International Finance

Balance of Payments • A country’s balance of payments summarizes all economic transactions that occur during a given period between residents of that country and residents of other countries • Balance of payments measures a flow • More descriptive phrase would be the balance of economic transactions

Balance of Payments • Balance of payments accounts are maintained according to the principles of double-entry bookkeeping • Entries on one side of the ledger are called credits • Entries on the other side are called debits • Consists of several individual accounts • Deficit in one or more accounts must be offset by a surplus in the other accounts

Merchandise Trade Balance • Merchandise trade balance equals the value of merchandise exports minus the value of merchandise imports • Reflects trade in goods, or tangible products and is often referred to as the trade balance • If the value of merchandise exports exceeds the value of merchandise imports, there is a trade surplus

Merchandise Trade Balance • If the value of merchandise imports exceeds the value of merchandise exports, there is a trade deficit • The trade balance depends on a variety of factors • Relative strength and competitiveness of the domestic economy compared to other economies • Relative value of the domestic currency compared to other currencies

Exhibit 1: Us Merchandise Trade Since 1960 Relative to GDP, U.S. imports have topped exports since 1976, and the trade deficit has widened

Merchandise Trade Balance • Since 1976 U.S. imports have exceeded U.S. exports every year • Trade deficits as a percent of GDP have increased steadily during the last decade, growing from 1.3% in 1991 to 4.6% in 2000

U.S. Balance of Payments: 2000 ($ billions) • Payments from foreigners to U.S. residents are credits (+) • Payments from U.S. residents to foreigners are debits (-)

Balance on Goods and Services • Merchandise trade balance focuses on the flow of goods, but services, intangibles, are also traded internationally • These services are often called invisibles • The balance on goods and services is the value of exports of goods and services minus the value of imports of goods and services • Common to refer to exports minus imports  net exports

Unilateral Transfers • Unilateral transfers consist of government transfers to foreign residents, foreign aid, personal gifts to individuals abroad, etc. • Net unilateral transfers equal the unilateral transfers received from abroad by U.S. residents minus unilateral transfers sent to foreign residents by U.S. residents

Balance on Current Account • The current account includes all transactions in currently produced goods and services plus net unilateral transfers • Can be negative  current account deficit • Can be positive  current account surplus • Zero

Capital Account • The capital account records transactions involving foreign assets and liabilities • Between 1917 and 1982, the United States ran a deficit in the capital account  U.S. residents purchased more foreign assets than foreigners purchased assets in the U.S. • This reversed itself in 1983 and since 1983, U.S. imports of capital have exceeded exports  surplus in capital account

Foreign Exchange • Foreign exchange is the currency of another country that is needed to carry out international transactions • A country runs a deficit in its current account when the amount of foreign exchange that country gets from exporting goods and services and from receipts of unilateral transfers falls short of the amount needed to pay for its imports and to make unilateral transfers

Foreign Exchange • The additional foreign exchange required must come from a net capital inflow • If a country runs a current account surplus, the foreign exchange received from selling exports and from unilateral transfers received exceeds the amount required to pay for imports and to make unilateral transfers • The deficit in the U.S. current account in recent years has been offset by a surplus in the capital account

Exchange Rate • The exchange rate is the price of a unit of one currency required to purchase a unit of another currency • Determined by the interaction of the households, firms, private financial institutions, governments, and central banks that buy and sell foreign exchange • Fluctuates to equate the quantity of foreign exchange demanded with the quantity supplied • Foreign exchange market incorporates all the arrangements used to buy and sell foreign exchange

Exchange Rate • We will consider the market for the euro in terms of the dollar • Euro is the common currency of 12 European countries • Big advantage of a common currency is that Europeans no longer have to change money every time they cross a border or trade with other countries in the group

Exchange Rate • The price, or exchange rate, of the euro in terms of the dollar is the number of dollars required to purchase one euro • An increase in the number of dollars needed to purchase a euro indicates a weakening, or a depreciation, of the dollar • A decrease in the number of dollars needed to purchase a euro indicates a strengthening, or an appreciation of the dollar

