International Finance

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International Finance

  1. 1. International Finance <ul><li>Chapter 33 </li></ul>© 2006 Thomson/South-Western
  2. 2. Balance of Payments <ul><li>A country’s balance of payments summarizes all economic transactions that occur during a given period between residents (people, firms, and governments) of that country and residents of other countries </li></ul><ul><li>Balance of payments measures a flow, or the balance of economic transactions </li></ul>
  3. 3. Balance of Payments <ul><li>Balance-of-payments accounts are maintained according to the principles of double-entry bookkeeping, in which entries on one side of the ledger are called credits, and entries on the other side are called debits. </li></ul>
  4. 4. Merchandise Trade Balance <ul><li>Equals the value of merchandise exports minus the value of merchandise imports </li></ul><ul><li>Reflects trade in goods, or tangible products, and is often referred to as the trade balance </li></ul><ul><ul><li>If the value of merchandise exports exceeds the value of merchandise imports, there is a trade surplus </li></ul></ul><ul><ul><li>If the value of merchandise imports exceeds the value of merchandise exports, there is a trade deficit </li></ul></ul>
  5. 5. Exhibit 1: Relative to GDP, U.S. Imports Have Topped Exports Since 1976, and the Trade Deficit Has Widened
  6. 6. Exhibit 2: U.S. Trade Deficits in 2003 by Country or Region
  7. 7. Balance on Goods and Services <ul><li>Balance on goods and services: the portion of a country’s balance-of-payments account that measures the value of a country’s exports of goods and services minus the value of its imports of goods and services (net exports) </li></ul><ul><li>Merchandise trade balance focuses on the flow of goods, but services (intangibles) are also traded internationally </li></ul>
  8. 8. Unilateral Transfers <ul><li>Unilateral transfers consist of government transfers to foreign residents: foreign aid, personal gifts to individuals abroad, etc. </li></ul><ul><li>Net unilateral transfers equal the unilateral transfers received from abroad by U.S. residents minus unilateral transfers sent to foreign residents by U.S. residents </li></ul>
  9. 9. Balance on Current Account <ul><ul><li>The portion of a country’s balance-of-payments account that measures that country’s balance on goods and services plus its net unilateral transfers </li></ul></ul><ul><ul><li>Can be negative = current account deficit </li></ul></ul><ul><ul><li>Can be positive = current account surplus </li></ul></ul>
  10. 10. Capital Account <ul><li>The record of a country’s international transactions involving purchases or sales of financial and real assets </li></ul><ul><li>Between 1917 and 1982, the United States ran a deficit in the capital account </li></ul><ul><ul><li>U.S. residents purchased more foreign assets than foreigners purchased assets in the U.S. </li></ul></ul><ul><ul><li>This reversed itself in 1983, and since then foreigners have purchased more U.S. assets than the other way around </li></ul></ul>
  11. 11. U.S. Balance of Payments 2003 (billions of dollars)
  12. 12. U.S. Balance of Payments 2003 (billions of dollars) <ul><li>All transactions requiring payments from foreigners to U.S. residents are entered as credits, indicated by a plus sign (+), because they result in an inflow of funds from foreign residents to U.S. residents. </li></ul><ul><li>All transactions requiring payments to foreigners from U.S. residents are entered as debits, indicated by a minus sign (  ), because they result in an outflow of funds from U.S. residents to foreign residents. As you can see, a surplus in the capital account of $579.0 billion more than offsets a current account deficit of $541.8 billion. </li></ul>
  13. 13. U.S. Balance of Payments <ul><li>The statistical discrepancy that balances p ayments is a negative $37.2 billion </li></ul><ul><li>Statistical discrepancy: the official “fudge factor” that: </li></ul><ul><ul><li>measures the error in the balance-of-payments </li></ul></ul><ul><ul><li>satisfies the double-entry bookkeeping requirement that total debits equal total credits </li></ul></ul>
  14. 14. Foreign Exchange and Exchange Rates <ul><li>Foreign exchange : foreign money needed to carry out international transactions </li></ul><ul><li>Exchange rate : the price measured in the currency of one country that is needed to purchase one unit of another country’s currency </li></ul>
  15. 15. The Euro and Exchange Rates <ul><li>The euro is now the common currency of the euro area </li></ul><ul><li>The price, or exchange rate, of the euro in terms of the dollar is the number of dollars required to purchase one euro </li></ul>
