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  1. 1. The Balance ofPayments,Exchange Rates,and Trade DeficitsChapter 38McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
  2. 2. Chapter Objectives• How currencies are exchanged• Balance sheet for recordinginternational payments• How exchange rates aredetermined• Flexible vs. fixed exchangerates• Causes and consequences oftrade deficits38-2
  3. 3. International Transactions• International trade–Buy/sell current goods or services–Imports and exports• International asset transactions–Buy/sell real or financial assets–Buy stock–Sell your house to a foreigner• Requires currency exchange38-3
  4. 4. Balance of Payments• Sum of international financialtransactions• Current account–Balance on goods and services–Net investment income–Net transfers–Balance on current account38-4
  5. 5. Balance of Payments• Capital and financial account–Capital account–Financial account• Balance of payments accountssum to zero• Current account deficits generateasset transfers to foreigners• Official reserves38-5
  6. 6. U.S. Trade BalancesGoods and Services, Select Nations, 2007SurplusDeficitAustraliaBelgiumCanadaChinaGermanyMexicoNetherlands+10.0-67.0-45.3+9.8-256.6-77.3+14.3Source: Bureau of Economic Analysis-10-20-30-40-50-60-70-250 10 20Japan -85.038-6
  7. 7. Flexible Exchange Rates• Demand for pounds• Supply of pounds• Market equilibrium• Increase in dollar price of pounds–Dollar depreciates–Pound appreciates• Decrease in dollar price of pounds–Dollar appreciates–Pound depreciates38-7
  8. 8. Q0DollarPriceof1PoundQuantity of PoundsPFlexible Exchange RatesThe Market for Foreign Currency (Pounds)D1S1DollarDepreciates(PoundAppreciates)DollarAppreciates(PoundDepreciates)ExchangeRate: $2 = £1$2$3$1Q138-8
  9. 9. Flexible Exchange Rates• Determinants of exchange rates• Factors that shift demand/supply–Changes in tastes–Relative income changes–Relative price-level changes•Purchasing-power-parity theory–Relative interest rates–Relative expected returns onassets–Speculation38-9
  10. 10. Q0DollarPriceof1PoundQuantity of PoundsPFlexible Exchange RatesThe Market for Foreign Currency (Pounds)D1S1ExchangeRate:$2 = £1$2$3$1Q1D2ExchangeRate:$3 = £1BalanceOf PaymentsDeficitQ2x abc38-10
  11. 11. Flexible Exchange Rates• Eliminate balance of paymentsdeficit or surplus• Disadvantages of flexibleexchange rates–Volatility–Uncertainty and diminished trade–Terms-of-trade changes–Instability38-11
  12. 12. Fixed Exchange Rates• Government intervention–Use of reserves• Trade policies• Exchange controls and rationing–Distorted trade–Favoritism–Restricted choice–Black markets• Macroeconomic adjustments 38-12
  13. 13. Exchange Rate Systems• Gold standard 1879-1934–Fixed exchange rate system• Bretton Woods 1944-1971–Fixed exchange rate systemindirectly tied to gold• Managed float 1971-present38-13
  14. 14. Managed Float• Dependence on foreignexchange markets• Occasional intervention• In support of managed float• Concerns with managedfloat38-14
  15. 15. U.S. Trade Deficit• Large and persistent• Causes of trade deficits–High U.S. growth (relatively)–China–Price oil–Low U.S. saving rate• Implications of trade deficits–Increased current consumption–Increased indebtedness 38-15
  16. 16. Speculation in Currency Markets• Positive or negative influence?• Contributes to currency marketfluctuations• Self-fulfilling expectations• Smoothing short-termfluctuations• Absorbing risk• Futures market at work• Positive role played overall38-16
  17. 17. Key Terms• balance of payments• current account• balance on goods andservices• trade deficit• trade surplus• balance on currentaccount• capital and financialaccount• balance on capital andfinancial• balance-of-paymentsdeficits and surpluses• official reserves• flexible- or floating-exchange-rate system• fixed-exchange-ratesystem• purchasing-power-parity theory• currency interventions• managed floatingexchange rate38-17