© 2005 Thomson C hapter 32 Exchange Rates, Balance of Payments, and International Debt

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CChapter 32hapter 32

Exchange Rates, Exchange Rates, Balance of Payments, Balance of Payments,

and International Debtand International Debt

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Gottheil - Principles of Economics, 4e

Economic PrinciplesEconomic Principles

Exchange rates

Foreign exchange markets

Appreciation and depreciation of currencies

Floating and fixed exchange rates

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Economic PrinciplesEconomic Principles

Arbitrage

Devaluation

Balance of payments

International debt and debt service

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The Foreign Exchange The Foreign Exchange Market: The Buying and Market: The Buying and

Selling of CurrenciesSelling of CurrenciesForeign exchange market

• A market in which currencies of different nations are bought and sold.

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Selling of CurrenciesSelling of CurrenciesExchange rate

• The number of units of foreign currency that can be purchased with one unit of domestic currency.

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Selling of CurrenciesSelling of Currencies1. Suppose that a kite costs 40 yaps, and the exchange rate is 10 yaps to the dollar. What is the dollar price of the kite?

• 40 yaps/10 = 4 dollars.

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EXHIBIT 1 FOREIGN EXCHANGE MARKET

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Exhibit 1: Foreign Exchange Exhibit 1: Foreign Exchange MarketMarket

At $2 per yap, is the foreign exchange market in Exhibit 1 in equilibrium, or is there an excess demand or excess supply of yaps?• Since the equilibrium price is $3 per yap, at $2 per yap there would be an excess demand for yaps.

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Exhibit 1: Foreign Exchange Exhibit 1: Foreign Exchange MarketMarket

At $4 per yap, is the foreign exchange market in Exhibit 1 in equilibrium, or is there an excess demand or excess supply of yaps?• Since the equilibrium price is $3 per yap, at $4 per yap there would be an excess supply of yaps.

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Selling of CurrenciesSelling of Currencies

• When the price of a foreign currency declines, the quantity of that foreign currency demanded increases.

2. Why is the demand curve for foreign currency downward-sloping?

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• For example, if a dollar can buy more yaps than before, then a dollar can also buy more yap-priced goods and services than before.

2. Why is the demand curve for foreign currency downward-sloping?

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Selling of CurrenciesSelling of Currencies2. Why is the demand curve for foreign currency downward-sloping?

• As a result, Americans wish to exchange dollars for more yaps in order to buy more yap-priced goods, increasing the quantity of yaps demanded in the foreign exchange market.

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• When the price of a foreign currency rises, then the purchasing power of the foreign currency rises when it comes to buying imported goods and services.

3. Why is the supply curve for foreign currency upward-sloping?

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Selling of CurrenciesSelling of Currencies3. Why is the supply curve for foreign currency upward-sloping?• For example, if it takes more dollars to buy a yap, then it takes fewer yasps to buy a dollar, and so the price of American goods are cheaper for people who use the yap.

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Selling of CurrenciesSelling of Currencies3. Why is the supply curve for foreign currency upward-sloping?• As a result, people who use yaps wish to exchange more yaps for dollars in order to buy more American goods, increasing the quantity of yaps supplied in the foreign exchange market.

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Selling of CurrenciesSelling of Currencies4. Which of the following will cause an increase in the demand for yaps?a. Decreasing American incomes

b. Increasing yap-priced interest rates

c. Increasing American interest rates

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a. Decreasing American incomes

b. Increasing yap-priced interest rates

c. Increasing American interest rates

4. Which of the following will cause an increase in the demand for yaps?

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EXHIBIT 2 EFFECT OF AN INCREASE IN THE DEMAND FOR YAPS ON THE DOLLARS-FOR-YAPS RATE OF EXCHANGE

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Exhibit 2: Effect of an Exhibit 2: Effect of an Increase in the Demand Increase in the Demand for Yaps on the Dollars-for Yaps on the Dollars-

for-Yaps Rate of for-Yaps Rate of ExchangeExchange1. After the increase in demand from D1

to D2, Is there excess supply, excess demand, or equilibrium at an exchange rate of $3 per yap?• There is excess demand of (70 - 30) = 40 thousand yaps.

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Exhibit 2: Effect of an Exhibit 2: Effect of an Increase in the Demand Increase in the Demand for Yaps on the Dollars-for Yaps on the Dollars-

for-Yaps Rate of Exchangefor-Yaps Rate of Exchange2. After the increase in demand from D1 to D2, what is the new equilibrium exchange rate?• The new equilibrium exchange rate is $5 per yap.

