Chapter 20: The Balance of Payments, Exchange Rates, and Trade Deficits Notes

International Financial Transactions

  • Definition of International Trade: This involves the buying or selling of current goods or services. Specific components include:

    • Imports and Exports: The cross-border movement of products and service-based offerings.

  • International Asset Transactions: This involves the buying or selling of real or financial assets. Examples provided in the material include:

    • Transactions involving stock.

    • Selling a domestic business to foreign investors or purchasing a foreign business.

    • Selling a house to a foreigner or purchasing real estate in another country.

  • Currency Requirement: These transactions require currency exchange to facilitate the transfer of value across different monetary systems.

The Balance of Payments

  • Definition: The balance of payments is the sum of all international financial transactions conducted by a nation.

  • The Current Account: This account tracks the following:

    • Balance on Goods and Services: The difference between exports and imports, resulting in either a trade deficit or a trade surplus.

    • Net Investment Income: The difference between income received from foreign assets and income paid to foreign owners of domestic assets.

    • Net Transfers: This includes things like foreign aid and remittances.

    • Balance on Current Account: The final sum of the items above.

Cumulative Total: The balance of payments must always balance, resulting in a total of 00.

Relationship between Accounts: Current account deficits generate asset transfers to foreigners, while surpluses generate asset transfers from foreigners.

Flexible Exchange Rates

  • Systems Defined:

    • Flexible- (or Floating-) Exchange Rate System: A system where the value of a currency is determined by supply and demand in the foreign exchange market.

    • Fixed-Exchange-Rate System: A system where the government pegs the value of the currency to another currency or a precious metal.

  • Vocabulary:

    • Depreciation: When the price of one currency rises relative to another (it takes more units of Currency A to buy one unit of Currency B).

    • Appreciation: When the price of one currency falls relative to another (it takes fewer units of Currency A to buy one unit of Currency B).

  • Determinants of Flexible Exchange Rates: Factors that shift the demand or supply curves for a currency:

    • Changes in Tastes: If Japanese electronics decline in popularity in the U.S., the Yen depreciates while the U.S. Dollar appreciates. Conversely, if European tourists visit the U.S. less frequently, the Dollar depreciates and the Euro appreciates.

    • Relative Income Changes: If England enters a recession (reducing imports) while U.S. real income surges (increasing imports), the British Pound appreciates and the U.S. Dollar depreciates.

    • Relative Inflation Rates (Purchasing-power-parity Theory): If Switzerland has 1%1\% inflation and Canada has 5%5\%, the Swiss Franc appreciates and the Canadian Dollar depreciates.

    • Relative Real Interest Rates: If the Federal Reserve raises U.S. interest rates while the Bank of England does nothing, the U.S. Dollar appreciates and the British Pound depreciates.

    • Relative Expected Returns on Assets: Corporate tax cuts in the U.S. that raise after-tax investment returns relative to Europe cause the U.S. Dollar to appreciate and the Euro to depreciate.

    • Speculation:

      • If traders believe South Korea will have higher inflation than Taiwan, the Won depreciates and the Taiwanese Dollar appreciates.

      • If traders believe Norway’s interest rates will plummet relative to Denmark, the Norwegian Krone depreciates and the Danish Krone appreciates.

  • Disadvantages of Flexible Rates:

    • Volatility: Significant swings in currency value.

    • Uncertainty: Makes long-term planning difficult, potentially diminishing international trade.

    • Terms-of-Trade Changes: Fluctuations can shift the relative prices of imports and exports.

    • Instability: Can lead to macroeconomic instability within a country.

Fixed Exchange Rates

  • Mechanism: The foreign exchange market is replaced by a government peg.

  • Official Reserves: Governments use stockpiles of foreign currency, known as foreign-exchange reserves, to maintain the pegged rate.

  • Methods to Defend a Peg:

    • Trade Policies: Using tariffs or quotas to manipulate trade flow.

    • Exchange Controls and Rationing: Direct government control over who can buy and sell foreign currency. Drawbacks include:

      • Distorted trade.

      • Favoritism toward certain industries or individuals.

      • Restricted consumer choice.

      • The emergence of black markets.

    • Domestic Macroeconomic Adjustments: Using monetary or fiscal policy specifically to influence exchange rates rather than domestic goals.

The Managed Float and Historical Context

  • History of Exchange Rate Systems:

    • Gold Standard (1879–1934): A fixed exchange rate system where currencies were tied to gold.

    • Bretton Woods (1944–1971): A fixed exchange rate system indirectly tied to gold via the U.S. Dollar.

    • Managed Float (1971–Present): Also known as "managed floating exchange rates," this system relies on foreign exchange markets but allows for occasional government intervention.

  • Characteristics of Managed Float:

    • Primary dependence on market forces.

    • Occasional intervention by central banks to stabilize or support currency values.

    • There are ongoing concerns regarding the degree and effectiveness of this intervention.

Recent U.S. Trade Deficits

  • Trend (2005–2021):

    • 2005-2008: Goods and services balances were between −700-700 and −760-760 billion.

    • 2009: The balance improved to approximately −400-400 billion.

    • 2020: The deficit was −690-690 billion.

    • 2021: The deficit on goods and services reached −850-850 billion. The current account balance was −810-810 billion.

  • Causes of Trade Deficits:

    • Relatively high U.S. economic growth compared to trading partners.

    • A significant trade imbalance with China.

    • A low domestic U.S. saving rate.

  • Implications:

    • Increased Current Consumption: Allows the nation to consume beyond its current production.

    • Increased Indebtedness: Results in a rise in the amount of U.S. assets owned by foreigners.

The Exchange Rate Trilemma

  • The Framework: Countries must choose between three possible exchange rate policy goals:

    1. Exchange-Rate Stability: Fixed or predictable currency values.

    2. Free Financial and Trade Flows: No restrictions on international capital or goods movement.

    3. Independent Monetary Policy: The ability to set domestic interest rates and money supply without needing to defend an exchange rate.

  • The Constraint: It is only possible for a country to achieve two of the three goals at any given time.