Unit 6 - Open Economy - International Trade and Finance

Mechanics of Foreign Exhange, Balance of Payments

What is Foreign Exchange?

• The buying/selling of currency

• Any transaction that occurs in the Balance of Payments (BOP) sheet

• The exchange rate (e) is determined in the foreign exchange currency markets

What is the exchange rate?

the price of a currency

An increase in the supply of a currency will…

decrease the exchange rate

A decrease in the supply of a currency will…

increase the exchange rate

An increase in the demand of a currency will…

increase the exchange rate

A decrease in the demand of a currency will…

decrease the exchange rate

Appreciation

an increase in the exchange rate

depreciation

a decrease in the exchange rate

Determinants of Exchange Rate (e)

• Consumer Tastes

• Relative Income

• Relative Price Level

• Speculation

Explain Consumer Tastes

If there is a preference for goods from country A then there will be an increase in the supply of country B’s currency. Appreciation of country A’s currency; Depreciation of country B’s currency.

Explain Relative Income

If country A has strong economy but country B is in a recesssion. country A will buy more of country B’s goods, which increases demand for country B’s currency. Depreciation of country A’s currency; Appreciation of country B’s currency.

Explain Relative Price Level

If country A has a higher price level, then goods in country B will be relatively cheaper and country A will import more country B goods. Appreciation of country B’s currency; Depreciation of country A’s currency.

Explain Speculation

If country A investors expect that country B’s interest rates will increase in the future, then country A will demand more of country B’s currency to earn higher rates of return. Appreciation of country B’s currency; Depreciation of country A’s currency.

Expansionary monetary policy

REINFORCES the increase in aggregate demand (AD)

Contractionary monetary policy

REINFORCES the decrease in aggregate demand (AD)

Expansionary Fiscal Policy

“Crowding-out effect” decreases in aggregate demand (AD) offset the initial increase in AD

Contractionary Fiscal Policy

“Crowding-in effect” increases in aggregate demand (AD) offset the initial decrease in AD

What is the Balance of Payments (BOP) sheet?

• Measure of money inflows (CREDITS) and outflows (DEBITS) between the US and the rest of the world.

How is the BOP divided?

• Current account

• Capital/Financial account

• Official Reserves account

The exchange rate is a…

determinant of imports and exports

Double Entry Bookkeeping

every transaction is recorded twice in accordance with standard accounting practices

Current Account includes…

• Exports (credits) and imports (debits)

• Net foreign income

• Net transfers (tend to be unilateral)

An increase in the exchange rate…

increases the price of goods and makes foreign goods become relatively cheaper, thus imports INCREASE and exports DECREASE

A decrease in the exchange rate…

decreases the price of goods and makes foreign goods relatively more expensive, thus imports DECREASE and exports INCREASE

Elaborate of Net Foreign Income

• Income earned by US foreign assets (credit)

• Income paid to foreign held US assets (debit)

Elaborate of Net Transfers

• Foreign aid (debit)

The Capital/Financial Account consists of...

• The balance of capital ownership

• Purchase of both real/financial assets

DEBITS to Capital/Financial Account include…

• Direct investment by US firms/individuals in another country

  • ex) Intel factory in Costa Rica

• Purchase of foreign financial assets

CREDITS to Capital/Financial Account include…

• Direct investment in the US

  • ex) Toyota (Japanese manufacturer) factory in San Antonio

• Purchase of domestic financial assets by foreigners

What causes Capital/Financial Flows?

• Differences in rates of return on investment

• Ceteris paribus (all things remaining the same), savings will flow toward higher returns

What should zero each other out?

The current account and the capital/financial account

What are the official reserves?

foreign currency holdings of the US Federal Reserve System (zeroes out the BOP)

What does the Fed do when there is a BOP surplus?

Fed accumulates foreign currency and DEBITS the BOP

What does the Fed do when there is a BOP deficit?

Fed depletes its reserves of foreign currency and CREDITS the BOP

The US is _________ with its use of Official Reserves

Passive (to not manipulate the exchange rate of the dollar)

The People’s Republic of China is ______ with its use of Official Reserves

Active (buy/sell dollars to keep the exchange rate steady w/ the US)