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Selling of CurrenciesSelling of Currencies5. Which of the following will cause a decrease in the supply of yaps?

a. Decreasing American tastes for yap-priced goods

b. Decreasing yap-priced interest rates

c. Decreasing yap-priced incomes

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5. Which of the following will cause a decrease in the supply of yaps?

a. Decreasing American tastes for yap-priced goods

b. Decreasing yap-priced interest rates

c. Decreasing yap-priced incomes

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EXHIBIT 3 EFFECT OF AN INCREASE IN THE SUPPLY OF YAPS ON THE DOLLARS-FOR-YAPS RATE OF EXCHANGE

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Exhibit 3: Effect of an Exhibit 3: Effect of an Increase in the Supply of Increase in the Supply of

Yaps on the Dollars-for-Yaps Yaps on the Dollars-for-Yaps Rate of ExchangeRate of Exchange1. After the increase in supply from S1

to S2, is there excess supply, excess demand, or equilibrium at an exchange rate of $3 per yap?• There is an excess supply of (50 - 30) = 20 thousand yaps.

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Exhibit 3: Effect of an Exhibit 3: Effect of an Increase in the Supply of Increase in the Supply of

Yaps on the Dollars-for-Yaps Yaps on the Dollars-for-Yaps Rate of ExchangeRate of Exchange2. After the increase in supply from S1

to S2, what is the new equilibrium exchange rate?• The new equilibrium exchange rate is $2 per yap.

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Floating Exchange Floating Exchange RatesRates

Floating exchange rate

• An exchange rate determined strictly by the demands and supplies for a nation’s currency.

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Appreciation

• A rise in the price of a nation’s currency relative to foreign currencies.

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Depreciation

• A fall in the price of a nation’s currency relative to foreign currencies.

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1. Complete the sentence:

When journalists say that the dollar has “weakened,” they mean that the dollar has _____ in value.

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1. Complete the sentence:

When journalists say that the dollar has “weakened,” they mean that the dollar has depreciated in value.

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2. If the dollar has appreciated in value relative to the yap, then which of the following is true:a. The exchange rate has more yaps per dollar than before.

b. The exchange rate has fewer yaps per dollar than before.

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2. If the dollar has appreciated in value relative to the yap, then which of the following is true:a. The exchange rate has more yaps per dollar than before.

b. The exchange rate has fewer yaps per dollar than before.

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Tourists at the MallTourists at the Mall

Has the U.S. dollar appreciated or depreciated in value relative to the Japanese yen between 1960 and 1996?

• Depreciated in value.

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Tourists at the MallTourists at the Mall

Has the U.S. dollar appreciated or depreciated in value relative to the Japanese yen between 1960 and 1996?• In 1960 the exchange rate was 358 yen per dollar. By 1996 there were only 131 yen per dollar.

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Arbitrage

• The practice of buying a foreign currency in one market at a low price and selling it in another at a higher price.

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3. How might floating exchange rates make international trade riskier? • Suppose that the price of an internationally traded good changes during the time between when a purchase is negotiated and the product is delivered.

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3. How might floating exchange rates make international trade riskier? • Then the change in exchange rates is like an unforeseen change in the price of the good, which redistributes the gains from trade in an unforeseen way.

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Fixed exchange rate

• A rate determined by government and then maintained through the process of buying and selling quantities of its own currency on the foreign exchange market.

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EXHIBIT 4A TRADE UNDER FREE AND FIXED EXCHANGE RATES

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EXHIBIT 4B TRADE UNDER FREE AND FIXED EXCHANGE RATES

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Exhibit 4: Trade Exhibit 4: Trade Under Free and Fixed Under Free and Fixed

Exchange RatesExchange Rates1. If there is a system of free or floating exchange rates, then what happens if the demand for a foreign currency increases?• The exchange rate (dollars per unit of foreign currency) increases and there is neither excess demand nor excess supply of the foreign currency.

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Exchange RatesExchange Rates2. If there is a system of fixed exchange rates, then what happens if the demand for a foreign currency increases?• Since the exchange rate cannot change, an increase in demand will create excess demand for the foreign currency.

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Exchange RatesExchange Rates

• The yap government will need to exchange some of its own yaps for dollars on the foreign exchange market.

3. If there is excess demand for yaps under a system of fixed exchange rates, what will the yap government need to do to eliminate the excess demand for the yap?

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• This will increase the supply of yaps on the foreign exchange market and eliminate the excess demand.


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• In order for the yap government to do this, it must have sufficient stock of yaps to exchange for dollars.


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Exchange RatesExchange Rates4. Continuing the yap example, what might the yap government be forced to do if it did not have a sufficient quantity of yaps on reserve to eliminate the excess demand?• The yap government might be forced to borrow yaps from another country, or even agree to increase the exchange rate ($ per yap).

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Foreign exchange reserves

• The stock of foreign currencies a government holds.

