Transcript Principles of Economics Third Edition by Fred Gottheil

Chapter 32
Exchange Rates, Balance of
Payments, and International Debt
© 2005 Thomson
Economic Principles
Exchange rates
Foreign exchange markets
Appreciation and depreciation
of currencies
Floating and fixed exchange
rates
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Economic Principles
Arbitrage
Devaluation
Balance of payments
International debt and debt
service
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The Foreign Exchange Market: The
Buying and Selling of Currencies
Foreign exchange market
• A market in which currencies of different
nations are bought and sold.
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The Foreign Exchange Market: The
Buying and Selling of Currencies
Exchange rate
• The number of units of foreign currency
that can be purchased with one unit of
domestic currency.
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The Foreign Exchange Market: The
Buying and Selling of Currencies
1. Suppose that a kite costs 40
yaps, and the exchange rate is 10
yaps to the dollar. What is the
dollar price of the kite?
• 40 yaps/10 = 4 dollars.
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EXHIBIT 1 FOREIGN EXCHANGE MARKET
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Exhibit 1: Foreign Exchange Market
At $2 per yap, is the foreign
exchange market in Exhibit 1 in
equilibrium, or is there an excess
demand or excess supply of yaps?
• Since the equilibrium price is $3 per
yap, at $2 per yap there would be an
excess demand for yaps.
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Exhibit 1: Foreign Exchange Market
At $4 per yap, is the foreign
exchange market in Exhibit 1 in
equilibrium, or is there an excess
demand or excess supply of yaps?
• Since the equilibrium price is $3 per
yap, at $4 per yap there would be an
excess supply of yaps.
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The Foreign Exchange Market: The
Buying and Selling of Currencies
2. Why is the demand curve for
foreign currency downward-sloping?
• When the price of a foreign currency
declines, the quantity of that foreign
currency demanded increases.
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The Foreign Exchange Market: The
Buying and Selling of Currencies
2. Why is the demand curve for
foreign currency downward-sloping?
• For example, if a dollar can buy more
yaps than before, then a dollar can also
buy more yap-priced goods and services
than before.
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The Foreign Exchange Market: The
Buying and Selling of Currencies
2. Why is the demand curve for
foreign currency downward-sloping?
• As a result, Americans wish to exchange
dollars for more yaps in order to buy more
yap-priced goods, increasing the quantity of
yaps demanded in the foreign
exchange market.
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The Foreign Exchange Market: The
Buying and Selling of Currencies
3. Why is the supply curve for
foreign currency upward-sloping?
• When the price of a foreign currency
rises, then the purchasing power of the
foreign currency rises when it comes to
buying imported goods and services.
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The Foreign Exchange Market: The
Buying and Selling of Currencies
3. Why is the supply curve for
foreign currency upward-sloping?
• For example, if it takes more dollars to
buy a yap, then it takes fewer yasps to buy
a dollar, and so the price of American
goods are cheaper for people who use the
yap.
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The Foreign Exchange Market: The
Buying and Selling of Currencies
3. Why is the supply curve for
foreign currency upward-sloping?
• As a result, people who use yaps wish to
exchange more yaps for dollars in order to
buy more American goods, increasing the
quantity of yaps supplied in the foreign
exchange market.
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The Foreign Exchange Market: The
Buying and Selling of Currencies
4. Which of the following will cause
an increase in the demand for yaps?
a. Decreasing American incomes
b. Increasing yap-priced interest rates
c. Increasing American interest rates
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The Foreign Exchange Market: The
Buying and Selling of Currencies
4. Which of the following will cause
an increase in the demand for yaps?
a. Decreasing American incomes
b. Increasing yap-priced interest rates
c. Increasing American interest rates
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EXHIBIT 2 EFFECT OF AN INCREASE IN THE DEMAND
FOR YAPS ON THE DOLLARS-FOR-YAPS
RATE OF EXCHANGE
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Exhibit 2: Effect of an Increase in
the Demand for Yaps on the
Dollars-for-Yaps Rate of Exchange
1. After the increase in demand from D1 to
D2, Is there excess supply, excess demand,
or equilibrium at an exchange rate of $3
per yap?
• There is excess demand of (70 - 30) = 40
thousand yaps.
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Exhibit 2: Effect of an Increase in
the Demand for Yaps on the
Dollars-for-Yaps Rate of Exchange
2. After the increase in demand from
D1 to D2, what is the new equilibrium
exchange rate?
• The new equilibrium exchange rate is
$5 per yap.
