Unit 6 Notes

Chapter 38 (In the book) Lecture Notes

The Balance of Payments- The sum of all financial transactions that take place between its residents and its residents of foreign nations. There are two main categories, the current account and the Capital and Financial Account.

The Current Account- Goods and services that are bought and sold between nations,

Import = Debit (-)

Export = Credit (+)

Net Investment Income- Earnings abroad minus foreign earnings made in the US.

Net Transfers- Foreign aid, pensions paid to US citizens living abroad and funds that immigrants send to families abroad.

Capital Account- The flow of money assets, stocks, factories, or factory equipment. Ultimately becomes an exchange of currency.

Capital going abroad = negative

Capital coming in = positive

The Official Reserve Account- Foreign currencies, reserves, stocks of gold that are used to equal out the overall balance statement. The Capital Account and Current Account must be balanced.

Pays the difference of any deficits

Pockets the surplus

Ex:

Current Account + Capital Account = -$4B

Official Reserve Account is going to have to pay +$4B

The Foreign Exchange Market- The market where currencies are exchanged for one another.

Exchange Rate- The amount of the rate one currency is exchanged for another.

Appreciation: Increases in value when exchanging

Depreciation: Decreases in value when exchanging

Dollar: Quantity of Dollars Yen: Quantity of Yen

~US citizen wants to buy something in Japan. (A car to drive to the house where I will ear sushi)

~The dollar depreciated it for the US and in Japan the dollar appreciates

Exchange Rates

The Flexible/Floating Exchange Rate- When the supply and demand for the currency determines the exchange rate.

The Fixed Exchange Rate- when the government determines the exchange rate.

Determinants of Exchange Rates:

1. Changes in taste and preferences

2. -Relative income and wealth (As nations acquire more wealth or higher income, they will begin to purchase more import)

3. Inflation/Price Level (A nation with lower inflation levels will have more exports)

4. Relative Interest Rates (Higher interest rates = Higher demand for that nations currency)

5. Expectations/Speculation (People will demand the products or currency that will benefit them the most. Ex: Expected inflation rates or returns on investment.)

College Board Notes

6.1 Balance of Payment Accounts

Balance of Payment (BOP)- Is an accounting system to keep track of transactions between countries over a period of time. It’s made up of two accounts, the Current Account (CA) and the Capital and Financial Account (CFA).

Formula: Current Accounts+ Capital and Financial Accounts= 0 (CA+CFA=0)

Current Account- Made up of net exports, money transfers, investment income, and net unilateral transfers.

CA is not always balanced: “Net exports” = trade balance = exports—imports

Exports = credit imports = debit

Exports > imports = surplus

Ex: Purchase of sale of goods between counties, earning income from assets owned in another country, sending or receiving income from another country

Capital and Financial Account- The balance of payments for assets between countries and financial capital transfers

CFA is not always balanced.

Financial capital going into an economy is a surplus. (Financial capital inflow)

Financial capital going out of an economy is a deficit. (Financial capital outflow)

Ex: Purchase/Sale of CD’s, bonds or other interest bearing assets, foreign market Like transactions, purchase/sale of physical assets, Foreign Direct Investment.

Credit vs. Debit

Money going in is a credit while money going out is a debt.

The sun of all credit entries should match the sum of all debit entries.

An increase in the Current Account balance must be offset by a decrease in the Capital and Financial Account balance.

In increase in Capital and Financial Account balance must be offset by a decrease in the Current Account balance.

Ex: The citizen of the USA makes a payment to a citizen in Country R, the USA has a debit while Country R has a credit.

6.2 Exchange Rates

Exchange Rates- The Price of one currency in terms of another. (Once currency is exchanged for another. The price of currency to another is the exchange rate.)

Value of exchange Rates- In order for any transactions to occur between two different countries, currencies must be exchanged.

Currency Appreciation- When a currency becomes more valuable in terms of other countries.

Currency Deprecation- When a currency becomes less valuable in terms of other countries.

6.3 The Foreign Exchange Market

The demand for a currency in a foreign exchange market arises from the demand for the countries goods, services and financial assets and shows the inverse relationship between the exchange rate and the quantity demanded of a currency.

What is in the Foreign Exchange Market?

~The interaction of buyers and sellers exchanging one currency for the currency of another.

~This determines the equilibrium exchange rate in a flexible exchange market and influences the flow of goods, services, and financial capital between countries.

~The demand for a currency in a foreign exchange market arises from the demand for the country’s goods, services, and financial assets and shows the inverse relationship between the exchange rate and the quantity demanded of a currency.

~The supply of a currency in a foreign exchange market arises from making payments in other currencies and shows the positive relationship between the exchange rate and the quantity supplied in a currency.

~In the foreign exchange market, equilibrium is achieved when the exchange rate is such that the quantities demanded and supplied of the currency are equal.

~Disequilibrium rates create surpluses and shortages in the foreign exchange market. Market forces drive exchange rates toward equilibrium.

6.4 Effect of Changes in Policies and Economic Conditions on the Foreign Exchange Market

Determinants of Currency Demand- Foreign demand for the country’s goods and services, foreign demand for the country’s assets, fiscal policy, and monetary policy.

Determinants of Currency Supply- Domestic demanded for other country’s assets, domestic demanded for other country’s assets, protectionist policies (tariffs, quotas) imposed on other country’s goods and services.

Essential Knowledge- Factors that shift the demand and supply of a currency exchange the equilibrium exchange rate. In a flexible exchange rate system regime, exchange rate fluctuates due to changes in currency demand and supply.

6.5 Changes in the Foreign Exchange Market and Net Exports

Essential Knowledge- Factors that cause a currency to appreciate causes that country’s exports to decrease and its imports to increase. As a result, net exports will decrease. Factors that cause a currency to depreciate cause that country’s exports to increase and its imports to decrease. As a result, net exports will increase.

Net Exports = Exports - Imports

Changes in the relative price of goods cause changes in net exports.

Fluctuating currency values cause changes in the relative price of goods.

An appreciated currency leads to more expensive exports and a decrease in aggregate demand.

A depreciated currency leads to less expensive exports and an increase in aggregate demand.

6.6 Real Interest Rates and International Capital Flows

In an open economy, differences in real interest rates across countries change the relative valuers of domestic and foreign assets. Financial capital will flow toward the country with the relatively higher interest rates. Central banks can influence the domestic interest rate in the short run, which in turn will affect net capital inflows.

Capital Inflow- Supply shifts right

Capital Flight(Outflow)- Supply shifts left.

Capital and Financial Account- Sale or purchase of financial assets (stocks, bonds, loans, bank accounts, currencies).