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Devaluation

• Government policy that lowers the nation’s exchange rate; its currency instantly is worth less in the foreign exchange market.

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4. In which of the following circumstances would a country most likely be forced into a devaluation of its currency: a. The excess supply of its currency in the foreign exchange market exceeds its foreign exchange reserves.

b. The excess demand for its currency in the foreign exchange market exceeds its foreign exchange reserves.

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4. In which of the following circumstances would a country most likely be forced into a devaluation of its currency: a. The excess supply of its currency in the foreign exchange market exceeds its foreign exchange reserves.

b. The excess demand for its currency in the foreign exchange market exceeds its foreign exchange reserves.

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Import controls

• Tariffs and quotas used by government to limit a nation’s imports.

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Exchange controls

• A system in which government, as the sole depository of foreign currencies, exercises complete control over how these currencies can be used.

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International Monetary Fund (IMF)

• An international organization formed to make loans of foreign currencies to countries facing balance of payments problems.

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Balance of PaymentsBalance of Payments

Balance of payments

• An itemized account of a nation’s foreign economic transactions.

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Balance on current account

• A category that itemizes a nation’s imports and exports of goods and services, income receipts and payments on investment, and unilateral transfers.

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EXHIBIT 5 THE U.S. BALANCE OF PAYMENTS ACCOUNT: 2002 ($ BILLIONS)

Source: Survey of Current Business (Washington, D.C.: U.S. Department of Commerce, February 2003).

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Exhibit 5: The U.S. Balance Exhibit 5: The U.S. Balance of Payments Account: of Payments Account:

2002 ($ billions)2002 ($ billions)In which of the following categories of the U.S. balance of payments did the U.S. run a surplus in 2002?a. Balance of trade

b. Balance on current account

c. Balance on capital account

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Exhibit 5: The U.S. Balance Exhibit 5: The U.S. Balance of Payments Account: 2002 of Payments Account: 2002

($ billions)($ billions)In which of the following categories of the U.S. balance of payments did the U.S. run a surplus in 2002?a. Balance of trade

b. Balance on current account

c. Balance on capital account

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EXHIBIT 6 U.S. BALANCE OF TRADE: 1950–2002

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Exhibit 6: U.S. Exhibit 6: U.S. Balance of Trade: Balance of Trade:

1950-20021950-2002What has been the overall trend in the U.S. balance of trade since the mid-1970s?• Since the mid-1970s the U.S. balance of trade has been in deficit.

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What is an example of an export of services?

• When a U.S. engineering firm provides engineering design services for a project in another country.

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Unilateral transfers

• Transfers of currency made by individuals, businesses, or government of one nation to individuals, businesses, or governments in other nations, with no designated return.

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Balance on capital account

• A category that itemizes changes in the foreign asset holdings of a nation and that nation’s asset holdings abroad.

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What is a Balance of What is a Balance of Payments Problem?Payments Problem?

Do trade imbalances always create problems?

• No. For example, a country may have a balance of trade deficit because it is importing capital equipment necessary for it to produce valuable exports in the future.

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How Deficits on How Deficits on Current Account Current Account

DevelopDevelop

• Foreign purchases of U.S. stocks and bonds increases the demand for U.S. dollars.

If foreigners make huge investments in U.S. stocks and bonds, how might this affect the current account?

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DevelopDevelop

• Increased demand for the U.S. dollar increases the value of the dollar relative to other currencies.

If foreigners make huge investments in U.S. stocks and bonds, how might this affect the current account?

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DevelopDevelopIf foreigners make huge investments in U.S. stocks and bonds, how might this affect the current account? • A high-valued dollar makes imports cheap for Americans, but makes American exports expensive for foreigners in other countries.

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DevelopDevelopIf foreigners make huge investments in U.S. stocks and bonds, how might this affect the current account? • Consequently imports increase and exports decline, causing a current account deficit.

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International DebtInternational Debt

International debt

• The total amount of outstanding IOUs a nation is obligated to repay other nations and international organizations.

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International DebtInternational Debt

Debt service

• Interest payments on international debt as a percentage of a nation’s merchandise exports.

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EXHIBIT 7 DEBT SERVICE OF SELECTED COUNTRIES, AS A PERCENTAGE OF EXPORTS: 2001

Source: United Nations Development Programme, Human Development Report 2003 (New York: Oxford University Press, 2003).

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Exhibit 7: Debt Service of Exhibit 7: Debt Service of Selected Countries, as a Selected Countries, as a Percentage of ExportsPercentage of Exports

What causes countries such as Argentina to have such high debt service as a percentage of their exports?• The amount of international debt held by these countries is quite large relative to the value of their exports, making repayment difficult.

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© 2005 Thomson C hapter 32 Exchange Rates, Balance of Payments, and International Debt