© OnlineTexts.com p. 1 Chapter 7 Econ124 Parks Foreign Exchange and the Balance of Payments Foreign Exchange and the Balance of Payments

© OnlineTexts.com p. 1

Chapter 7Econ124 Parks

Foreign Exchange and

the Balance of Payments

Foreign Exchange and

the Balance of Payments


Foreign Exchange

• Foreign exchange is currency and bank deposits that are denominated in foreign money.– Consumers indirectly deal in the foreign exchange

market every time they purchase an import.– A purchase by a person in the U.S. of a German

automobile ultimately means that dollars are converted into euros to pay for the car.

• Foreign exchange is currency and bank deposits that are denominated in foreign money.– Consumers indirectly deal in the foreign exchange

market every time they purchase an import.– A purchase by a person in the U.S. of a German

automobile ultimately means that dollars are converted into euros to pay for the car.


Exchange Rate

• The exchange rate (e) is the amount of domestic currency that it takes to purchase one unit of foreign currency.– We will view everything from the U.S. perspective. – Example: if US$1 purchases 5 pesos, then it takes

US$0.20 to purchase 1 peso, so the exchange rate e is $0.2/peso or 1/5.

– Exactly like $/six_pack – Alternatively, if US$1 purchases 0.50 pounds, then it

takes US$2 to purchase one pound so the exchange rate is 2.0.

• The exchange rate (e) is the amount of domestic currency that it takes to purchase one unit of foreign currency.– We will view everything from the U.S. perspective. – Example: if US$1 purchases 5 pesos, then it takes

US$0.20 to purchase 1 peso, so the exchange rate e is $0.2/peso or 1/5.

– Exactly like $/six_pack – Alternatively, if US$1 purchases 0.50 pounds, then it

takes US$2 to purchase one pound so the exchange rate is 2.0.


Exchange Rate Tables

• Exchange rates are often quoted two ways.

• The definition this book uses is “U.S. $ Equivalent.”

• Exchange rates are often quoted two ways.

• The definition this book uses is “U.S. $ Equivalent.”

TABLE 1Exchange Rates

Country CurrencyU.S.$

EquivalentCurrency per U.S. $

Brazil Real 0.369 2.71

Britain Pound 1.87 0.535

Canada Dollar 0.812 1.23

E.M.U. Euro 1.30 0.766

India Rupee 0.023 43.76

Japan Yen 0.010 104.84

Mexico Peso 0.089 11.28

Taiwan Dollar 0.031 32.01Note: Many exchange listings use the Currency per U.S. $ method except when quoting the British pound. The British pound is almost always quoted as the U.S. $ Equivalent.






$ per Brazilain real

0

0.2

0.4

0.6

0.8

1

1.2

1.4

Jan-1995 Sep-1997 Jun-2000 Mar-2003 Dec-2005 Sep-2008



$ per Canadian Dollar

0.61

0.66

0.71

0.76

0.81

0.86

0.91

0.96

1.01

Jan-1971 Jun-1976 Dec-1981 Jun-1987 Nov-1992 May-1998 Nov-2003 May-2009



$ per rupee

0

0.02

0.04

0.06

0.08

0.1

0.12

0.14

0.16

Jan-1973 Jun-1978 Dec-1983 Jun-1989 Nov-1994 May-2000 Nov-2005

$ per rupee



$ per yen

0.0026

0.0036

0.0046

0.0056

0.0066

0.0076

0.0086

0.0096

0.0106

0.0116




$ per yuan

0.1

0.2

0.3

0.4

0.5

0.6

Jan-1981 Jun-1986 Dec-1991 Jun-1997 Nov-2002 May-2008





$ per Baht

0

0.01

0.02

0.03

0.04

0.05

0.06




$ per kroner

0

0.05

0.1

0.15

0.2

0.25




$ per Singapore dollar

0.405

0.455

0.505

0.555

0.605

0.655

0.705




$ per Venezuelan bolivar

0

1

2

3

4

5

6

7

Jan-1995 Sep-1997 Jun-2000 Mar-2003 Dec-2005 Sep-2008





PPPI

• Purchasing Power Parity Index

• Like a price index, take a market basket, determine in home country’s currency the value, and then use ratios to construct a ‘conversion of currency’

• Big Mac 'index' http://www.nationmaster.com/graph/eco_big_mac_ind-economy-big-mac-index

http://www.oanda.com/products/bigmac/bigmac.shtml

• Purchasing Power Parity Index

• Like a price index, take a market basket, determine in home country’s currency the value, and then use ratios to construct a ‘conversion of currency’

• Big Mac 'index' http://www.nationmaster.com/graph/eco_big_mac_ind-economy-big-mac-index


http://www.nationmaster.com/graph/eco_big_mac_ind-economy-big-mac-index









Changes in exchange rates• Currencies are traded continuously much like

stocks so that their relative prices (exchange rates) fluctuate minute by minute.– Suppose 1 U.S. dollar = 1 Argentine peso, e = 1.0.– The U.S. dollar then appreciates--becomes

stronger--relative to the peso so that one U.S. dollar purchases 1.25 pesos, or 1 peso costs US$0.80. The exchange rate declines from 1.0 to 0.80.

