention
 Governments often intervene in foreign-exchange
markets to achieve greater exchange-rate stability.
 Bretton Woods 1944
LO2
Fixed Exchange Rates
 Under a gold standard, each country determines that
its currency is worth so much gold.

LO2
Gold Standard - An agreement by countries to fix the price
of their currencies in terms of gold; a mechanism for fixing
exchange rates.
Balance of Payment Problems
 Market supply and demand of currency naturally
shift.
 This moves the equilibrium exchange rate away from
the fixed exchange rate.
LO2
Fixed Rates and Market Imbalance
Dollar Price of Pounds
If there is an increase demand for British goods under a fixed rate…
D1
S1
Excess demand
for pounds
e2
e1
0
LO2
D2
qS
qD
Quantity of Pounds
Balance of Payment Problems
 Excess demand for a foreign currency implies:
A balance-of-payments deficit for the
domestic nation (U.S)
Excess demand for Pounds
A balance-of-payments surplus for the
foreign nation (Britain).
Excess supply of Pounds
LO2
Balance of Payment Problems
 There are only two ways to deal with balance-of-
payments problems when there are fixed exchange
rates:
Opt1: Alter market supply or demand so
that they intersect at the established
exchange rate.
Opt 2: Allow exchange rates to change.
LO2
The Need for Reserves
 The Treasury could help maintain the officially
established exchange rate by selling some of its
foreign exchange reserves.

LO2
Foreign-Exchange Reserves - Holdings of foreign
exchange by official government agencies, usually the central
bank or treasury.
The Impact of Monetary Intervention
Dollar Price of Pounds
Correcting the balance of payments deficit by selling foreign exchange…
D2
S1
e1
Excess
demand
0
qS
qD
Quantity of Pounds
LO2
S2
The Role of Gold
 Gold reserves are a potential substitute for foreign-
exchange reserves.

LO2
Gold Reserves - Stocks of gold held by a government to
purchase foreign exchange.
Domestic Adjustments
 Trade protection can be used to prop up fixed
exchange rates.
 Deflationary (or restrictive) policies help correct a
balance-of-payments deficit by lowering domestic
incomes and thus the demand for imports.


LO2
Contractionary Fiscal Policies?
Contractionary Monetary Policies?
COSTS of Domestic Adjustments
BALANCE OF
PAYMENTS DEFICITS
LO2
BALANCE OF
PAYMENTS SURPLUS
Flexible Exchange Rates
 Flexible exchange rates is a system in which
exchange rates are permitted to vary with market
supply and demand conditions.

Also called floating exchange rates.
 With flexible exchange rates, the quantity of foreign
exchange demand always equals the quantity
supplied.
LO2
Flexible Exchange Rates
 Someone is always hurt (and others are helped) by
exchange-rate movements.
Currency depreciation may cause
domestic cost-push inflation by pushing
up input prices.
Currency appreciation reduces exports
by raising the price of domestically
produced goods to foreigners.
LO2
Speculation
 Speculators often counteract short-term changes in
foreign-exchange supply and demand.
 Sometimes, speculators move “with the market” and
make swings in the exchange rate even more
extreme.
LO2
Managed Exchange Rates
 Governments may buy and sell foreign exchange for
the purpose of narrowing exchange-rate
movements.
 Such limited intervention in foreign-exchange
markets is referred to as managed exchange rates.

LO2
AKA: “Dirty Floats”