  16. 16. Foreign Exchange <ul><li>Currency depreciation : with respect to the dollar, an increase in the number of dollars needed to purchase 1 unit of foreign exchange in a flexible rate system </li></ul><ul><li>Currency appreciation : With respect to the dollar, a decrease in the number of dollars needed to purchase 1 unit of foreign exchange in a flexible rate system </li></ul>
  17. 17. Demand for Foreign Exchange <ul><li>U.S. residents need euros to pay for goods and services produced in the euro area </li></ul><ul><li>The demand curve for euros the inverse relationship between the dollar price of the euro and the quantity of euros demanded, other things constant </li></ul><ul><ul><li>Incomes and preferences of U.S. consumers </li></ul></ul><ul><ul><li>The expected inflation rates in the U.S. and the euro area </li></ul></ul><ul><ul><li>The euro price of goods in the euro area </li></ul></ul><ul><ul><li>Interest rates in the U.S. and the euro area </li></ul></ul>
  18. 18. Demand for Foreign Exchange <ul><li>In the aggregate, the lower the dollar price of foreign exchange, other things constant, the greater the quantity demanded </li></ul><ul><li>A drop in the dollar price of foreign exchange, in this case the euro, means that fewer dollars are required to purchase each euro: prices of euro goods become cheaper </li></ul>
  19. 19. Supply of Foreign Exchange <ul><li>The supply of foreign exchange is generated by the desire of foreign residents to acquire dollars </li></ul><ul><li>The positive relationship between the dollar-per-euro exchange rate and the quantity of euros supplied in the foreign exchange market implies an upward-sloping supply curve </li></ul><ul><li>Assumed constant are: </li></ul><ul><ul><li>euro area incomes and preferences </li></ul></ul><ul><ul><li>expectations about the rates of inflation in the euro area and the United States </li></ul></ul><ul><ul><li>interest rates in the euro area and the United States </li></ul></ul>
  20. 20. Exhibit 4: The Foreign Exchange Market 1.10 0 D S Foreign exchange (millions of euros) 800 820 Exchange rate (dollars per euro) <ul><li>Initial equilibrium exchange rate is $1.10 </li></ul><ul><li>If the exchange rate is allowed to adjust freely, or to float in response to market forces, the market will clear continually </li></ul>1.20 1.00
  21. 21. Exhibit 5: Effect on the Foreign Exchange Market of an Increased Demand for Euros 1.10 0 D S Foreign exchange (millions of euros) 800 $1.12 820 <ul><li>Suppose an increase in U.S. incomes causes Americans to increase their demand for all normal goods, including those from the euro area: demand curve shifts from D to D' </li></ul><ul><li>The shift of the demand curve leads to an increase in the exchange rate from $1.10 to $1.12 per euro </li></ul><ul><li>The euro appreciates and the dollar depreciates: euro area people purchase more American products </li></ul>Exchange rate (dollars per euro) D'
  22. 22. Arbitrageurs <ul><li>Dealers who take advantage of temporary geographic differences in exchange rates by simultaneously buying a currency in one market and selling it in another </li></ul><ul><ul><li>If one euro costs $0.89 in New York and $0.90 in Frankfurt, the arbitrageur would buy euros in New York and at the same time sell them in Frankfurt </li></ul></ul><ul><ul><ul><li>Demand for euros in New York would increase </li></ul></ul></ul><ul><ul><ul><li>Supply of euros in Frankfurt would increase </li></ul></ul></ul><ul><ul><ul><li>Price differential would be eliminated </li></ul></ul></ul>
  23. 23. Speculators <ul><li>Speculators buy or sell foreign exchange in hopes of profiting from fluctuations in the exchange rate over time </li></ul><ul><ul><li>trading the currency at a more favorable exchange rate later </li></ul></ul><ul><li>By taking risks, speculators aim to profit from market fluctuations by trying to buy low now and sell high later </li></ul>
  24. 24. Purchasing Power Parity <ul><li>Purchasing power parity theory (PPP): predicts the exchange rate between two currencies will adjust in the long run to reflect price-level differences between the two currency regions </li></ul><ul><li>This is true as long as trade across borders is unrestricted and exchange rates are allowed to adjust freely </li></ul><ul><li>PPP is generally a long-run indicator </li></ul>
  25. 25. Purchasing Power Parity <ul><li>A given basket of internationally traded goods should therefore sell for about the same around the world after adjusting for transportation costs and the like </li></ul><ul><li>Big Mac Index </li></ul>
  26. 26. Exhibit 6: In May 2004, the U.S. Price of a Big Mac Exceeded Prices in Most Other Countries
  27. 27. Flexible Exchange Rates <ul><li>Exchange rate determined by the forces of demand and supply without government intervention </li></ul>