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The Foreign Exchange Market: The
Buying and Selling of Currencies
5. Which of the following will cause
a decrease in the supply of yaps?
a. Decreasing American tastes for yappriced goods
b. Decreasing yap-priced interest rates
c. Decreasing yap-priced incomes
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The Foreign Exchange Market: The
Buying and Selling of Currencies
5. Which of the following will cause
a decrease in the supply of yaps?
a. Decreasing American tastes for yappriced goods
b. Decreasing yap-priced interest rates
c. Decreasing yap-priced incomes
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EXHIBIT 3 EFFECT OF AN INCREASE IN THE SUPPLY OF
YAPS ON THE DOLLARS-FOR-YAPS RATE OF
EXCHANGE
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Exhibit 3: Effect of an Increase in the
Supply of Yaps on the Dollars-for-Yaps
Rate of Exchange
1. After the increase in supply from S1
to S2, is there excess supply, excess
demand, or equilibrium at an exchange
rate of $3 per yap?
• There is an excess supply of (50 - 30) = 20
thousand yaps.
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Exhibit 3: Effect of an Increase in the
Supply of Yaps on the Dollars-for-Yaps
Rate of Exchange
2. After the increase in supply from S1
to S2, what is the new equilibrium
exchange rate?
• The new equilibrium exchange rate is
$2 per yap.
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Floating Exchange Rates
Floating exchange rate
• An exchange rate determined strictly by
the demands and supplies for a nation’s
currency.
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Floating Exchange Rates
Appreciation
• A rise in the price of a nation’s currency
relative to foreign currencies.
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Floating Exchange Rates
Depreciation
• A fall in the price of a nation’s currency
relative to foreign currencies.
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Floating Exchange Rates
1. Complete the sentence:
When journalists say that the dollar
has “weakened,” they mean that
the dollar has _____ in value.
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Floating Exchange Rates
1. Complete the sentence:
When journalists say that the dollar
has “weakened,” they mean that the
dollar has depreciated in value.
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Floating Exchange Rates
2. If the dollar has appreciated in
value relative to the yap, then
which of the following is true:
a. The exchange rate has more yaps per
dollar than before.
b. The exchange rate has fewer yaps
per dollar than before.
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Floating Exchange Rates
2. If the dollar has appreciated in
value relative to the yap, then
which of the following is true:
a. The exchange rate has more yaps per
dollar than before.
b. The exchange rate has fewer yaps
per dollar than before.
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Tourists at the Mall
Has the U.S. dollar appreciated
or depreciated in value relative to
the Japanese yen between 1960
and 1996?
• Depreciated in value.
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Tourists at the Mall
Has the U.S. dollar appreciated
or depreciated in value relative to
the Japanese yen between 1960
and 1996?
• In 1960 the exchange rate was 358 yen
per dollar. By 1996 there were only 131
yen per dollar.
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Floating Exchange Rates
Arbitrage
• The practice of buying a foreign currency
in one market at a low price and selling it
in another at a higher price.
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Floating Exchange Rates
3. How might floating exchange
rates make international trade
riskier?
• Suppose that the price of an internationally
traded good changes during the time between
when a purchase is negotiated and the
product is delivered.
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Floating Exchange Rates
3. How might floating exchange
rates make international trade
riskier?
• Then the change in exchange rates is like
an unforeseen change in the price of the
good, which redistributes the gains from
trade in an unforeseen way.
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Floating Exchange Rates
Fixed exchange rate
• A rate determined by government and
then maintained through the process of
buying and selling quantities of its own
currency on the foreign exchange market.
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EXHIBIT 4A TRADE UNDER FREE AND FIXED EXCHANGE
RATES
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EXHIBIT 4B TRADE UNDER FREE AND FIXED EXCHANGE
RATES
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Exhibit 4: Trade Under Free
and Fixed Exchange Rates
1. If there is a system of free or
floating exchange rates, then
what happens if the demand for a
foreign currency increases?
• The exchange rate (dollars per unit of
foreign currency) increases and there is
neither excess demand nor excess supply
of the foreign currency.
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Exhibit 4: Trade Under Free
and Fixed Exchange Rates
2. If there is a system of fixed
exchange rates, then what happens
if the demand for a foreign
currency increases?
• Since the exchange rate cannot change,
an increase in demand will create excess
demand for the foreign currency.
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Exhibit 4: Trade Under Free
and Fixed Exchange Rates
3. If there is excess demand for yaps
under a system of fixed exchange rates,
what will the yap government need to
do to eliminate the excess demand for
the yap?
• The yap government will need to exchange
some of its own yaps for dollars on the foreign
exchange market.
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Exhibit 4: Trade Under Free
and Fixed Exchange Rates
3. If there is excess demand for yaps
under a system of fixed exchange rates,
what will the yap government need to
do to eliminate the excess demand for
the yap?
• This will increase the supply of yaps on the
foreign exchange market and eliminate the
excess demand.
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Exhibit 4: Trade Under Free
and Fixed Exchange Rates
3. If there is excess demand for yaps
under a system of fixed exchange rates,
what will the yap government need to
do to eliminate the excess demand for
the yap?
• In order for the yap government to do this, it
must have sufficient stock of yaps to exchange
for dollars.
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Exhibit 4: Trade Under Free
and Fixed Exchange Rates
4. Continuing the yap example, what
might the yap government be forced to
do if it did not have a sufficient
quantity of yaps on reserve to
eliminate the excess demand?