Demand for Foreign Exchange • U.S. residents need euros to pay for goods and services produced in Euroland • The demand curve for euros the inverse relationship between the dollar price of the euro and the quantity of euros demanded, other things constant • Incomes and preferences of U.S. consumers • The expected inflation rates in the U.S. and Euroland • The euro price of goods in Euroland • Interest rates in the U.S. and Euroland

Demand for Foreign Exchange • In the aggregate, the lower the dollar price of foreign exchange, other things constant, the greater the quantity demanded • A drop in the dollar price of foreign exchange, in this case the euro, means that fewer dollars are required to purchase each euro  prices of euro goods become cheaper

Supply of Foreign Exchange • The supply of foreign exchange is generated by the desire of foreign residents to acquire dollars • The positive relationship between the dollar-per-euro exchange rate and the quantity of euros supplied in the foreign exchange market implies an upward-sloping supply curve

Supply of Foreign Exchange • The supply curve is drawn assuming other things constant • Euroland incomes and preferences • Expectations about the rates of inflation in Euroland and the United States • Interest rates in Euroland and the United States • Exhibit 3 brings together the demand for and supply of foreign exchange to determine the equilibrium exchange rate

Exhibit 3: The Foreign Exchange Market The fewer dollars needed to purchase 1 unit of foreign exchange, the lower the price of foreign goods and the greater the quantity of foreign goods demanded  the greater the amount of exchange demanded  demand curve for foreign exchange slopes downward. S $1.00 Exchange rate (dollars per euro) 0.90 0.80 D Foreign exchange (millions of euros) 0 800 An increase in the exchange rate makes U.S. products cheaper for foreigners  increased demand for U.S goods  an increase in the quantity of foreign exchanged supplied  the supply curve of foreign exchange slopes upward

Exhibit 3: The Foreign Exchange Market S The equilibrium exchange rate of $0.90 per euro occurs where the quantity of euros demanded equals the quantity supplied $1.00 Exchange rate (dollars per euro) 0.90 Once achieved, this equilibrium will remain constant until a change occurs in one of the factors that affect supply or demand 0.80 D Foreign exchange (millions of euros) 0 800 If the exchange rate is allowed to adjust freely, or to float, in response to market forces, the market will clear continually

$0.92 D' 820 Exhibit 4: Increase in Demand for Euros Suppose an increase in U.S. incomes causes Americans to increase their demand for all normal goods, including those from Euroland  demand curve shifts from D to D' S Exchange rate (dollars per euro) 0.90 The supply curve does not change since an increase in U.S. income should not affect Eurolanders’ willingness to supply euros. D Foreign exchange (millions of euros) 0 800 The shift of the demand curve leads to an increase in the exchange rate from $0.90 per euro to $0.92 per euro  the euro appreciates and the dollar depreciates. This prompts some Eurolanders to purchase more American products

Arbitrageurs • Exchange rates between specific currencies are nearly identical at any given time in markets around the world • Arbitrageurs are dealers who take advantage of any difference in exchange rates between markets by buying low and selling high ensure this equality  their actions help to equalize exchange rates across markets

Arbitrageurs • Because they buy and sell simultaneously, relatively little risk is involved • For example, if one euro costs $0.89 in New York but $0.90 in Frankfurt, the arbitrageur would buy euros in New York and the same time selling them in Frankfurt • the demand for euros in New York would increase and the supply of euros in Frankfurt would increase • price differential would be eliminated

Speculators • Speculators buy or sell foreign exchange in hopes of profiting by trading the currency at a more favorable exchange rate later • By taking risks, speculators aim to profit from market fluctuations by trying to buy low now and selling high later

Purchasing Power Parity • As long as trade across borders is unrestricted and as long as exchange rates are allowed to adjust freely, the purchasing power parity theory (PPP) predicts that the exchange rate between two currencies will adjust in the long run to reflect price-level differences between the two currency regions • A given basket of internationally traded goods should therefore sell for about the same around the world after adjusting for transportation costs and the like

Purchasing Power Parity • The PPP theory is more of a long-run predictor than a day-to-day indicator of the relationship between changes in the price level and the exchange rate • Because of trade barriers, central bank intervention in exchange markets, and the fact that many of the products are not traded, the PPP theory usually does not explain exchange rates at a particular point in time

