Ch 38: EXCHANGE RATES, THE BALANCE OF POWER, AND TRADE DEFICITShttps://www.youtube.com/watch?v=xwtgByffoUw (fx 6:24)

Financing International TradeForeign exchange markets enable international transactions to take place by providing markets for the exchange of national currencies.

Example: AMERICAN EXPORT• A U.S. firm sells computers to a British firm.• the British sends the U.S. firm a check on its deposits (in British pounds ₤) at a London bank• The U.S. firm deposits (technically “sells” ) the British check to an American bank to receive

dollars • The American bank may:

- hold the pounds as an asset for future use- may exchange the pounds for dollars in the foreign exchange market

NOTE that:• Exports create a demand for dollars and a supply of foreign money, in this case ₤.• The financing of an American export reduces the supply of money (demand deposits) in

Britain and increases it in the U.S.

The above analysis is reversed for an American import.

FOREIGN CURRENCY EXCHANGE

Foreign exchange markets: - competitive microeconomic markets - large numbers of buyers, large numbers of sellers - Dollars for euros, euros for pounds, pounds for pesos

- “FX” markets always exist in pairs.

Freely floating fx rates (i.e. prices) are determined by the forces of demand & supply.

Downward sloping demand: - as a nation’s currency becomes less expensive, more of it’s goods can be bought

(and larger quantities of the currency are demanded)

Upward sloping supply: - as a nation’s currency becomes more expensive, holders of that currency can

obtain other currencies more cheaply- Holder’s of that nation’s currency will want to buy imported goods

(and larger quantities of the currency are supplied)

FLEXIBLE EXCHANGE RATES

Depreciation: - the value of a currency has fallen - it takes more units of that country’s currency to buy another country’s currency.

Appreciation: - the value of a currency (its purchasing power) has risen; - it takes less of that currency to buy another country’s currency.

Changing rates

If the demand for yen rises, the dollar price of yen rises. (i.e. The yen appreciates and the dollar depreciates relative to the yen.)

The result is that Japanese goods would become more expensive to Americans and U.S. products would become less expensive to the Japanese.

(The above analysis can be reversed.)

DETERMINANTS of EXCHANGE RATES

• Changes in tastes or preferences for a country’s products

• Relative income changes - Rising incomes increase the demand for imports,

increases the supply of that country’s currency… …and the demand for other country’s currencies.

• Relative price level changes

• Changes in relative real interest rates - Higher U.S. interest rates attract foreign savings.

they raise the demand for dollars and reduce the supply of dollars …as U.S. investment dollars may remain in this country.

• Speculation. - Belief that the value of a currency is about to fall will increase the

supply of that currency and reduce its demand. (The reverse is also true.)

- this can become a self fulfilling prophecy ‑(Δ in demand is in the same price direction as

supply)

a. Indicate whether each of the following creates a demand for or a supply of European euros in foreign exchange markets. b. Then state whether the Euro will appreciate or depreciate in value.

c. A U.S. airline firm purchases several Airbus planes assembled in France.creates a demand for euros (appreciation)

b. A German automobile firm decides to build an assembly plant in South Carolina.creates a supply of euros (depreciation)

c. A U.S. college student decides to spend a year studying at the Sorbonne.creates a demand for euros (appreciation)

d. An Italian manufacturer ships machinery from one Italian port to another on a Liberian freighter.

creates a supply of euros… (depreciation)**note that Liberia is an non-EU nation (in Africa)

e. The United States economy grows faster than the French economy.

… creates a demand for euros (French PL < US PL; US income ↑ … appreciation)f. A United States government bond held by a Spanish citizen matures, and the loan is paid

back to that person.creates a demand for euros (appreciation)

g. It is widely believed that the Swiss franc will fall in the near future.Switzerland is not in the EU and does not use the euro as currency…

… this expectation would create a demand for euros (appreciation)

Assuming a system of floating exchange rates between Mexico and the United States, indicate whether each of the following would cause the Mexican peso to appreciate or depreciate:a. The United States unilaterally reduces tariffs on Mexican products.

The peso appreciates (demand for pesos increases)b. Mexico encounters severe inflation.

The peso depreciates (demand for pesos decreases and supply of pesos likely increases)

c. Deteriorating political relations reduce American tourism in Mexico. The peso depreciates (demand for pesos decreases)

d. The United States’ economy moves into a severe recession. The peso depreciates (demand for pesos decreases)

e. The U.S. engages in a high interest rate monetary policy. The peso depreciates (U.S. PL decreases…demand for pesos decreases)

f. Mexican products become more fashionable to U.S. consumers.The peso appreciates (demand for pesos increases)

g. The Mexican government encourages U.S. firms to invest in Mexican oil fields.The peso appreciates (demand for pesos increases)

h. The rate of productivity growth in the United States diminishes sharply. peso appreciates (U.S. AS shifts left; PL increases…demand for pesos increases)

True, false, or uncertain. Explain. a. “A country that grows faster than its major trading partners can expect the international value of its currency to depreciate.”TRUE:• Significant economic growth implies increases in price level and real incomes.• Imports will rise more than its exports. • The demand for foreign currency by its citizens will increase (more than any impact on the supply of foreign currency), causing the value of the domestic currency to decline.

b. “A nation whose interest rate is rising more rapidly than interest rates in other nations can expect the international value of its currency to appreciate.”