– An appreciation of the domestic currency corresponds with a decrease in the exchange rate as Yeager defines the exchange rate – dollar cost of foreign currency.

• Currencies are traded continuously much like stocks so that their relative prices (exchange rates) fluctuate minute by minute.– Suppose 1 U.S. dollar = 1 Argentine peso, e = 1.0.– The U.S. dollar then appreciates--becomes

stronger--relative to the peso so that one U.S. dollar purchases 1.25 pesos, or 1 peso costs US$0.80. The exchange rate declines from 1.0 to 0.80.

– An appreciation of the domestic currency corresponds with a decrease in the exchange rate as Yeager defines the exchange rate – dollar cost of foreign currency.


• Note that using Yeager’s definition of exchange rate, e=$/foreign, if e increases, the dollar has ‘depreciated’ where depreciate means the value of the dollar has decreased. If e decreases, the dollar has appreciated or increased in value.

• Note that using Yeager’s definition of exchange rate, e=$/foreign, if e increases, the dollar has ‘depreciated’ where depreciate means the value of the dollar has decreased. If e decreases, the dollar has appreciated or increased in value.


Changes in exchange rates

• The converse is also true.– Suppose 1 U.S. dollar = 1 Argentine peso, e = 1.0.

– The U.S. dollar then depreciates--becomes weaker--relative to the peso so that $1.25 purchases one peso. The exchange rate rises from 1.0 to 1.25.

– A depreciation of the domestic currency corresponds with an increase in the exchange rate.

• The converse is also true.– Suppose 1 U.S. dollar = 1 Argentine peso, e = 1.0.

– The U.S. dollar then depreciates--becomes weaker--relative to the peso so that $1.25 purchases one peso. The exchange rate rises from 1.0 to 1.25.

– A depreciation of the domestic currency corresponds with an increase in the exchange rate.


Historical U.S. Exchange Rates

• U.S. exchange rates have fluctuated widely over time. • U.S. exchange rates have fluctuated widely over time.

Exchange RatesTrade-w eighted value of U.S. $ vs. Major currencies

(inverted scale)

60

70

80

90

100

110

120

130

140Ja

n-7

3

Jan

-76

Jan

-79

Jan

-82

Jan

-85

Jan

-88

Jan

-91

Jan

-94

Jan

-97

Jan

-00

Jan

-03

Jan

-06


Determination of the Exchange Rate

• The forces of supply and demand interact to determine the exchange rate.

• Currency is supplied and demanded, and the equilibrium price of the currency is the exchange rate.


• Currency is supplied and demanded, and the equilibrium price of the currency is the exchange rate.


Demand for Foreign Exchange

• Demand for foreign exchange is domestic demand for foreign currency. IMPORTS

• The demand curve for foreign exchange is negatively sloped; as the exchange rate rises, quantity demanded of foreign exchange falls.

• Demand for foreign exchange is domestic demand for foreign currency. IMPORTS

• The demand curve for foreign exchange is negatively sloped; as the exchange rate rises, quantity demanded of foreign exchange falls.


Supply of Foreign Exchange

• Supply of foreign exchange is foreign demand for domestic currency EXPORTS

• The supply curve for foreign exchange is positively sloped; as the exchange rate rises quantity supplied of foreign exchange also rises.

• Supply of foreign exchange is foreign demand for domestic currency EXPORTS

• The supply curve for foreign exchange is positively sloped; as the exchange rate rises quantity supplied of foreign exchange also rises.


The Equilibrium Exchange Rate




Exports, Imports and Trade Deficits

• International trade has surged in recent years.– In 2005 the United States exported US$1.3 trillion

in goods and services.– In 2005 the United States imported US$2.0 trillion

in goods and services.– The excess of imports over exports is referred to as

the trade deficit or the (negative) balance on goods and services.

– In 2005 the trade deficit was U.S.$717 billion.

• International trade has surged in recent years.– In 2005 the United States exported US$1.3 trillion

in goods and services.– In 2005 the United States imported US$2.0 trillion

in goods and services.– The excess of imports over exports is referred to as

the trade deficit or the (negative) balance on goods and services.

– In 2005 the trade deficit was U.S.$717 billion.


Recent U.S. Trade Deficits

• The U.S. has run persistent and growing trade deficits since the 1980s.

• The U.S. has run persistent and growing trade deficits since the 1980s.

TABLE 2U.S. Trade

Deficits

Year

Trade Deficit(US$

Billions)

1980

19.4

1985

121.9

1990

80.9

1995

96.3

2000

377.6

2003

494.9

2004

611.3

2005

716.7




How are Trade Deficits Financed?

• Trade deficits suggest that the demand for foreign exchange exceeds the supply of foreign exchange.

• Thought question:– If the U.S. demands US$1.5 trillion in foreign

exchange to purchase imports but it supplies just US$1.0 trillion to provide exports, does that not imply that the market is in disequilibrium?