Flexible Exchange Rates • In our preceding examples, we have been discussing a system of flexible exchange rates exchange rates are determined by supply and demand • Flexible, or floating, exchange rates adjust continually to the myriad forces that buffet the foreign exchange market • Government officials usually have little direct role in foreign exchange markets

Fixed Exchange Rates • If government officials try to set exchange rates, acting and ongoing central bank intervention is necessary to establish and maintain these fixed exchange rates • Suppose, for example, the European Central Bank selects what it thinks is an appropriate rate of exchange between the dollar and the euro it attempts to fix or peg the exchange rate within a narrow band around the particular value selected

Fixed Exchange Rates • If the value of the euro threatens to climb above the maximum acceptable exchange rate, monetary authorities • must sell euros and buy dollars • thereby keeping the dollar price of the euro down • Conversely, if the value of the euro threatens to drop below the minimum acceptable exchange rate, monetary authorities • must sell dollars and buy euros in foreign exchange markets

Fixed Exchange Rates • If monetary officials must keep selling foreign exchange to maintain the pegged rate, they risk running out of foreign exchange reserves • The government has several options • The pegged exchange rate can be increased: devaluation of the domestic currency • The pegged exchange rate can be decreased: revaluation of the domestic currency • The government can attempt to reduce the domestic demand for foreign exchange directly by imposing restrictions on imports or capital flows

Fixed Exchange Rates • The government can adopt contractionary fiscal or monetary policies to reduce the country’s income level, increase interest rates, or reduce inflation relative to that of the country’s trading partners • Finally, the government can allow the disequilibrium to persist and ration the available foreign reserves through some form of foreign exchange control

Gold Standard • From 1879 to 1914, the international financial system operated under a gold standard the major currencies were convertible into gold at a fixed rate • The gold standard provided a predictable exchange rate, one that did not vary as long as currencies could be redeemed for gold at the announced rate

Gold Standard • However, the money supply in each country was determined in part by the flow of gold between countries  each country’s monetary policy was influenced by the supply of gold • A balance-of-payments deficit resulted in a loss of gold, which theoretically caused a country’s money supply to drop

Gold Standard • Conversely, a balance-of-payments surplus resulted in an increase in gold  a country’s money supply would increase • The supply of money throughout the world also depended on the vagaries of gold discoveries

Bretton Woods Agreement • During World War I, many countries could no longer convert their currencies into gold with the result that the gold standard eventually collapsed • At the end of World War II, the Allies met to formulate a new international monetary system • Because the U.S. had a strong economy, the dollar was selected as the key reserve currency

Bretton Woods Agreement • All exchange rates were fixed in terms of the dollar and the U.S. stood ready to convert foreign holdings of dollars into gold at a rate of $35 an ounce • Even though exchange rates were fixed by the Bretton Woods accord, other countries could adjust their exchange rates relative to the U.S. dollar if they found a chronic disequilibrium in their balance of payments

International Monetary Fund • The Bretton Woods agreement also created the International Monetary Fund (IMF) to • Set rules for maintaining the international monetary system • Standardize financial reporting for international trade • Make loans to countries with temporary balance of payments problems • Establish a revolving fund to lend money to troubled economies

Demise of the Bretton Woods System • During the latter part of the 1960s, inflation in the U.S. caused the dollar to become overvalued at the official exchange rate • the gold value of the dollar exceeded the exchange value of the dollar • The result was that in August 1971, the U.S. stopped exchanging gold for Dollars

Demise of the Bretton Woods System • The dollar was devalued with the hope that this would put the dollar on firmer footing and would save the dollar standard • With prices rising at different rates, an international monetary system based on fixed exchanged rates was doomed • The Bretton Woods system collapsed

Managed Float • Managed float system combines features of a freely floating exchange rate with sporadic intervention by central banks as a way of moderating exchange rate fluctuations among the world’s major currencies • Most smaller countries still peg their currencies to one of the major currencies or to a basket of major currencies

Managed Float • Major criticisms of flexible exchange rates • They are inflationary since they free monetary authorities to pursue expansionary policies • They have often been volatile, especially since the late 1970s • This volatility creates uncertainty and risks for importers and exporters and can lead to wrenching changes in the competitiveness of a country’s export sector

International Finance