Transcript International Finance and the Foreign Exchange

Chapter 18
International Finance
and the Foreign
Exchange Market
Slides to Accompany “Economics: Public and Private Choice 9th ed.”
James Gwartney, Richard Stroup, and Russell Sobel
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1. Foreign
Exchange Market
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Foreign Exchange Market



The market where one currency is traded
for another.
The exchange rate enables people in one
country to translate the prices of foreign
goods into units of their own currency.
An appreciation of a nation’s currency will
make foreign goods cheaper. A depreciation
will make foreign goods more expensive.
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2. Determinants of
the Exchange Rate
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Determinants of
the Exchange Rate

Under a flexible rate system, the exchange
rate is determined by supply and demand.



The dollar demand for foreign exchange originates
from the demand of Americans for foreign goods,
services, and assets (either real or financial).
The supply of foreign exchange originates from
sales of goods, services, and assets from
Americans to foreigners.
The foreign exchange market will bring the
quantity demanded and quantity supplied into
balance. As it does so, it will also bring the
purchases by Americans from foreigners into
equality with the sales of Americans to foreigners.
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Equilibrium in the
Foreign Exchange Market
• The dollar price of the pound is
measured on the vertical axis.
The horizontal axis indicates the
flow of pounds to the foreign
exchange market.
• Where the demand and supply
of pounds are in equilibrium,
the exchange rate is
$1.50 = 1 pound.
• At this equilibrium price, the
quantity demanded equals the
quantity supplied to the market.
• A higher price of pounds (such
as $1.80 = 1 pound), would lead
to an excess supply of pounds ...
causing the dollar price of the
pound to fall (depreciate).
• A lower price of pounds (such
as $1.20 = 1 pound), would lead
to an excess demand for pounds
… causing the dollar price of the
pound to rise (appreciate).
$ Price of
foreign
exchange
Supply
(sales to foreigners)
(for pounds)
Excess supply
of pounds
$1.80
$1.50
e
$1.20
Excess demand
for pounds
Demand
(purchases from foreigners)
Quantity of
Q
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foreign exchange
(pounds)
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Changes in the Exchange Rate

The following factors will cause a currency
to depreciate:



A rapid growth of income (relative to trading partners)
that stimulates imports relative to exports.
A higher rate of inflation than one's trading partners.
A reduction in domestic real interest rates (relative to
rates abroad).
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Growth of Income
and Growth of Imports
$ Price of
foreign
exchange
S
(for pounds)
• Other things constant, if
incomes increase in the United
States, U.S. imports will grow.
• The increase in imports will
increase the demand for pounds
b
$1.80
$1.50
a
(in the foreign exchange market) . . .
causing the dollar price of the
pound to rise from $1.50 to $1.80.
D2
D1
Quantity of
Q1
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Q2
foreign exchange
(pounds)
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Inflation With
Flexible Exchange Rates
S2
$ Price of
foreign
exchange
S1
(for pounds)
• If prices were stable in Britain
while the price level in the U.S.
increased by 50 percent . . .
the U.S. demand for British goods
(and pounds) would increase . . .
as U.S. exports to Britain would
be relatively more expensive they
would decline and thereby cause
the supply of pounds to fall.
• These forces would cause the
dollar to depreciate relative to
the pound.
$2.25
b
$1.50
a
D1
D2
Quantity of
Q1
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foreign exchange
(pounds)
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Changes in the Exchange Rate

The following factor will cause a currency
to appreciate:



