International Finance

1. International Finance • International Finance -- measures of international transactions, and determination of exchange rates in the US.

2. Measures of International Finance • Record of all transactions between Americans and residents of other countries over a flow interval. • Current Account • Capital Account • Official Settlements Balance

3. The Current Account • Current Account = {Exports + Foreign Transfers to US + Income earned from American holdings of investments abroad} -- {Imports + US Transfers to Foreigners + Income earned from foreign investments in US}

4. The Current Account: Interpretation • Items in the first set of { } -- current account inflows, ways that dollars enter into the US from international current account transactions. • Items in the second set of { } -- current account outflows, ways that dollars leave the US from international current account transactions.

5. The Current Account: Characteristics • Comprehensive measure of the Balance of Trade (NX is an approximation). • Net income generated to Americans as a result of international transactions.

6. The Capital Account • Capital Account = {New Foreign Purchases of US Assets} - {New US Purchases of Foreign Assets} • Capital Account = {Capital Inflows} - {Capital Outflows}

7. The Official Settlements Balance • Official Settlements Balance= Current Account + Capital Account • Represents “net total dollar inflows” after all international transactions have been completed during a flow period. • Recorded as change in official reserve assets at the International Monetary Fund (IMF)

8. The Recent US Record -- International Transactions • Current Account < 0 • Capital Account > 0 • Official Settlements Balance  0 • Example -- 2000 (Billions of $) -- Current Account = -$435 -- Capital Account = $399 -- Settlements Balance = -$36

9. A Quick review About Exchange Rates • Exchange Rate (e) -- the amount of foreign currency needed to be exchanged for one (US) dollar. • Also known as the “value of the dollar”. • Conversion Ratio, in units of (foreign currency)/(US dollar)

10. Exchange Rate Changes e  price of American goods and services to foreigners  price of foreign goods and services to Americans e  price of American goods and services to foreigners  price of foreign goods and services to Americans

11. Exchange Rate Regimes • Fixed (Pegged) Exchange Rates -- exchange rates are fixed by the government, unless changed by economic policy. • Floating Exchange Rates -- exchanged rates determined by natural forces in the foreign exchange market.

12. The Foreign Exchange Market & the Exchange Rate • The Foreign Exchange Market -- the demand and supply for dollars for use in international transactions.

13. Concepts to Understand Foreign Exchange Behavior • Items (goods, services, financial assets) are priced in a country’s home currency. • If one wishes to buy from another country, he/she must convert from their own currency to the currency of the country selling the item.

14. More Important Foreign Exchange Concepts • The exchange rate (e) specifies the ratio of conversion. • The same exchange rate holds for all transactions – purchases or sales of goods, services and financial assets.

15. The Demand for Dollars • The Demand for Dollars -- foreigners demand for US dollars, to buy American goods, services, or financial assets. • Inversely related to the exchange rate (e), with other causes (shift variables) as well.

16. The Supply of Dollars • The Supply of Dollars -- Americans supplying dollars to the foreign exchange market, in order to buy foreign goods, services, or financial assets. • Positively related to the exchange rate (e), with other causes (shift variables) as well.

17. Foreign Exchange Market Equilibrium • Equilibrium exchange rate (foreign currency)/(US$) -- “price of dollars.” • At equilibrium, total dollar inflows equal total dollar outflows. • Therefore, at equilibrium, the Official Settlements Balance = 0 automatically without any need for policy.

18. Major Causes of Exchange Rate Movements • US Interest Rates (r*) • Interest Rates of Other Nations (rW) • Speculation -- Expectations of future exchange rate changes.

19. US Interest Rates and Exchange Rate Movements • Suppose r*. • This causes substitution away from foreign assets into US assets. • The demand for dollars increases (D$ curve shifts rightward) and the supply of dollars decreases (S$ curve shifts leftward). • As a result e*.

20. Foreign Interest Rates and Exchange Rate Movements • Suppose rW. • This causes substitution away from US assets into foreign assets. • The demand for dollars decreases (D$ curve shifts leftward) and the supply of dollars increases (S$ curve shifts rightward). • As a result e*.

21. Speculation and Exchange Rate Movements • Constantly fluctuating exchange rate creates opportunities to make capital gains from timed purchases or sales of currency. • Incentive to buy dollars when exchange rate is low, then sell dollars when exchange rate rises. • Creates “speculative bubble” behavior -- like stock market.

22. Floating Exchange Rates • Advantages -- No loss of official reserves at the IMF, market equilibrium  current account + capital account = 0. -- Federal Reserve does not need to participate in foreign exchange market, can focus solely on domestic policy.

23. Floating Exchange Rates (Continued) • Disadvantages -- Fluctuating exchange rate is disruptive to International Trade. -- Exchange rates can fluctuate a great deal, especially due to speculation (speculative bubbles).

24. Fixed Exchange Rates • Advantages -- exchange rate is constant, stability in International Trade.

25. Fixed Exchange Rates (Continued) • Disadvantages -- Federal Reserve must intervene constantly in the foreign exchange market  money supply decreases or loss of official reserves. -- Fed might be forced into contractionary monetary policy to raise US interest rates and increase e* to the target fixed rate.

26. Exchange Rate Regimes -- Overall • Ideal system: floating exchange rates which do not exhibit much movement. • Actual system (US): Managed Float -- floating exchange rates with occasional Federal Reserve intervention, to stop large movement in e*.