• Trade deficits suggest that the demand for foreign exchange exceeds the supply of foreign exchange.

• Thought question:– If the U.S. demands US$1.5 trillion in foreign

exchange to purchase imports but it supplies just US$1.0 trillion to provide exports, does that not imply that the market is in disequilibrium?


• Trade deficit• Trade deficit


International Capital Flows

• Besides imports, another source of demand for foreign currency comes from investing in foreign assets.

• A capital outflow is the purchase of a foreign asset by a domestic entity.– If Coca-Cola Inc. builds a production plant in

Singapore, the U.S. experiences a capital outflow when U.S. dollars are converted to the Singapore currency.

• Besides imports, another source of demand for foreign currency comes from investing in foreign assets.

• A capital outflow is the purchase of a foreign asset by a domestic entity.– If Coca-Cola Inc. builds a production plant in

Singapore, the U.S. experiences a capital outflow when U.S. dollars are converted to the Singapore currency.


Capital Outflows and the Exchange Rate

• An increase in capital outflows increases the demand for foreign exchange, or shifts the demand for foreign exchange to the right, increasing both the exchange rate and the quantity of foreign exchange traded.

• An increase in capital outflows increases the demand for foreign exchange, or shifts the demand for foreign exchange to the right, increasing both the exchange rate and the quantity of foreign exchange traded.


Capital Inflows

• Supply of foreign exchange is also affected by international capital flows.

• When foreigners decide to invest in U.S. assets, the U.S. economy receives a capital inflow.– purchase of a U.S. stock or bond by a Mexican

citizen.– a Japanese firm purchases builds an auto plant in

the U.S.

• Supply of foreign exchange is also affected by international capital flows.

• When foreigners decide to invest in U.S. assets, the U.S. economy receives a capital inflow.– purchase of a U.S. stock or bond by a Mexican

citizen.– a Japanese firm purchases builds an auto plant in

the U.S.


Capital Inflows and the Exchange Rate

• An increase in capital inflows increases the supply of foreign exchange and shifts the supply curve for foreign exchange to the right, decreasing the exchange rate and increasing the quantity of foreign exchange traded.

• An increase in capital inflows increases the supply of foreign exchange and shifts the supply curve for foreign exchange to the right, decreasing the exchange rate and increasing the quantity of foreign exchange traded.


The Paradox Resolved

• We can now explain the paradox of persistent trade deficits.– If foreigners are willing to invest more funds each

year in U.S. assets than U.S. citizens are willing to invest in foreign assets, then the U.S. can run a persistent trade deficit year after year.

– The difference is made up in international capital flows. Ultimately, the supply and demand for foreign exchange are equal.

• We can now explain the paradox of persistent trade deficits.– If foreigners are willing to invest more funds each

year in U.S. assets than U.S. citizens are willing to invest in foreign assets, then the U.S. can run a persistent trade deficit year after year.

– The difference is made up in international capital flows. Ultimately, the supply and demand for foreign exchange are equal.


The Balance of Payments

• The Balance of Payments is a record of a country's trade in goods, services, and financial assets with the rest of the world.

• Debits are items that represent demand for foreign exchange.

• Credits are items that represent supply of foreign exchange .

• The Balance of Payments is a record of a country's trade in goods, services, and financial assets with the rest of the world.

• Debits are items that represent demand for foreign exchange.

• Credits are items that represent supply of foreign exchange .



• The Balance of Payments is composed of two major accounts:– The current account primarily tracks the

international flow of goods and services.• Exports and imports dominate the current account.

– The capital account primarily tracks the international flow of financial assets.

• Capital inflows are credits while capital outflows are debits.

• The Balance of Payments is composed of two major accounts:– The current account primarily tracks the

international flow of goods and services.• Exports and imports dominate the current account.

– The capital account primarily tracks the international flow of financial assets.

• Capital inflows are credits while capital outflows are debits.



• Because the current and capital accounts must sum to zero in theory, but rarely do in practice, the statistical discrepancy account corrects for errors and omissions in the accounts to ensure that the balance of payments sums to zero, or

Current Account + Capital Account = 0

• Because the current and capital accounts must sum to zero in theory, but rarely do in practice, the statistical discrepancy account corrects for errors and omissions in the accounts to ensure that the balance of payments sums to zero, or

Current Account + Capital Account = 0


Debits Credits BalanceCurrent AccountExports Goods 894.6 Services 380.6 Income 474.6Imports Goods 1677.4 Services 314.6 Income 463.4Net Unilateral Transfers 86.1Current Account Balance -791.7

Capital Account Capital Outflows 426.8 Capital Inflows 1212.3Capital Account Balance 785.5

Statistical Discrepancy 6.2

TABLE 3U.S. Balance of Payments, 2005

(Billion US$)



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© OnlineTexts.com p. 1 Chapter 7 Econ124 Parks Foreign Exchange and the Balance of Payments Foreign Exchange and the Balance of Payments