A slower growth rate relative to one’s trading
partners.
A lower inflation than one's trading partners.
An increase in domestic real interest rates
(relative to rates abroad).
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Question for Thought:
1. If the exchange rate between the U.S. dollar and
Mexican peso fluctuates freely, indicate which
of the following will cause the dollar to appreciate
(or depreciate) relative to the peso.
(a) An increase in the quantity of drilling equipment purchased
in the U.S. by Pemex (the Mexican oil company) as a result
of a Mexican oil discovery?
(b) An increase in the U.S. purchase of crude from Mexico as a
result of development of Mexican oil fields?
(c) Higher real interest rates in Mexico, inducing U.S. citizens to
move their financial investments from U.S. to Mexican banks?
(d) Lower real interest rates in the U.S., inducing Mexican
investors to borrow dollars and then exchange them for pesos?
(e) Inflation in the United States and stable prices in Mexico?
(f ) An increase in the inflation rate from 2% to 10% in both the
U.S. and Mexico?
(g) An economic boom in Mexico, inducing Mexicans to buy
more U.S.–made automobiles, trucks, appliances, and TV sets?
(h) Attractive investment opportunities, inducing U.S. investors to
buy stock in Mexican firms?
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3. Balance of
Payments
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Balance of Payments




Any transaction that creates a demand for foreign
currency (and a supply of the domestic currency) in the
foreign exchange market is recorded as a debit,
or minus, item.
Example: Imports
Transactions that create a supply of foreign
currency (and demand for the domestic currency) on the
foreign exchange market are recorded as a credit,
or plus, item.
Example: Exports
Under a pure flexible system, the quantity demanded
will equal the quantity supplied in the foreign
exchange market.
Thus, in the balance of payments accounts:
total debits = total credits
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Balance of Payments

Current Account Transactions:

Current Account:
-- All payments (and gifts) related to the purchase
or sale of goods and services and income flows
during the current period.

The 4 categories of current account transactions are:




Merchandise trade
-- import and export of goods
Service trade
-- import and export of services
Income from investments
Unilateral transfers
-- gifts to and from foreigners
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Balance of Payments

Capital Account Transactions:

Capital Account:
-- Transactions that involve changes in the
ownership of real and financial assets.

The Capital Account includes both



Direct investments by foreigners in
the U.S. and by Americans abroad, and,
Loans to and from foreigners.
Under a pure flexible-rate system, official
reserve transactions are zero; therefore:


a current-account deficit
implies a capital-account surplus.
a current-account surplus
implies a capital-account deficit.
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U.S. Balance of Payments, 1997*
Debits Credits
Balance:
Deficit (-) or Surplus (+)
Current account:
1. U.S. Merchandise exports
2. U.S. Merchandise imports
3. Balance of merchandise
+ trade (1+2)
4. U.S. Service exports
5. U.S. Service imports
6. Balance on service
+ trade (4+5)
+679.3
-877.3
-198.0
+258.3
-170.5
-87.8
7. Balance on goods and services (3 +6)
8. U.S. Investment income on U.S. Assets abroad
9. Foreign income on foreign assets in the U.S.
10. Net investment income (8+ 9)
11. Net unilateral transfers
12. Balance on current account (7 + 10 + 11)
-110.2
+241.8
-247.1
-5.3
-39.7
-39.7
-155.2
Capital
account
13. Foreign investment in the U.S. (Capital inflow)
14. U.S. Investment abroad (capital outflow)
15. Balance on capital account (13+14)
+717.6
-577.2
16. Official reserve account balance
+140.4
+14.8
17. Total (12+15+16)
0.0
Source: Survey of Current Business, U.S. Dept. of Commerce, October 1998
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* Figures are in Billions of Dollars
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4. Macroeconomic
Policy in an
Open Economy
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Macroeconomic Policy
in an Open Economy

Monetary Policy and the Exchange Rate

An unanticipated shift to a more restrictive
monetary policy will:






raise the real interest rate,
reduce the rate of inflation, and,
at least temporarily, reduce aggregate
demand and the growth of income.
These factors will all cause the nation’s currency
to appreciate.
In turn, the currency appreciation along
with the inflow of capital will result in
a current account deficit.
In contrast, the effects of a more expansionary
monetary policy will be just the opposite:




lower interest rates, and,
an outflow of capital.
These factors lead to currency depreciation, and,
a shift toward a current account surplus.
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Macroeconomic Policy
in an Open Economy

