International Finance

•Balance of payments•Trade deficits and surpluses•Foreign exchange markets

BOP accounting is the recording of transactions between domestic and foreign economic agents.Any transaction that results in a receipt of money by domestic agents from abroad is recorded as a credit in the BOP accounts.Any transaction that entails the payment of money by domestic units to foreigners is recorded as a debit in the BOP accounts.The current account records foreign transactions involving merchandise and services.The financial account records foreign transactions involving financial assets and land.

Balance of payments

Definitions•Net investment income abroad: Investment earnings by U.S. residents minus investment earnings by foreign residents from their assets in the United States•Net unilateral transfers abroad : The unilateral transfers (gifts and grants) received abroad by U.S. residents minus the unilateral transfers U.S. residents send abroad

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U.S. balance of payments for 2006 (billions of dollars)

Current Account

1. Merchandise exports2. Merchandise imports3. Merchandise trade balance (1+2)4. Service exports5. Service imports6. Goods and services balance (3+4+5)7. Net Investment Income from abroad8. Net unilateral transfers9. Current account balance (6+7+8)

+1,023.1- 1,861.4

- 838.3+422.6

- 342.8- 758.5

+36.6- 89.6

- 811.5Financial Account

10. Change in U.S. owned assets abroad 11. Change in foreign-owned assets in U.S.12. Financial account balance (10+11)13. Statistical discrepancy

- 1,059.1+1,888.4

+829.3- 17.8

TOTAL (9+12+13) 0.0

As you can see, the United States had a large current

account deficit in 2006

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U.S. imports have exceeded U.S. exports since 1976, and the trade deficit has widened

7

U.S. trade deficit in 2006 by country or region

U.S. imports more goods from each of the world’s major economies than it exports to them. The largest U.S. trade deficit is with China, which exported five times more to the United States in 2006 than it imported from the United States.

If Wal-Mart was a country, it would be

China’s seventh largest trading partner

An exchange rate is the priceof one national currency

expressed in terms of another national currency. For example, the dollar

price of the British pound is $1.71--meaning it takes $1.71 to buy 1 pound

Exchange rates

If the dollar price of the British pound ($/£) is:

$1.49 = £1 Then the pound price of the dollar (£/$) is given by the reciprocal of the dollar-pound exchange rate. That is:

$/£ = pounds67.049.11

Exchange Rates are Determined by the Supply & Demand for Foreign Exchange

Dollars per Euro

Euros0

Supply of euros

Demand for euros

E*

1.26

•To purchase European-made goods and services.•To purchase stocks in European companies companies or other euro-denominated assets.•To speculate on future exchange rate movements.

Why do agents want to exchange dollars for euros ?

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The foreign exchange market

8000 Foreign exchange(millions of euros)

1.20

1.25

$1.30

Exch

ange

rate

(dol

lars

per

eur

o)

D

S

The fewer dollars needed to purchase 1 unit of foreign exchange, the lower the price of foreign goods, the greater the quantity of foreign goods demanded, and the greater the quantity of foreign exchange demanded. The D curve slopes downward.

An increase in in the exchange rate makes US products cheaper for foreigners. The increases demand for US goods implies an increase in the quantity of foreign exchange supplied. The S curve slopes upward.

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Effect on the foreign exchange market of an increased demand for euros

1.251.27

Exch

ange

rate

(dol

lars

per

eur

o)

D’

S

D

8000 Foreign exchange(millions of euros)820

The intersection of the demand curve for foreign exchange, D, and the supply curve for foreign exchange, S, determines the exchange rate. At an exchange rate of $1.25 per euro, the quantity demanded of euros equals the quantity supplied.

An increase in the demand for euros from D to D’ increases the exchange rate from $1.25 to $1.27 per euro.

The dollar has strengthened against the euro recently

Exchange Rates and the Prices of Imported Goods

Question: Suppose the dollar price of a new Harley Davidson is $22,000. How much would a German buyer have to pay in euros?

Euro price of the Harley

Euro price = dollar price of the Harley × euro price of the dollar

Thus, at the current exchange rate (€ 0.79 = $1) we have:

Euro price = $22,000 × 0.79 = € 17,380

An appreciating dollar makes U.S.-made goods and services

less price-competitive

Example: Let the dollar appreciate against the euro

The new exchange rate is € 1 = $1

Thus we have:

Euro price = $22,000 × 1.00 = €22,000

Exchange rates and the Affordability of Imported Goods

The euro price of a Krups coffee maker is €45.00

Question: What is the price of the coffee maker expressed in dollars?

If the dollar price of one euro is $1.26, then:

$Price = (1.26)(45) = $56.70

Effect of an appreciating dollar on the price of imported goods

What if the dollar should appreciate, or gain value, against the euro?

Let the dollar price of the euro to decrease to $1.00 .

Question: What is the dollar price of the Krups coffee maker?

$ price = (1.00)(45) = $45.00

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In late June 2007, a Big Mac cost more in the US than in most other countries