→ the BOP summary is within a given year prepared in the domestic country’s currency
→ made up of two accounts: the current account (CA) and the capital and financial account (CFA)
→ includes the sale and purchase of goods, services, and assets
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Current Account (CA)
( 1 ) Trades in Goods and Services (Net Exports) → the difference between a nation’s exports of goods and services and its imports of goods and services
( 2 ) Investment Income → income from the factors of production including payments made to foreign investors
( 3 ) Net Transfers → money flows from the private or public sectors
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Capital and Financial Account (CFA)
measures the purchase and sale of financial assets abroad
→ purchases of things that continue to earn money
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Foreign Direct Investment
when a foreign company buys a business in a different country
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Net Capital Outflow
the difference between the purchase of foreign assets and domestic assets purchased by foreigners
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Financial Account Surplus
inflow > outflow
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Financial Account Deficit
inflow < outflow
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CA + CFA = 0
the CA and the CFA must balance out (if one has a surplus, the other has a deficit)
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Exchange Rate
price of one currency relative to another currency
→ the buyer (importer) must exchange their currency for that of the seller’s (exporter)
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Depreciation
the loss of value of a country’s currency with respect to a foreign currency
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Appreciation
the increase of value of a country’s currency with respect to a foreign currency
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Overview of Demand
→ in general, foreigners demand dollars
→ there is an inverse relationship between the exchange rate (price) and quantity demanded
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Overview of Supply
→ in general, Americans supply dollars
→ there is a direct relationship between the exchange rate (price) and quantity supplied
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Disequilibrium
→ shortages cause the exchange rate to rise
→ surpluses cause the exchange rate to fall
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FOREX Supply & Demand Simplified
if you demand one currency, you must supply your currency
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FOREX Shifters
( 1 ) Changes in Tastes
( 2 ) Changes in Relative Incomes (resulting in more imports)
( 3 ) Changes in Relative Price Level (resulting in more imports)
( 4 ) Changes in Relative Interest Rates
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FOREX Double Shifters
changes in price level and interest rates are double shifters
→ they effect the behavior of both buyers and sellers of the currency
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Fixed Exchange Rate
the government actively manages the country’s currency
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Floating Exchange Rate
the market determines the value of a country’s currency
→ some governments attempt to depreciate their country’s currency in order to promote exports
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Tariff
a tax on imports
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Quota
a limit on the quantity of imports
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Trade Restrictions
tariffs and quotas decrease the supply of the currency, restricting trade since fewer transactions are taking place
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Currency and Net Exports
a change in the international value of a country’s currency can drastically affect their exports and imports
Appreciation → Net Exports ↓
Depreciation → Net Exports ↑
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What happens if American tourists increase visits to Japan? (Practice example with USD and Japanese Yen)
Shifter: Change in Tastes
US Dollar Supply ↑, dollar depreciates
Japanese Yen Demand ↑, yen appreciates
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What happens if the US government significantly decreases income tax? (Practice example with USD and Japanese Yen)
Shifter: Change in Income
US Dollar Supply ↑, dollar depreciates
Japanese Yen Demand ↑, yen appreciates
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What happens if inflation in Japan rises significantly faster than in the US?
Shifter: Change in Price Level
US Dollar Demand ↑, US Dollar Supply ↓, dollar appreciates
Japanese Yen Supply ↑, Japanese Yen Demand ↓, yen depreciates
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Explain why higher inflation causes a shift in both the demand for dollars and the supply of dollars?
Demand ↓, Supply ↑
with higher inflation, fewer people demand the dollar but the US will demand more of other currencies
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When the dollar price of the Indian rupee increases, how is the value of the dollar affected?
the dollar depreciates in value
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How will inflation in Venezuela affect their currency, the bolivar?
the bolivar will depreciate
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Net Exports
exports - imports
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A Canadian buys lumber in the US - included in the US’s CA or CFA?
Current Account (CA)
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An American buys a beach resort in Mexico - included in the US’s CA or CFA?
Capital/Financial Account (CFA)
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An American on vacation buys Japanese government bonds - included in the US’s CA or CFA?
Capital/Financial Account (CFA)
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An immigrant in the US sends a portion of their earnings to family overseas - included in the US’s CA or CFA?
Current Account (CA)
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Why can’t two currencies both appreciate relative to each other at the same time?
exchange rates between countries are reciprocals of each other; if one currency appreciates, the other must depreciate
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Assume $1 went from equaling £0.9 to equaling £1 - which currency appreciated/depreciated?
the dollar appreciated, the pound depreciated
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Assume it now takes ￥100 to purchase $1 instead of ￥120 - which currency appreciated/depreciated?
the dollar depreciated, the yen appreciated
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Why is Demand downward sloping?
when exchange rates increase, foreigners are willing and able to buy less; when the rate falls, they buy more
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Why is supply upward sloping?
when the exchange rate increases, citizens are willing and able to supply more of their currency; when the rate falls, they supply less
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If a country’s currency appreciates, net exports will…
decrease
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If a country’s currency depreciates, net exports will…
increase
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Net Capital Inflow
the difference between the amount of money coming into a country to buy domestic assets and the amount of money leaving a country to buy foreign assets
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Why does an increase in the real interest rate cause an increase in net capital inflow?
when interest rates are higher, foreigners want to buy more domestic assets (like bonds) because they provide a higher rate of return
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Will a decrease in the real interest rate move a country’s CFA toward a deficit or toward a surplus?
towards a deficit because a lower real interest rate would cause foreigners to purchase less domestic financial assets and decrease net capital inflow
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How will an increase in private savings in the United States most likely affect financial capital flows and the value of the dollar in foreign exchange markets?
The United States will experience financial capital outflows and the dollar will depreciate
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