• The yap government might be forced to
borrow yaps from another country, or even
agree to increase the exchange rate ($ per yap).
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Floating Exchange Rates
Foreign exchange reserves
• The stock of foreign currencies a
government holds.
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Floating Exchange Rates
Devaluation
• Government policy that lowers the nation’s
exchange rate; its currency instantly is
worth less in the foreign exchange market.
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Floating Exchange Rates
4. In which of the following circumstances
would a country most likely be forced into a
devaluation of its currency:
a. The excess supply of its currency in the foreign
exchange market exceeds its foreign exchange
reserves.
b. The excess demand for its currency in the
foreign exchange market exceeds its foreign
exchange reserves.
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Floating Exchange Rates
4. In which of the following circumstances
would a country most likely be forced into a
devaluation of its currency:
a. The excess supply of its currency in the foreign
exchange market exceeds its foreign exchange
reserves.
b. The excess demand for its currency in the
foreign exchange market exceeds its foreign
exchange reserves.
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Floating Exchange Rates
Import controls
• Tariffs and quotas used by government
to limit a nation’s imports.
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Floating Exchange Rates
Exchange controls
• A system in which government, as the
sole depository of foreign currencies,
exercises complete control over how these
currencies can be used.
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Floating Exchange Rates
International Monetary Fund (IMF)
• An international organization formed to
make loans of foreign currencies to
countries facing balance of payments
problems.
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Balance of Payments
Balance of payments
• An itemized account of a nation’s foreign
economic transactions.
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Balance of Payments
Balance on current account
• A category that itemizes a nation’s
imports and exports of goods and services,
income receipts and payments on
investment, and unilateral transfers.
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EXHIBIT 5 THE U.S. BALANCE OF PAYMENTS ACCOUNT:
2002 ($ BILLIONS)
Source: Survey of Current Business (Washington, D.C.: U.S. Department of Commerce, February 2003).
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Exhibit 5: The U.S. Balance of
Payments Account: 2002 ($ billions)
In which of the following categories
of the U.S. balance of payments did
the U.S. run a surplus in 2002?
a. Balance of trade
b. Balance on current account
c. Balance on capital account
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Exhibit 5: The U.S. Balance of
Payments Account: 2002 ($ billions)
In which of the following categories
of the U.S. balance of payments did
the U.S. run a surplus in 2002?
a. Balance of trade
b. Balance on current account
c. Balance on capital account
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EXHIBIT 6 U.S. BALANCE OF TRADE: 1950–2002
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Exhibit 6: U.S. Balance of
Trade: 1950-2002
What has been the overall trend
in the U.S. balance of trade since
the mid-1970s?
• Since the mid-1970s the U.S. balance of
trade has been in deficit.
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Balance of Payments
What is an example of an export
of services?
• When a U.S. engineering firm provides
engineering design services for a project in
another country.
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Balance of Payments
Unilateral transfers
• Transfers of currency made by individuals,
businesses, or government of one nation to
individuals, businesses, or governments in
other nations, with no designated return.
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Balance of Payments
Balance on capital account
• A category that itemizes changes in the
foreign asset holdings of a nation and that
nation’s asset holdings abroad.
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What is a Balance of
Payments Problem?
Do trade imbalances always create
problems?
• No. For example, a country may have a
balance of trade deficit because it is
importing capital equipment necessary for it
to produce valuable exports in the future.
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How Deficits on Current
Account Develop
If foreigners make huge investments
in U.S. stocks and bonds, how might
this affect the current account?
• Foreign purchases of U.S. stocks and bonds
increases the demand for U.S. dollars.
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How Deficits on Current
Account Develop
If foreigners make huge investments
in U.S. stocks and bonds, how might
this affect the current account?
• Increased demand for the U.S. dollar
increases the value of the dollar relative to
other currencies.
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How Deficits on Current
Account Develop
If foreigners make huge investments
in U.S. stocks and bonds, how might
this affect the current account?
• A high-valued dollar makes imports cheap
for Americans, but makes American exports
expensive for foreigners in other countries.
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How Deficits on Current
Account Develop
If foreigners make huge investments
in U.S. stocks and bonds, how might
this affect the current account?
• Consequently imports increase and exports
decline, causing a current account deficit.
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International Debt
International debt
• The total amount of outstanding IOUs a
nation is obligated to repay other nations
and international organizations.
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International Debt
Debt service
• Interest payments on international debt
as a percentage of a nation’s merchandise
exports.
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EXHIBIT 7 DEBT SERVICE OF SELECTED COUNTRIES,
AS A PERCENTAGE OF EXPORTS: 2001
Source: United Nations Development Programme, Human Development Report 2003 (New York: Oxford University Press, 2003).
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Exhibit 7: Debt Service of Selected
Countries, as a Percentage of Exports
What causes countries such as
Argentina to have such high debt
service as a percentage of their
exports?
• The amount of international debt held by
these countries is quite large relative to the
value of their exports, making repayment
difficult.
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