Chapter 38 - The balance of payments, exchange rates, and trade deficits. This chapter explain how currencies of different nations are exchanged when international transactions take place, analyze the balance sheet the United States uses to account for the international payments it makes and receives, discuss how exchange rates are determined in currency markets, describe the difference between flexible exchange rates and fixed exchange rates, Identify the causes and consequences of recent record-high U.S. trade deficits.
Chapter 38 The Balance of Payments, Exchange Rates, and Trade Deficits McGrawưHill/Irwin Copyrightâ2009byTheMcGrawưHillCompanies,Inc.Allrightsreserved Chapter Objectives How currencies are exchanged • Balance sheet for recording international payments • How exchange rates are determined • Flexible vs fixed exchange rates • Causes and consequences of trade deficits 38-2 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 38-3 Balance of Payments • Sum of international financial transactions • Current account – Balance on goods and services – Net investment income – Net transfers – Balance on current account 38-4 Balance of Payments • Capital and financial account – Capital account – Financial account • Balance of payments accounts sum to zero • Current account deficits generate asset transfers to foreigners • Official reserves 38-5 U.S Trade Balances Goods and Services, Select Nations, 2007 Deficit Surplus +10.0 Australia Belgium +9.8 Canada -67.0 China -256.6 Germany -45.3 Japan -85.0 Mexico -77.3 +14.3 Netherlands -250 -70 -60 -50 -40 -30 -20 -10 10 20 Source: Bureau of Economic Analysis 38-6 Flexible Exchange Rates • • • • Demand for pounds Supply of pounds Market equilibrium Increase in dollar price of pounds – Dollar depreciates – Pound appreciates • Decrease in dollar price of pounds – Dollar appreciates – Pound depreciates 38-7 Flexible Exchange Rates The Market for Foreign Currency (Pounds) Dollar Price of Pound P $3 $2 $1 Dollar Depreciates (Pound Appreciates) Exchange Rate: $2 = £1 S1 Dollar Appreciates (Pound Depreciates) D1 Q1 Q Quantity of Pounds 38-8 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 38-9 Flexible Exchange Rates The Market for Foreign Currency (Pounds) Dollar Price of Pound P S1 c $3 $2 $1 a x Exchange Rate: $3 = £1 Balance Of Payments Deficit b D Exchange Rate: $2 = £1 D1 Q1 Q2 Q Quantity of Pounds 38-10 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 38-11 Fixed Exchange Rates • Government intervention – Use of reserves • Trade policies • Exchange controls and rationing – Distorted trade – Favoritism – Restricted choice – Black markets • Macroeconomic adjustments 38-12 Exchange Rate Systems • Gold standard 1879-1934 – Fixed exchange rate system • Bretton Woods 1944-1971 – Fixed exchange rate system indirectly tied to gold • Managed float 1971-present 38-13 Managed Float • Dependence on foreign exchange markets • Occasional intervention • In support of managed float • Concerns with managed float 38-14 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 38-15 Speculation in Currency Markets • Positive or negative influence? • Contributes to currency market fluctuations • Self-fulfilling expectations • Smoothing short-term fluctuations • Absorbing risk • Futures market at work • Positive role played overall 38-16 Key Terms • balance of payments • current account • balance on goods and services • trade deficit • trade surplus • balance on current account • capital and financial account • balance on capital and financial • balance-of-payments deficits and surpluses • official reserves • flexible- or floatingexchange-rate system • fixed-exchange-rate system • purchasing-powerparity theory • currency interventions • managed floating exchange rate 38-17 ... Germany -4 5.3 Japan -8 5.0 Mexico -7 7.3 +14.3 Netherlands -2 50 -7 0 -6 0 -5 0 -4 0 -3 0 -2 0 -1 0 10 20 Source: Bureau of Economic Analysis 3 8- 6 Flexible Exchange Rates • • • • Demand for pounds Supply... Official reserves 3 8- 5 U.S Trade Balances Goods and Services, Select Nations, 2007 Deficit Surplus +10.0 Australia Belgium +9.8 Canada -6 7.0 China -2 56.6 Germany -4 5.3 Japan -8 5.0 Mexico -7 7.3 +14.3... capital and financial • balance-of-payments deficits and surpluses • official reserves • flexible- or floatingexchange-rate system • fixed-exchange-rate system • purchasing-powerparity theory • currency