C H A P T E R 19 The World of International Finance Copyright © 2012 Pearson Prentice Hall All rights reserved Copyright © 2012 Pearson Prentice Hall All rights reserved 19-1 CHAPTER The World of International Finance 19 Today, the world currency markets are always open When foreign exchange traders in New York City are sound asleep at 3:00 A.M., their counterparts in London are already on their phones and computers at 8:00 A.M PREPARED BY Brock Williams Copyright © 2012 Pearson Prentice Hall All rights reserved C H A P T E R 19 The World of International Finance APPLYING THE CONCEPTS How can the price of a Big Mac in China shed light on the U.S.-Chinese currency tensions? The Chinese Yuan and Big Macs What factors may allow the United States to continue running large trade deficits with the rest of the world? World Savings and U.S Current Account Deficits How did the 2008 financial crisis lead to problems for some countries in the Euro-zone? A Downside to the Euro What are the causes of financial collapses that occur throughout the globe? The Argentine Financial Crisis Copyright © 2012 Pearson Prentice Hall All rights reserved 19-3 C H A P T E R 19 The World of International Finance 19.1 HOW EXCHANGE RATES ARE DETERMINED What Are Exchange Rates? • exchange rate The price at which currencies trade for one another in the market • euro The common currency in Europe •An increase in the value of a currency relative to the currency of another nation is called an appreciation of a currency •A decrease in the value of a currency relative to the currency of another nation is called a depreciation of a currency Copyright © 2012 Pearson Prentice Hall All rights reserved 19-4 C H A P T E R 19 The World of International Finance 19.1 HOW EXCHANGE RATES ARE DETERMINED (cont’d) How Demand and Supply Determine Exchange Rates FIGURE 19.1 The Demand for and Supply of U.S Dollars Market equilibrium occurs where the demand for U.S dollars equals the supply Copyright © 2012 Pearson Prentice Hall All rights reserved 19-5 C H A P T E R 19 The World of International Finance 19.1 HOW EXCHANGE RATES ARE DETERMINED (cont’d) Changes in Demand or Supply FIGURE 19.2 Shifts in the Demand for U.S Dollars An increase in the demand for dollars will increase (appreciate) the dollar’s exchange rate Higher U.S interest rates or lower U.S prices will increase the demand for dollars Copyright © 2012 Pearson Prentice Hall All rights reserved 19-6 C H A P T E R 19 The World of International Finance 19.1 HOW EXCHANGE RATES ARE DETERMINED (cont’d) Changes in Demand or Supply FIGURE 19.3 Shifts in the Supply of U.S Dollars An increase in the supply of dollars will decrease (depreciate) the dollar exchange rate Higher European interest rates or lower European prices will increase the supply of dollars Copyright © 2012 Pearson Prentice Hall All rights reserved 19-7 C H A P T E R 19 The World of International Finance 19.1 HOW EXCHANGE RATES ARE DETERMINED (cont’d) Changes in Demand or Supply Let’s summarize the key facts about the foreign exchange market, using euros as our example: The demand curve for dollars represents the demand for dollars in exchange for euros The curve slopes downward As the dollar depreciates, there will be an increase in the quantity of dollars demanded in exchange for euros The supply curve for dollars is the supply of dollars in exchange for euros The curve slopes upward As the dollar appreciates, there will be an increase in the quantity of dollars supplied in exchange for euros Increases in U.S interest rates and decreases in U.S prices will increase the demand for dollars, leading to an appreciation of the dollar Increases in European interest rates and decreases in European prices will increase the supply of dollars in exchange for euros, leading to a depreciation of the dollar Copyright © 2012 Pearson Prentice Hall All rights reserved 19-8 C H A P T E R 19 The World of International Finance REAL EXCHANGE RATES AND PURCHASING POWER PARITY 19.2 REAL-NOMINAL PRINCIPLE What matters to people is the real value of money or income—its purchasing power—not the face value of money or income • real exchange rate The price of U.S goods and services relative to foreign goods and services, expressed in a common currency Copyright © 2012 Pearson Prentice Hall All rights reserved 19-9 C H A P T E R 19 The World of International Finance 19.2 REAL EXCHANGE RATES AND PURCHASING POWER PARITY (cont’d) FIGURE 19.4 Real Exchange Rate and Net Exports as Percent of GDP, 1980–2009 The figure shows the real exchange rate for the United States compared to its net exports as a share of GDP Notice that, in general, when the real (multilateral) exchange rate increased, U.S net exports fell Copyright © 2012 Pearson Prentice Hall All rights reserved 19-10 C H A P T E R 19 The World of International Finance 19.3 THE CURRENT ACCOUNT, THE FINANCIAL ACCOUNT, AND THE CAPITAL ACCOUNT • balance of payments A system of accounts that measures transactions of goods, services, income, and financial assets between domestic