24 The Balance of Payments, Exchange Rates, and Trade Deficits McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc All rights reserved Chapter Objectives U.S Export Transaction U.S Import Transaction Balance of Payments Flexible Exchange Rates The Market for Currency Determinants of Exchange Rates Fixed Exchange Rates Exchange Controls and Ra tioning International Exchange R ate Systems Recent U.S Trade Deficits Key Terms Previous Slide End Show 38 - Next Slide • How Currencies of Different Nations are Exchanged When International Transactions Take Place • About the Balance Sheet the United States Uses to Account for the International Payments it Makes and Receives • How Exchange Rates are Determined in Currency Markets • The Difference Between Flexible Exchange Rates and Fixed Exchange Rates • The Causes and Consequences of Recent Record-High U.S Trade Deficits Copyright McGraw-Hill/Irwin, 2002 International Transactions • International trade –Buy/sell current goods or services –Imports and exports • International asset transactions –Buy/sell real or financial assets –Buy stock –Sell your house to a foreigner • Requires currency exchange LO1 24-3 Financing International Trade U.S Export Transaction U.S Import Transaction Balance of Payments Flexible Exchange Rates The Market for Currency Determinants of Exchange Rates Fixed Exchange Rates Exchange Controls and Ra tioning International Exchange R ate Systems Recent U.S Trade Deficits Key Terms Previous Slide End Show 38 - Next Slide • • • • U.S Export Transactions U.S Import Transactions Balance of Payments The Current Account – Balance on Goods – Balance on Services – Trade Deficit – Trade Surplus – Balance on Current Account Copyright McGraw-Hill/Irwin, 2002 W24.1 U.S EXPORT TRANSACTION Assume $2 = £1 U.S Export Transaction U.S Import Transaction Balance of Payments Flexible Exchange Rates The Market for Currency Determinants of Exchange Rates Fixed Exchange Rates Exchange Controls and Ra tioning International Exchange R ate Systems Recent U.S Trade Deficits Key Terms Previous Slide End Show 38 - Next Slide $300,000 in American computers purchased by a British buyer for £150,000 £150,000 check drawn on British bank to pay for computers £150,000 check is exchanged for $300,000 at a New York bank New York bank sends £150,000 check to London bank for future sale to buyers who need pounds Copyright McGraw-Hill/Irwin, 2002 U.S IMPORT TRANSACTION Assume $2 = £1 U.S Export Transaction U.S Import Transaction Balance of Payments Flexible Exchange Rates The Market for Currency Determinants of Exchange Rates Fixed Exchange Rates Exchange Controls and Ra tioning International Exchange R ate Systems Recent U.S Trade Deficits Key Terms Previous Slide End Show 38 - Next Slide £150,000 in British compact discs purchased by a U.S buyer for $300,000 £150,000 check purchased from U.S bank to pay for CDs for $300,000 £150,000 check is exchanged for CD purchase from supplier CD firm deposits £150,000 check to British bank Copyright McGraw-Hill/Irwin, 2002 U.S IMPORT TRANSACTION Points to remember: U.S Export Transaction U.S Import Transaction Balance of Payments Flexible Exchange Rates The Market for Currency Determinants of Exchange Rates Fixed Exchange Rates Exchange Controls and Ra tioning American exports create a foreign demand for dollars which creates a supply of foreign currencies which are available to American buyers International Exchange R ate Systems Recent U.S Trade Deficits Key Terms Previous Slide End Show 38 - Next Slide Financing an American export reduces the supply of foreign currencies available and increases the domestic money supply Copyright McGraw-Hill/Irwin, 2002 BALANCE OF PAYMENTS U.S Export Transaction U.S Import Transaction Balance of Payments Flexible Exchange