  28. 28. Fixed Exchange Rates <ul><li>Fixed exchange rates : rate of exchange between currencies pegged within a narrow range and maintained by the central bank’s ongoing purchases and sales of currencies </li></ul><ul><li>Suppose the European Central Bank selects what it thinks is an appropriate rate of exchange between the dollar and the euro: it attempts to fix, or peg, the exchange rate within a narrow band around the particular value selected </li></ul>
  29. 29. Fixed Exchange Rates <ul><li>If the value of the euro threatens to climb above the maximum acceptable exchange rate, monetary authorities </li></ul><ul><ul><li>Sell euros and buy dollars keeping the dollar price of the euro down </li></ul></ul><ul><li>If the value of the euro threatens to drop below the minimum acceptable exchange rate, monetary authorities </li></ul><ul><ul><li>Sell dollars and buy euros in foreign exchange markets </li></ul></ul>
  30. 30. Fixed Exchange Rates <ul><li>If monetary officials must keep selling foreign exchange to maintain the pegged rate, they risk running out of foreign exchange reserves </li></ul><ul><li>The government has several options </li></ul><ul><ul><li>The pegged exchange rate can be increased: devaluation of the domestic currency </li></ul></ul><ul><ul><li>The pegged exchange rate can be decreased: revaluation of the domestic currency </li></ul></ul><ul><ul><li>The government can attempt to reduce the domestic demand for foreign exchange directly by imposing restrictions on imports or capital flows </li></ul></ul>
  31. 31. Fixed Exchange Rates <ul><li>The government can adopt contractionary fiscal or monetary policies to reduce the country’s income level, increase interest rates, or reduce inflation relative to that of the country’s trading partners </li></ul><ul><li>Finally, the government can allow the disequilibrium to persist and ration the available foreign reserves through some form of foreign exchange control </li></ul>
  32. 32. Development of the International Monetary System <ul><li>From 1879 to 1914, the international financial system operated under a gold standard </li></ul><ul><li>The gold standard provided a fixed, predictable exchange rate that did not vary as long as currencies could be redeemed for gold at the announced rate </li></ul>
  33. 33. Bretton Woods Agreement <ul><li>Because the U.S. had a strong economy, the dollar was selected as the key reserve currency </li></ul><ul><li>Created the International Monetary Fund (IMF) to </li></ul><ul><ul><li>Set rules for maintaining the international monetary system </li></ul></ul><ul><ul><li>Standardize financial reporting for international trade </li></ul></ul><ul><ul><li>Make loans to countries with temporary balance of payments problems </li></ul></ul><ul><ul><li>Establish a revolving fund to lend money to troubled economies </li></ul></ul>
  34. 34. Demise of the Bretton Woods System <ul><li>During the latter part of the 1960s, inflation in the U.S. caused the dollar to become overvalued at the official exchange rate </li></ul><ul><ul><li>The gold value of the dollar exceeded the exchange value of the dollar </li></ul></ul><ul><li>The result was that in August 1971, the U.S. stopped exchanging gold for dollars </li></ul>
  35. 35. Demise of the Bretton Woods System <ul><li>The dollar was devalued with the hope that this would put the dollar on firmer footing and would save the dollar standard </li></ul><ul><li>With prices rising at different rates, an international monetary system based on fixed exchanged rates was doomed and the Bretton Woods system collapsed </li></ul>
  36. 36. Current System: Managed Float <ul><li>Managed float system: combines features of a freely floating exchange rate with sporadic intervention by central banks as a way of moderating exchange rate fluctuations among the world’s major currencies </li></ul><ul><li>Most smaller countries still peg their currencies to one of the major currencies or to a basket of major currencies </li></ul>
  37. 37. Managed Float <ul><li>Major criticisms of flexible exchange rates: </li></ul><ul><ul><li>They are inflationary because they free monetary authorities to pursue expansionary policies </li></ul></ul><ul><ul><li>They have often been volatile, especially since the late 1970s </li></ul></ul><ul><ul><li>This volatility creates uncertainty and risks for importers and exporters and can lead to wrenching changes in the competitiveness of a country’s export sector </li></ul></ul><ul><li>Policymakers’ ideal is a system that will foster international trade, lower inflation, and promote a more stable world economy </li></ul>

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