households, businesses, and governments and residents of the rest of the world during a specific time period • current account The sum of net exports (exports minus imports) plus net income received from abroad plus net transfers from abroad Copyright © 2012 Pearson Prentice Hall All rights reserved 19-13 C H A P T E R 19 The World of International Finance 19.3 THE CURRENT ACCOUNT, THE FINANCIAL ACCOUNT, AND THE CAPITAL ACCOUNT (cont’d) • financial account The value of a country’s net sales (sales minus purchases) of assets • capital account The value of capital transfer and transaction in nonproduced, nonfinancial assets in the international accounts Copyright © 2012 Pearson Prentice Hall All rights reserved 19-14 C H A P T E R 19 The World of International Finance 19.3 THE CURRENT ACCOUNT, THE FINANCIAL ACCOUNT, AND THE CAPITAL ACCOUNT (cont’d) Rules for Calculating the Current, Financial, and Capital Accounts •Here is a simple rule for understanding transactions on the current, financial, and capital accounts: Any action that gives rise to a demand for foreign currency is a deficit item Any action that gives rise to a supply of foreign currency is a surplus item •The current, financial, and capital accounts of a country are linked by a very important relationship: current account + financial account + capital account = Copyright © 2012 Pearson Prentice Hall All rights reserved 19-15 C H A P T E R 19 The World of International Finance 19.3 THE CURRENT ACCOUNT, THE FINANCIAL ACCOUNT, AND THE CAPITAL ACCOUNT (cont’d) Rules for Calculating the Current, Financial, and Capital Accounts Copyright © 2012 Pearson Prentice Hall All rights reserved 19-16 C H A P T E R 19 The World of International Finance 19.3 THE CURRENT ACCOUNT, THE FINANCIAL ACCOUNT, AND THE CAPITAL ACCOUNT (cont’d) Rules for Calculating the Current, Financial, and Capital Accounts • net international investment position Domestic holding of foreign assets minus foreign holdings of domestic assets • sovereign investment fund Assets accumulated by foreign governments that are invested abroad Copyright © 2012 Pearson Prentice Hall All rights reserved 19-17 C H A P T E R 19 The World of International Finance APPLICATION WORLD SAVINGS AND U.S CURRENT ACCOUNT DEFICITS APPLYING THE CONCEPTS #2: What factors may allow the United States to continue running large trade deficits with the rest of the world? •The 2006 Economic Report of the President directly addressed whether the United States can continue to run large current account deficits and, of course, financial account surpluses In the report, the government recognized that the current account deficits would eventually be reduced However, it also highlighted a number of factors suggesting the deficits could continue for a long period of time •For the United States to continue to run a current account deficit, other countries in the world need to continue to purchase U.S assets •In recent years, four major countries experienced circumstances that encouraged them to save by purchasing assets from abroad: Japan, Germany, Russia, and China •For the United States to continue to run trade deficits in the future, these or other countries must want to continue to save more than they want to invest domestically Copyright © 2012 Pearson Prentice Hall All rights reserved 19-18 19.4 C H A P T E R 19 The World of International Finance FIXED AND FLEXIBLE EXCHANGE RATES To set the stage for understanding exchange rate systems, let’s recall what happens when a country’s exchange rate appreciates—increases in value There are two distinct effects: The increased value of the exchange rate makes imports less expensive for the residents of the country where the exchange rate appreciated The increased value of the exchange rate makes U.S goods more expensive on world markets Copyright © 2012 Pearson Prentice Hall All rights reserved 19-19 C H A P T E R 19 The World of International Finance 19.4 FIXED AND FLEXIBLE EXCHANGE RATES (cont’d) Fixing the Exchange Rate • foreign exchange market intervention The purchase or sale of currencies by government to influence the market exchange rate FIGURE 19.5 Government Intervention to Raise the Price of the Dollar To increase the price of dollars, the U.S government sells Euros in exchange for dollars This shifts the demand curve for dollars to the right Copyright © 2012 Pearson Prentice Hall All rights reserved 19-20 C H A P T E R 19 The World of International Finance 19.4 FIXED AND FLEXIBLE EXCHANGE RATES (cont’d) Fixed versus Flexible Exchange Rates FLEXIBLE EXCHANGE RATE SYSTEM • flexible exchange rate system A currency system in which exchange rates are determined by free markets FIXED EXCHANGE RATES • fixed exchange rate system A system in which governments peg exchange rates to prevent their currencies from fluctuating Copyright © 2012 Pearson Prentice Hall All rights reserved 19-21 C H A P T E R 19 The World of International Finance 19.4 FIXED AND FLEXIBLE EXCHANGE RATES (cont’d) Fixed versus Flexible Exchange Rates BALANCE OF