International Finance
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Learning Objectives
• Explain how international trade is financed
• Describe a country’s balance of payments
accounts
• Explain what determines the amount of
international borrowing and lending
2
Learning Objectives (cont.)
• Explain why the United States changed
from being a lender to being a borrower in
the mid-1980s
• Explain how the foreign exchange value of
the dollar is determined
• Explain why the foreign exchange value of
the dollar fluctuates
3
Financing International Trade
Balance of Payments Accounts
Balance of payments accounts record a
country’s international trading, borrowing, and
lending.
5
Balance of Payments: Credits
• Credits, + (receipts from foreigners)
•
•
•
•
Exports of goods and services
Income receipts
Unilateral current transfers to the US
Financial inflows
• “Dollars in”
6
Balance of Payments: Debits
• Debits, - (payment to foreigners)
•
•
•
•
Imports of goods and services
Income payments
Unilateral current transfers to foreigners
Financial outflows
• “Dollars out”
7
Balance of Payments
Paired Transactions
• Every international transaction enters the
balance of payments twice, once as a credit
and once as a debit
• If you buy something from a foreigner, you
must pay her. She must then spend or store
your payment.
8
9
Examples of
Paired Transactions
Credit
JD buys an Italian
bike (Masi)
(current account)
Sale of bank
deposit by Chase
Bank
(Financial account)
Debit
11
Examples of
Paired Transactions
Credit
Julia buys meal at
l’Escargot d’Or
(current account)
Sale of claim on
BofA card
(Financial
account)
Debit
13
Examples of
Paired Transactions
Credit
TJ buys 1 share
of Shell (Dutch)
(Financial
account)
Shell deposits in
US bank
(Financial
account)
Debit
Credits to the Current Account
• Credits, + (receipts from foreigners)
• Exports of goods and services
• income receipts
• unilateral current transfers to the US
15
Debits to the Current Account
• Debits, - (payment to foreigners)
• Imports of goods and services
• Income payments
• Unilateral current transfers to foreigners
16
Credits to the Financial Account
• Credits, + (receipts from foreigners)
• Financial inflows
• Increase in foreign-owned assets (U.S. liabilities)
• Decrease in U.S.-owned assets (U.S. claims).
17
Debits to the Financial Account
• Debits, - (payment to foreigners)
• Financial outflows
• Decrease in foreign-owned assets (U.S.
liabilities)
• Increase in U.S.-owned assets (U.S. claims)
18
Financing International Trade
The balance of payments accounts include:
1) Current account
•Exports of goods and services + US
income receipts
•Imports of goods and services+US
income payments
•Unilateral current transfers, net
•US receipts – US payments
•“Net interest income” = US income
receipts –US income payments
CAB  NX  Net interest income  Net transfers
19
Financing International Trade
The balance of payments accounts include:
2) Financial account*
• Records changes in foreign assets in the
United States minus changes US assets
abroad
* Prior to 1997, the Financial account was known as
the Capital account
20
Financing International Trade
The balance of payments accounts include:
3) Official settlements account
• Records the change in official U.S. reserves.
• Official U.S reserves -- mainly the
government’s holdings of foreign currency.
• If official reserves increase, the official
settlements accounts balance is negative.
Part of the Financial account & it’s small!
21
Financing International Trade
22
Fundamental balance of payments accounts identity:
Current account + Financial account = 0
U.S. Balance of Payments
Accounts in 1996
Current account
(billion $)
Import of goods and services
Exports of goods and services
Net interest income
Net transfers
Current account balance
-940
+830
–10
–40
–160
Financial account (increases in ...)
Foreign investment in the United States
U.S. investment abroad
Statistical discrepancy
Financial account balance
+430
-240
–40
+150
Official settlements account
Decrease in official U.S. reserves
+10
23
24
U.S. Balance of Payments
Accounts in 1998
Current account
(billion $)
Import of goods and services
Exports of goods and services
Net interest income
Net transfers
Current account balance
-1,120
+910
+20
–40
–230
Financial account (increases in ...)
Foreign investment in the United States
U.S. investment abroad
Statistical discrepancy
Financial account balance
+540
-310
–40
+230
Official settlements account
Increase in official U.S. reserves
-
U.S. Balance of Payments
• Let’s visit the Bureau of Economic Analysis
http://www.bea.doc.gov/bea/di1.htm
28
The Balance of Payments:
1975-1998
29
Financing International Trade
Borrowers and Lenders, Debtors and
Creditors
• A net borrower is a country that is borrowing
more from the rest of the world than it is
lending.
• A net lender is a country that is lending more
than it is borrowing.
30
Financing International Trade
Borrowers and Lenders, Debtors and
Creditors
• Debtor nations are countries that during their
entire history have borrowed more from the rest
of the world than they have lent to it.
• Creditor nations are countries that have
invested more in the rest of the world than other
countries have invested in it.
31
Financing International Trade
Borrowers and Lenders, Debtors and Creditors
• The United States is both a net borrower and a debtor
nation.
• We became a borrower as a result of a string of current
account deficits.
Is there any reason to be concerned?
33
Financing International Trade
No — if the borrowing is financing
investment that is generating economic
growth and higher income.
Yes — if the money is being used to finance
consumption.
This will result in higher interest payments and
consumption will eventually have to be
reduced.
34
Financing International Trade
Current Account Balance
The current account balance (CAB) equals:
CAB  NX  Net interest income  Net transfers
35
Financing International Trade
Net Exports
• Largest part of the current account balance.
• Determined by the government budget and
private saving and investment.
36
Financing International Trade
Net Exports
• Net exports is exports of goods and services
minus imports of goods and services (X-M)
• A government sector surplus or deficit is net
taxes minus government purchases of goods
and services (T – G)
• A private sector surplus or deficit is saving
minus investment (S – I)
37
Net Exports, the Government
Budget, Saving, and Investment
United States
Symbols and
in 1998
equations (billions of dollars)
Variables
Exports
X
959
Imports
M
1,110
Government purchases G
1,487
Net Taxes
T
1,563
Investment
I
1,367
Saving
S
1,140
38
Net Exports, the Government
Budget, Saving, and Investment
Surpluses and deficits in 1998
Net Exports
X - M = 959 – 1,110 = – 151
Government sector
T - G = 1,563 – 1,487 = 76
Private sector
S - I = 1,140 – 1,367 = –227
39
Net Exports, the Government
Budget, Saving, and Investment
Relationship among surpluses and deficits in 1998
National accounts
Y =C+I+G+X–M
=C+S+T
Rearranging
X –M=S–I+T–G
Net exports
X–M
–151
T –G
76
equals:
Government sector
plus
Private sector
S –I
–227
40
Financing International Trade
The Twin Deficits
• The government sector balance (T-G) and the
Current Account balance (X-M) tend to move
in the same direction
• The US has frequently had a deficit on both
• Hence, they are known as the twin deficits.
44
The Twin Deficits
45
Financing International Trade
Is U.S. Borrowing for Consumption or
Investment
• Net exports were –$99 billion in 1996
• The government buys structures (e.g. highways,
dams) that exceed $200 billion/year.
• The government spends on education and
health care—increases human capital.
46
Financing International Trade
Is U.S. Borrowing for Consumption or
Investment
Our borrowing is financing investment
47
The Exchange Rate
• The foreign exchange market is the market
in which the currency of one country is
exchanged for the currency of another.
• The foreign exchange rate is the price at
which one currency exchanges for another.
• In April 1997==>$1 = 123 Japanese yen
49
The Exchange Rate
50
The Exchange Rate
Currency depreciation is the fall in the value
of one currency in terms of another.
• The dollar depreciates if in later months it will
buy less yen than before (e.g. 90 yen as
compared to 114).
Currency appreciation is the rise in the value
of one currency in terms of another
currency.
51
The Exchange Rate
Demand in the Foreign Exchange Market
The quantity of dollars demanded in the foreign
exchange market depends upon:
1) The exchange rate
2) Interest rates in the United States and other
countries
3) The expected future exchange rate
52
The Exchange Rate
The Law of Demand for Foreign Exchange
• The demand for dollars is a derived
demand.
• They (RoW) buy dollars in order to buy
U.S.-made goods and services.
• Holding other things the same, the higher the
exchange rate, the less is the quantity of dollars
demanded.
53
Exchange rate (yen per dollar)
The Demand for Dollars
Other things remaining
the same, a rise in the
exchange rate decreases
the quantity of dollars
demanded...
150
100
50
0
…and a fall in the
exchange rate
increases the quantity
of dollars demanded
1.1
1.2
1.3
D
1.4
1.5
Quantity (trillions of dollars per day)
54
The Exchange Rate
Why do exchange rates influence the
quantity of dollars demanded?
1) Exports Effect
2) Expected Profit Effect
55
The Exchange Rate
Changes in the Demand for Dollars
A change in any other influence on the dollars
that people plan to buy in the foreign exchange
market:
• Changes the demand for dollars
• Shifts the demand curve for dollars
56
The Exchange Rate
The other factors that change the demand
for dollars are:
1) Interest rates in the United States and
other countries
interest rate differential = US rate – other rate
2) The expected future exchange rate
57
Exchange rate (yen per dollar)
Changes in the Demand for Dollars
150
Increase in the
demand for dollars
100
50
Decrease
in the
demand for
dollars
D2
0
1.1
1.2
1.3
1.4
D0
1.5
Quantity (trillions of dollars per day)
D1
58
Changes in the
Demand for Dollars
The demand for dollars
increases if:
The demand for dollars
decreases if:
• The U.S interest rate
• The U.S. interest rate
differential increases
differential decreases
• The expected future
• The expected future
exchange rate rises
exchange rate falls
59
The Exchange Rate
Supply in the Foreign Exchange Market
The quantity of dollars supplied in the foreign
exchange market depends upon:
1) The exchange rate
2) Interest rates in the United States and
other countries
3) The expected future exchange rate
60
The Exchange Rate
The Law of Supply for Foreign Exchange
• U.S. residents supply dollars in the foreign
exchange market when they buy imports.
• Holding other things the same, the higher the
exchange rate, the higher is the quantity of
dollars supplied.
61
The Exchange Rate
Why do exchange rates influence the
quantity of dollars supplied?
1) Imports Effect
2) Expected Profit Effect
62
Exchange rate (yen per dollar)
The Supply of Dollars
150
Other things remaining
the same, a rise in the
exchange rate increases
the quantity of dollars
supplied...
S
100
…and a fall in the
exchange rate
decreases the quantity
of dollars supplied
50
0
1.1
1.2
1.3
1.4
1.5
Quantity (trillions of dollars per day)
63
The Exchange Rate
Changes in the Supply of Dollars
A change in any other influence on the dollars
that people plan to sell in the foreign exchange
market:
• Changes the supply of dollars
• Shifts the supply curve of dollars
64
The Exchange Rate
The other factors that change the supply of
dollars are:
1) Interest rates in the United States and
other countries
2) The expected future exchange rate
65
The Supply of Dollars
Exchange rate (yen per dollar)
S1
150
S0
Decrease in the
supply of dollars
S2
100
Increase in the
supply of dollars
50
0
1.1
1.2
1.3
1.4
1.5
Quantity (trillions of dollars per day)
66
Changes in the
Supply of Dollars
The supply of dollars
increases if:
The supply of dollars
decreases if:
• The U.S interest rate
• The U.S. interest rate
differential decreases
differential increases
• The expected future
• The expected future
exchange rate falls
exchange rate rises
67
The Exchange Rate
Market Equilibrium
• If the exchange rate is too high, there is a
surplus of dollars.
• If the exchange rate is too low, there is a
shortage of dollars.
68
The Exchange Rate
Market Equilibrium
At the equilibrium exchange rate, there is
neither a shortage nor a surplus.
69
Exchange rate (yen per dollar)
Equilibrium Exchange Rate
Surplus at
150 yen per dollar
S
150
Equilibrium at
100 yen per dollar
100
50
D
Shortage at
50 yen per dollar
0
1.1
1.2
1.3
1.4
1.5
Quantity (trillions of dollars per day)
70
The Exchange Rate
Changes in the Exchange Rate
Why the Exchange Rate is Volatile
• Supply and demand are not independent of
each other.
• A change in the expected future exchange
rate or U.S. interest rate differential shifts
both supply and demand.
72
Exchange rate (yen per dollar)
Exchange Rate Fluctuations
1994 to 1995
S94
S95
100
84
D94
D95
0
Q0
Quantity (trillions of dollars per day)
73
Exchange rate (yen per dollar)
Exchange Rate Fluctuations
1995 to 1997
S97
S95
123
D97
84
D95
0
Q0
Quantity (trillions of dollars per day)
74
The Exchange Rate
Exchange Rate Expectations
Two expectations that effect the value of money
are:
1) Purchasing power parity
2) Interest rate parity
75
The Exchange Rate
Purchasing Power Parity
• Money is worth what it will buy.
• Purchasing power parity means equal value of
money.
76
The Exchange Rate
Purchasing Power Parity
• If prices increase in other countries but remain
constant in the United States, people will
generally expect that the value of the U.S.
dollar is too low and will expect it to rise.
• Supply of and demand for dollars change
• The exchange rate changes
77
The Exchange Rate
Interest Rate Parity
• Money is worth what it can earn.
• Interest rate parity means equal interest rates.
78
The Exchange Rate
Interest Rate Parity
If the rate of return is higher in the United
States than in another country, the demand for
U.S. dollars rise and the exchange rate rises
until expected interest rates are equal.
79
The Exchange Rate
The Fed in the Foreign Exchange Market
• Since the Fed influences the supply of money, it
also has an impact on the exchange rate
• The Fed can intervene in the foreign exchange
market and smooth out fluctuations in the
exchange rate
80
Exchange rate (yen per dollar)
Foreign Exchange
Market Intervention
S
130
Target exchange
rate
130
120
130
130
D2
0
1.1
1.2
1.3
1.4
D0
D1
1.5
Quantity (trillions of dollars per day)
81
Financing International Trade
The balance of payments accounts include:
4) Balance of official reserve transactions equals:
• Net increase in foreign official reserve claims on the US
• less: the net increase in US official reserves
• Measures the degree to which monetary authorities
in the US and abroad joined with other lenders to
cover the US current account deficit
• The bookkeeping offset to this is the official settlements
accounts balance
84
Financing International Trade
Official settlements accounts balance (a.k.a
“the balance of payments”) equals:
• Current account balance
• plus: the non-reserve portion of the capital &
financial account balance
• plus: the statistical discrepancy
• Measures the payments gap that official
reserve transactions need to cover
85
Financing International Trade
Official settlements accounts balance (a.k.a “the
balance of payments”)
• Played an important historical role as a measure of
disequilibrium in international payments (still plays
this role for many countries)
• Negative balance of payments (deficit) may signal a
crisis – means a country is running down its foreign
reserves (or borrowing foreign reserves)
86