TRUE:• Rapidly rising interest rates increases the return on savings/investment.• Foreign financial investment will be attracted to the country, causing a rise in the supply of foreign currency (and an increased demand for the domestic currency).• Therefore, the domestic currency will appreciate.

c. “A country’s currency will appreciate if its inflation rate is less than that of the rest of the world.”TRUE:• Domestic price level will be relatively lower than foreign price levels.• Exports will increase, increasing the supply of foreign currency and demand for domestic currency.• Any domestic imports would be at relatively higher real prices, decreasing the demand for foreign currency.• Both factors will cause the country’s currency to appreciate.

THE BALANCE OF PAYMENTS

Balance of payments: the sum of all transactions that take place between a nation’s residents and the residents of all foreign nations.

Transactions include: - merchandise exports and imports, - tourist expenditures, and - interest & dividends from the purchase &sale of financial assets abroad.

Three components of the balance of payment: - the current account, the financial account, and the official reserves account.

Current Account - summarizes U.S. trade in currently produced goods & services (e.g. video games, tourism)

Financial Account (formerly called the capital account)- summarizes the flows of payments (money “capital”) from the purchase or sale of

real (e.g. land, machinery) or financial assets (e.g. bonds, stocks).

Official Reserves AccountThe central banks of nations hold quantities of foreign currencies called official reserves. These reserves can be drawn on to make up any net deficit in the combined current and capital accounts.

38-1 Explain how a U.S. automobile importer might finance a shipment of Toyotas from Japan. • The American importer can purchase a check made out in yen from its American bank. • The bank buys the yen by decreasing its yen denominated deposit with a Japanese bank and receives

payment by reducing the importing firm’s dollar denominated deposit. • Once Toyota receives the check, it will deposit it in its yen denominated account at a Japanese bank.

Trace the steps as to how a U.S. export of machinery to Italy might be financed. • An Italian importer of American machinery can draw a euros denominated check from its Italian bank. • The bank takes payment by decreasing the firm’s euros denominated bank account. • Once the American exporter receives the euros, it will sell it to an American bank, receiving payment

through an increase in its dollar denominated deposit. • The American bank deposits the euros in its account with an Italian bank for later use.

Explain: “U.S. exports earn supplies of foreign currencies, which Americans can use to finance imports.”• American exports lead to an increase in the foreign currency bank deposit holdings of Americans.• These holdings will be decreased through American purchases of imports. • Hence, the foreign currency assets earned through exports can be used to finance imports.

38 5‑ Suppose a Swiss watchmaker imports watch components from Sweden and exports watches to the United States. Also suppose the dollar depreciates, and the Swedish Krona appreciates, relative to the Swiss franc. Speculate as to how this would hurt the Swiss watchmaker.

If the dollar depreciated relative to the franc, this means that it took more dollars to get the francs necessary to buy a watch. In other words, the watch becomes more expensive in dollar terms which would cause a decline in imported watches purchased in the United States. Second, if the krona appreciated relative to the Swiss franc, this is the same thing as saying that the franc depreciated relative to the krona. In other words, it took more Swiss francs to buy parts in Sweden than it did previously. As a result, the imported components for the watches became more expensive to the Swiss company. The Swiss Watchmaker was hurt twice. Its costs rose while its export sales declined.

38 6 part 1: Explain why the U.S. demand for Mexican pesos is downsloping and the supply of pesos to Americans is upsloping. U.S. demand for pesos is downsloping:• When the peso depreciates in value (relative to the dollar) the US finds that

Mexican goods and services are less expensive in dollar terms. • The US purchases more Mexican goods, demanding a greater quantity of pesos in

the process.

The supply of pesos to the United States is upsloping: • As the peso appreciates in value (relative to the dollar), US. goods and services

become cheaper to Mexicans in peso terms. • Mexicans buy more dollars to obtain more U.S. goods, supplying a larger quantity of

pesos.

38 4 “A rise in the dollar price of yen necessarily means a fall in the yen price of dollars.” Do you agree? • Yes/true/agree. • A increase in the “dollar price of yen” means is takes more dollars to buy yen (i.e.

the yen has appreciated relative to the dollar). • At the same time, it takes fewer yen to buy a dollar, meaning that the yen price of

dollars has fallen.

Illustrate and elaborate: “The critical thing about exchange rates is that they provide a direct link between the prices of goods and services produced in all trading nations of the world.”• Exchange rates allow residents of all trading nations to express the prices of other

nations’ goods in terms of their own domestic currencies. • A change in the exchange rate between any two countries will automatically lead to

an adjustment in the prices of all goods and services in both countries in terms of the other’s currency.

Explain the purchasing power parity theory of exchange rates.• The purchasing power parity theory of exchange rates holds that exchange rates

change to equal the ratios of the nations’ price levels. • For example, if a certain item costs $100 in the U.S. and 22,900 yen in Japan, then

the exchange rate should be $1 = 229 yen. • It should take the same amount of dollars to buy the item anywhere in the world if

exchange rates adjust to maintain purchasing power parity.