Chapter 18 International Finance and Exchange Rates McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc All rights reserved Chapter Outline • International Financial Transactions • Foreign Exchange Markets • Alternative Foreign Exchange Systems • Determinants of Exchange Rates McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 18-2 1-2 Balance of Payments • Balance of Payments: the accounting system for how money moves between countries to facilitate the purchase of goods, services, financial instruments, and physical investments • Current Account: The portion of the Balance of Payments accounting that represents that impacts of trade, short-term investment payments, and American payments of foreign taxes, foreign payments of American taxes, and the net transfer of private money • The Capital Account represents the changes in holding of longer term financial and physical assets by citizens of one country in another country McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 18-3 1-3 Balance of Payments United States, 2009 ($ millions) Major Accounting Item Sub Accounting Item Sub Acct component Current Account Balance of Trade Balance of Shortterm Investment Income Component Amount Sub Acct Balance Balance Exports 1,834 -496 -470 Imports 2,329 Income to the US 662 Payments from the US 499 Net Transfers (taxes, private payments) Capital Account Change in the Ownership of Assets -137 US owned assets abroad 1,025 Foreign owned assets in the US 1,245 Financial Derivatives Net Statistical Discrepancy & Net Derivatives McGraw-Hill/Irwin 163 470 15 235 ©2012 The McGraw-Hill Companies, All Rights Reserved 18-4 1-4 Current Account Mirrors the Balance of Trade McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 18-5 1-5 Foreign Purchases of US Assets & US Purchases of Foreign Assets McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 18-6 1-6 Trade Requires Currency • Trade between countries is beneficial • International trade requires that the currency of the trading partners be exchanged • The market where people come to trade currencies is called the foreign exchange market • E.g the production and export of a radio can require several currency transactions McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 18-7 1-7 Foreign Exchange Markets • The demand for a currency (say the dollar) is also the supply of the other currency (say the yen) • The supply for a currency (say the dollar) is also the demand of the other currency (say the yen) McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 18-8 1-8 Modeling Foreign Exchange Price of Yuan in U.S dollars equilibrium exchange rate A curve which represents the willingness of those who have Yuan to trade them for U.S dollars A curve which represents the willingness of those who have Yuan to trade them for U.S dollars Quantity of Yuan McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 18-9 1-9 Various Exchange Rates Amount of Currency needed to get $1 Amount of US Dollars needed to get one unit of the Currency 0.621892 1.608 Canadian Dollar 976125 1.02446 Chinese Yuan 6.55997 15244 Euro 708466 1.4115 Hong Kong Dollar 7.79454 128295 Japanese Yen 81.169 01232 Mexican Peso 11.951 083675 Russian Ruble 28.3149 0353171 South Korean Won 1112.24 000899087 Foreign Currency British Pound McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 18-10 1-10 Various Exchange Rates McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 18-11 1-11 Alternative Foreign Exchange Systems • Floating exchange rate system: a system whereby markets determine the value of a currency relative to all other currencies • Fixed exchange rate system : a system whereby a government sets the value of a currency relative to all other currencies and uses its reserve of foreign currencies or gold to maintain the exchange rate • Gold standard: one means by which a country can execute a fixed exchange rate • Managed Float exchange rate system: a system whereby governments decide the range of exchange rates they will allow the market to create, and act only when either the top end or the bottom end of that range is breached McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 18-12 1-12 Fixed Exchange Rates Price of Yuan in Dollars S1 S2 ERfixed D2 D1 Yuan* McGraw-Hill/Irwin Yuan ©2012 The McGraw-Hill Companies, All Rights Reserved 18-13 1-13 Managed Float Price of Yuan in Dollars S1 S2 ERceiling ERtarget ERfloor D2 D1 Yuan* McGraw-Hill/Irwin Yuan ©2012 The McGraw-Hill Companies, All Rights Reserved 18-14 1-14 Determinants of Exchange Rates • Desire to hold one currency or another to • Facilitate trade • Facilitate the purchase of financial assets • Interest Rates • Projected Inflation Rates • Relative safety of the currency McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 18-15 1-15 ... Capital Account represents the changes in holding of longer term financial and physical assets by citizens of one country in another country McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All...Chapter Outline • International Financial Transactions • Foreign Exchange Markets • Alternative Foreign Exchange Systems • Determinants of Exchange Rates McGraw-Hill/Irwin ©2012 The McGraw-Hill... Balance of Payments: the accounting system for how money moves between countries to facilitate the purchase of goods, services, financial instruments, and physical investments • Current Account: