Chapter 38
The Balance of
Payments,
Exchange Rates,
and Trade Deficits
McGraw-Hill/Irwin
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
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 - interest
–Net transfers
–Balance on current account
38-4
Balance of Payments
• Capital and financial account
–Capital account – Debt forgiveness
–Financial account - Assets
• Balance of payments accounts
sum to zero
• Current account deficits generate
asset transfers to foreigners
• Official reserves
38-6
1945 - 2009
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
38-9
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
38-10
Flexible Exchange Rates
The Market for Foreign Currency (Pounds)
P
Dollar Price of 1 Pound
S1
$3
$2
Dollar
Depreciates
(Pound
Appreciates)
Exchange
Rate: $2 = £1
Dollar
Appreciates
(Pound
Depreciates)
$1
D1
0
Q1
Q
Quantity of Pounds
38-11
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
38-12
Change in Tastes
Vs.
Change in Relative Income
Change in Relative Price Level
Change in Relative Interest Rates
Change in
Relative
Expected
Returns on
Investment
Currency Speculation
Selffulfilling
prophecy
Flexible Exchange Rates
The Market for Foreign Currency (Pounds)
P
Dollar Price of 1 Pound
S1
c
$3
$2
$1
a
x
Exchange
Rate:
$3 = £1
Balance
Of Payments
Deficit
b D
2
Exchange
Rate:
$2 = £1
D1
0
Q1
Q2
Q
Quantity of Pounds
38-18
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
• Depreciation of dollar = more exports = higher prices
(inflation)
• Appreciation of dollar = more imports/less exports =
38-19
more unemployment
Fixed Exchange Rates
• Government intervention
– Alter Supply/Demand
• Use of reserves (show on graph)
– Selling pounds = transfer of assets
• Trade policies – tariffs, subsidies
• Exchange controls and rationing
– Distorted trade lessens advantages
– Favoritism to certain importers
– Restricted choice for consumers
– Black markets – LEVIS!
38-20
Macroeconomic Adjustments
• Monetary/Fiscal Policy
–Trade deficit with Britain
–Reduce demand for British Pounds
by undertaking contractionary
policy
–The cost?
–Recession.
Exchange Rate Systems
• Gold standard 1879-1934
–Fixed exchange rate system
• Bretton Woods 1944-1971
–Fixed exchange rate system
indirectly tied to gold
–International Monetary Fund
• Managed float 1971-present
38-22
Managed Float
• Dependence on foreign exchange
markets
• Occasional intervention (IMF)
– Tsunami
• In support of managed float
– Track Record
• Concerns with managed float
– Volatility
– Manipulation
38-23
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
38-24
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
38-25
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
38-26