PAYMENTS DEFICITS AND SURPLUSES • balance of payments deficit Under a fixed exchange rate system, a situation in which the supply of a country’s currency exceeds the demand for the currency at the current exchange rate • balance of payments surplus Under a fixed exchange rate system, a situation in which the demand of a country’s currency exceeds the supply for the currency at the current exchange rate • devaluation A decrease in the exchange rate to which a currency is pegged under a fixed exchange rate system • revaluation An increase in the exchange rate to which a currency is pegged under a fixed exchange rate system Copyright © 2012 Pearson Prentice Hall All rights reserved 19-22 C H A P T E R 19 The World of International Finance 19.4 FIXED AND FLEXIBLE EXCHANGE RATES (cont’d) The U.S Experience with Fixed and Flexible Exchange Rates Fixed exchange rate systems provide benefits, but they require countries to maintain similar economic policies—especially to maintain similar inflation rates and interest rates Higher prices in the United States cause the U.S real exchange rate to rise This increase in the real exchange rate over time causes a trade deficit to emerge Exchange Rate Systems Today The flexible exchange rate system has worked well enough since the breakdown of Bretton Woods Some economists believe that the world will eventually settle into three large currency blocs: the euro, the dollar, and the yen Copyright © 2012 Pearson Prentice Hall All rights reserved 19-23 C H A P T E R 19 The World of International Finance APPLICATION THE DOWNSIDE TO THE EURO APPLYING THE CONCEPTS #3: How did the 2008 financial crisis lead to problems for some countries in the Eurozone? •When the euro was launched economically weaker and less disciplined countries benefited from the strong single central bank •As investments picked up worldwide in 2003, funds poured into many countries in the Euro-zone, fueling real estate and construction and financing projects As their economics boomed, prices and wages were driven up Ireland, Spain, Italy, and Greece were especially effected •When the boom came to an end, their wage and price structure was out of line and they needed to make adjustments •However, their options were limited Since they could not depreciate their currency, so they could either cut spending or raise taxes or face a prolonged period of unemployment to reduce wages and prices •This is a downside to a single currency Copyright © 2012 Pearson Prentice Hall All rights reserved 19-24 C H A P T E R 19 The World of International Finance 19.5 MANAGING FINANCIAL CRISES •Hardly a year goes by without some international financial crisis •Even when a country takes strong, institutional steps to peg its currency, a collapse is still possible Copyright © 2012 Pearson Prentice Hall All rights reserved 19-25 C H A P T E R 19 The World of International Finance APPLICATION THE ARGENTINE FINANCIAL CRISIS APPLYING THE CONCEPTS #4: What are the causes of financial collapses that occur throughout the globe? During the late 1980s, Argentina suffered from hyperinflation As part of its financial reforms, it pegged its currency to the U.S dollar, making pesos “convertible” into dollars To issue pesos, the central bank had to have an equal amount of dollars, or its equivalent in other hard currencies, on hand Some economists believed this reform would bring stability to the financial system Unfortunately, they were proved wrong Several problems developed: • As the dollar appreciated, Argentina began to suffer from a large trade deficit • Wage increases also pushed up the real exchange rate • Argentina had to borrow extensively in dollar-denominated loans Eventually, Argentina was forced to default on its international debt in 2002 and freeze bank accounts The hopes of the reforms in the early 1990s had become a bitter memory Copyright © 2012 Pearson Prentice Hall All rights reserved 19-26 C H A P T E R 19 The World of International Finance KEY TERMS balance of payments flexible exchange rate system balance of payments deficit balance of payments surplus foreign exchange market intervention capital account law of one price current account net international investment position devaluation purchasing power parity euro real exchange rate exchange rate revaluation financial account sovereign investment funds fixed exchange rate system Copyright © 2012 Pearson Prentice Hall All rights reserved 19-27 ... reserved 19- 4 C H A P T E R 19 The World of International Finance 19. 1 HOW EXCHANGE RATES ARE DETERMINED (cont’d) How Demand and Supply Determine Exchange Rates FIGURE 19. 1 The Demand for and Supply... World of International Finance 19. 2 REAL EXCHANGE RATES AND PURCHASING POWER PARITY (cont’d) FIGURE 19. 4 Real Exchange Rate and Net Exports as Percent of GDP, 198 0–2009 The figure shows the... reserved 19- 15 C H A P T E R 19 The World of International Finance 19. 3 THE CURRENT ACCOUNT, THE FINANCIAL ACCOUNT, AND THE CAPITAL ACCOUNT (cont’d) Rules for Calculating the Current, Financial, and