Rates The Market for Currency Determinants of Exchange Rates Fixed Exchange Rates Exchange Controls and Ra tioning International Exchange R ate Systems Recent U.S Trade Deficits Key Terms Previous Slide End Show 38 - Next Slide Current Account Trade Deficits & Surpluses Balance on Goods & Services Balance on Current Account Capital Account Balance on Capital Account Official Reserves Balance of Payment Deficits & Surpluses Copyright McGraw-Hill/Irwin, 2002 Balance of Payments LO2 24-9 Official Reserves • Foreign currencies, certain • • LO2 reserves with the IMF, and stocks of gold Owned by government or central bank Used as balancing mechanism in balance of payments 24-10 U.S Trade Balances U.S Export Transaction U.S Import Transaction Balance of Payments Flexible Exchange Rates The Market for Currency Determinants of Exchange Rates Fixed Exchange Rates Exchange Controls and Ra tioning International Exchange R ate Systems Recent U.S Trade Deficits Key Terms Previous Slide End Show 38 - 15 LO2 Next Slide Copyright McGraw-Hill/Irwin, 2002 24-15 Flexible Exchange Rates Flexible or FloatingU.S Export Transaction U.S Import Transaction Balance of Payments Flexible Exchange Rates The Market for Currency Exchange-Rate System Determinants of Exchange Rates Fixed Exchange Rates Exchange Controls and Ra tioning Fixed Exchange-Rate System International Exchange R ate Systems Recent U.S Trade Deficits Key Terms Previous Slide End Show 38 - 16 Depreciation & Appreciation Next Slide Copyright McGraw-Hill/Irwin, 2002 Flexible Exchange Rates U.S Export Transaction U.S Import Transaction Balance of Payments Flexible Exchange Rates The Market for Currency Determinants of Exchange Rates Fixed Exchange Rates Exchange Controls and Ra tioning International Exchange R ate Systems Recent U.S Trade Deficits Key Terms • • • • Demand for pounds Supply of pounds Market equilibrium Increase in dollar price of pounds – Dollar depreciates – Pound appreciates • Decrease in dollar price of pound Previous Slide End Show 38 - 17 Next Slide – Dollar appreciates – Pound depreciates Copyright McGraw-Hill/Irwin, 2002 38-17 Flexible Exchange Rates The Market for Foreign Currency (Pounds) U.S Export Transaction U.S Import Transaction P Sl Balance of Payments The Market for Currency Determinants of Exchange Rates Fixed Exchange Rates Exchange Controls and Ra tioning International Exchange R ate Systems Recent U.S Trade Deficits Key Terms Previous Slide End Show 38 - 18 Next Slide Dollar Price of Pound Flexible Exchange Rates $3 $2 $1 Dollar Depreciates (Pound Appreciates) Exchange Rate: $2 = £1 Dollar Appreciates (Pound Depreciates) Dl Ql Quantity of Pounds Copyright McGraw-Hill/Irwin, 2002 Q • • LO3 Flexible Exchange Rates Determinants of exchange rates Factors that shift demand/supply –Changes in tastes –Relative income changes –Relative price-level changes • Purchasing-power-parity theory –Relative interest rates –Relative expected returns on assets –Speculation 24-19 Flexible Exchange Rates The Market for Foreign Currency (Pounds) U.S Export Transaction U.S Import Transaction P Sl Balance of Payments The Market for Currency Determinants of Exchange Rates Fixed Exchange Rates Exchange Controls and Ra tioning International Exchange R ate Systems Recent U.S Trade Deficits Key Terms Previous Slide End Show 38 - 20 Next Slide Dollar Price of Pound Flexible Exchange Rates c $3 $2 $1 a x Exchange Rate: $3 = £1 Balance Of Payments Deficit b D Exchange Rate: $2 = £1 Dl Ql Quantity of Pounds Copyright McGraw-Hill/Irwin, 2002 Q2 Q • • LO4 Flexible Exchange Rates Eliminate balance of payments deficit or surplus Disadvantages of flexible exchange rates –Volatility –Uncertainty and diminished trade –Terms-of-trade changes –Instability 24-21 Flexible Exchange Rates LO4 24-22 • • • • LO4 Fixed Exchange Rates Government intervention –Use of reserves Trade policies Exchange controls and rationing –Distorted trade –Favoritism –Restricted choice –Black markets Macroeconomic adjustments 24-23 Fixed Exchange Rates • Government intervention –Use of reserves • Trade policies • Exchange controls and rationing –Distorted trade –Favoritism –Restricted choice –Black markets • Macroeconomic adjustments LO4 24-24 Exchange Rate Systems U.S Export Transaction U.S Import Transaction Balance of Payments Flexible Exchange Rates The Market for Currency Determinants of Exchange Rates Fixed Exchange Rates Exchange Controls and Ra tioning International Exchange R ate Systems Recent U.S Trade Deficits Key Terms • Gold standard 1879-1934 – Fixed exchange rate system • Bretton Woods 1944-1971 – Fixed exchange rate system indirectly tied to gold • Managed float 1971-present – G-7 (G-8) Interventions Previous Slide End Show 38 - 25 Next Slide Copyright McGraw-Hill/Irwin, 2002 38-25 U.S Trade Deficit • Large and persistent • Causes of trade deficits – High U.S growth (relatively) – China – Price oil – Low U.S saving rate • Implications of trade deficits – Increased current consumption – Increased indebtedness 38-26 U.S Trade Deficits -50 Billions of Dollars -100 Goods and Services -150 -200 Balance of Trade -250 -300 -350 -400 -450 Goods -500 -550 -600 Billions of Dollars -650 2001 2002 2003 2004 2005 2006 2007 2008 2009 -700 -750 -50 -800 -100 -850 -150 -900 -200 Balance on Current Account -250 -300 -350 -400 -450 -500 -550 -600 -650 LO5 -700 2001 2002 2003 2004 2005 2006 2007 2008 2009 24-27 Speculation in Currency Markets U.S Export Transaction U.S Import Transaction Balance of Payments Flexible Exchange Rates The Market for Currency Determinants of Exchange Rates Fixed Exchange Rates Exchange Controls and Ra tioning International Exchange R ate Systems Recent U.S Trade Deficits Key Terms Previous Slide End Show 38 - 28 Next Slide Negative or Positive Influence on Currency Markets and Trade • Currency Purchases to Purchase Goods and Services • Contributing to Currency Market Fluctuations • Speculator’s Role and Activities • Smoothing Short-Term Fluctuations • Absorbing Risk • Futures Market at Work • Positive Role Played Overall Copyright McGraw-Hill/Irwin, 2002 Key Terms U.S Export Transaction U.S Import Transaction Balance of Payments Flexible Exchange Rates The Market for Currency Determinants of Exchange Rates Fixed Exchange Rates Exchange Controls and Ra tioning International Exchange R ate Systems Recent U.S Trade Deficits Key Terms Previous Slide End Show 38 - 29 Next Slide • balance of payments • current account • balance on goods and serv ices • trade deficit • trade surplus • balance on current accoun t • capital and financial acco unt • balance on capital and fin ancial • balance-of-payments deficits and surpluses • official reserves Copyright McGraw-Hill/Irwin, 2002 • flexible- or floatingexchange-rate system • fixed-exchange-rate system • purchasing-power-parity theory • currency interventions • exchange controls • gold standard • devaluation • Bretton Woods system • International Monetary Fund (IMF) • managed floating exchange rates ... purchased by a U.S buyer for $300,000 £150,000 check purchased from U.S bank to pay for CDs for $300,000 £150,000 check is exchanged for CD purchase from supplier CD firm deposits £150,000 check... intervention Use of reserves • Trade policies • Exchange controls and rationing –Distorted trade –Favoritism –Restricted choice –Black markets • Macroeconomic adjustments LO4 24- 24 Exchange Rate... intervention Use of reserves Trade policies Exchange controls and rationing –Distorted trade –Favoritism –Restricted choice –Black markets Macroeconomic adjustments 24- 23 Fixed Exchange Rates