Fiscal Policy and the Exchange Rate

An unanticipated shift to a more expansionary
fiscal policy will tend to:




an increase in real interest rates,
an inflow of capital, and,
these factors will cause the nation’s
current account to shift toward a deficit.
In contrast, the effects of a more restrictive
fiscal policy will be just the opposite:



lower interest rates, and,
an outflow of capital.
These factors move the economy
toward a current account surplus.
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5. Macroeconomic Policy,
Exchange Rates,
Capital Flows, and
Current Account Deficits
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The Exchange Rate, Current-Account Balance,
and Net Foreign Investment
Real Exchange Rate
trade-weighted value of the $
(March 1973=100)
130
• A more restrictive monetary
policy coupled with
expansionary fiscal policy –
will cause:
• higher real interest rates,
• an inflow of capital,
• currency appreciation,
• and a current account
deficit.
• This policy combination was
followed in the early 1980’s.
• Note:
- the appreciation of the $ (top)
- the increase in the current
account deficit (middle), and,
- the net inflow of foreign
capital (bottom).
120
110
100
90
80
1973
Year
1978
1983
1988
1993
1998
1978
1983
1988
1993
1998
1978
1983
1988
1993
1998
Current - Account
as a share of GDP
surplus (+) or deficit (-)
1
0
-1
-2
-3
-4
1973
Year
Net Foreign Investment
as a share of GDP
surplus (+) or deficit (-)
3
2
1
0
-1
-2
1973
Year
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6. How Do Current
Account Deficits
Affect the Economy?
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How do Current Account
Deficits Affect the Economy?



Under a flexible exchange rate system, an inflow
of capital implies a current account deficit.
An outflow of capital implies a current account
surplus.
A trade deficit is not necessarily bad. Rapid growth
will stimulate imports. A healthy growing economy
that offers attractive investment opportunities will
often generate an inflow of capital. These factors
are not bad. However, both are likely to cause a
current account trade deficit.
A nation’s trade deficit or surplus is an aggregation
of the voluntary choices of businesses and
individuals. In contrast with a budget deficit of an
individual, business, or government, there is no
legal entity that is responsible for the trade deficit.
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7. International Finance and
Exchange Rate Regimes
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Exchange Rate Regimes

There are 3 major types of exchange
rate regimes:




flexible rates,
fixed- rate (unified currency), and,
pegged exchange rates.
Examples of a Fixed Rate (Unified) System:



Nations of the European Union have recent
adopted a unified currency system.
Countries can also use a currency board to
unify their currency with another.
The currencies of Hong Kong, Argentina, and
Panama are unified with the U.S. dollar.
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Exchange Rate Regimes

Pegged Rate Systems:

A nation can either


follow an independent monetary policy and
allow its exchange rate to fluctuate, or,
tie its monetary policy to the maintenance of the
fixed exchange rate.
It cannot, however,


maintain the convertibility of its currency at the
fixed exchange rate while following a monetary
policy more expansionary than that of the
country to which the domestic currency is tied.
Attempts to peg rates and follow a monetary
policy that is too expansionary have lead to
several recent financial crises—a situation
where falling foreign currency reserves
eventually force the country to forego the
pegged exchange rate.
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Questions for Thought:
1. Explain why a current account balance and a
capital account balance must sum to zero under a
pure flexible-rate system.
2. Will a flexible exchange rate lead to a balance
between merchandise exports and imports? Why or
why not? What exactly is a trade deficit? Is it
necessarily bad? Why or why not?
3. Several politicians have suggested that the federal
government should run a sizeable budget surplus
during the next decade in order to "save social
security." If the federal government does run a large
surplus, what is the expected impact on interest rates,
the inflow of capital, the current account deficit, and
the foreign exchange value of the dollar? Explain.
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End
Chapter 18
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