International financial transactions

• International trade - Purchasing or selling currently produced goods or services across an international border

• International asset transactions - The transfer of the property rights to either real or financial assets between the citizens of one country and the citizens of another country

• Money flows from the buyers of the goods, services, or assets to the sellers of the goods, services, or assets

• When the people involved in an exchange are from places that use different currencies, the buyer must convert their type of money into the currency that the seller uses and accepts

Balance of payments - The sum of all the financial transactions that take place between its residents and the residents of foreign nations

• Mostly includes exports and imports of goods, exports and imports of services, and international purchases and sales of financial and real assets

• Flows of in-payments into the country and out-payments out of the country

• Organized into 2 sections: the current account and the capital and financial account

Current account - The section of the balance of payments that summarizes trade in currently produced goods and services

• Credits generate flows of money into the country, debits cause flows of money out of the country

• Balance of trade on goods - The difference between its exports and its imports of goods

• Balance on goods and services - The difference between a country’s exports of goods and services and their imports of goods and services

• Trade deficit - Imports exceed exports

• Trade surplus - Exports exceed imports

• Foreign aid and pensions are included because they can be thought of as the financial flows that accompany the exporting and importing of goods and services

• Balance of current account - The total of all transactions in the current account

Capital and financial account - A country’s international asset transactions

• Capital account measures debt forgiveness

• Financial account summarizes international asset transactions having to do with international purchases and sales of real or financial assets

• Balance on the capital and financial account - Sum of the deficit on the capital account and the surplus on the financial account

Why the balance of payments balances

• The balance on the current account and the balance on the capital and financial account must always sum to zero because any deficit or surplus in the current account automatically creates an offsetting entry in the capital and financial account

• Trade deficits show that there are automatic and unavoidable asset transfers

• Current account deficits automatically generate transfers of assets to foreigners while current account surpluses automatically generate transfers of assets from foreigners

Payments, deficits, and surpluses

• Official reserves - Consists of foreign currencies, reserves held with the International Monetary Fund, and stocks of gold

  • Drawn on—or replenished—to make up any net deficit or surplus that otherwise would occur in the balance-of-payment account

• Balance of payments deficit - A nation must make an in-payment of official reserves to its capital and financial account in order to balance it with the current account

• Balance of payments surplus - An out-payment of official reserves from the capital and financial account must occur to balance that account with the current account

• Persistent payments deficits deplete reserves

• Large current account deficits can become a problem because they need to be financed by equally large surpluses in the capital and financial account

Flexible exchange rates

• Flexible (or floating) exchange rate system - Demand and supply determine exchange rates and in which no government intervention occurs

• Fixed exchange rate system - Governments determine exchange rates and make necessary adjustments in their economies to maintain those rates

• The demand for a currency is downward-sloping, while the supply of a currency is upward-sloping

  • The intersection of the supply and demand determine the dollar price of a currency

Depreciation and appreciation

• An exchange rate determined by market forces can, and often does, change daily

• When a currency appreciates, fewer units of it (dollars) are needed to buy a single unit of some other currency (pounds)

  • When the dollar appreciated relative to the pound, the pound depreciated relative to the dollar (and vice versa)

Determinants of exchange rates

• Changes in tastes - Any change in consumer tastes or preferences for the products of a foreign country may alter the demand for that nation’s currency and change its exchange rate

• Relative income changes - A nation’s currency is likely to depreciate if its growth of national income is more rapid than that of other countries

• Relative price level changes - Changes in the relative price levels of two nations may change the demand and supply of currencies and alter the exchange rate between the two nations’ currencies

  • Purchasing power parity theory - Exchange rates equate the purchasing power of various currencies

• Relative interest rates - Changes in relative interest rates between two countries may alter their exchange rate

• Changes in relative expected returns on stocks, real estate, and production facilities - Investors in one country must sell their currencies to purchase the foreign currencies needed for the foreign investments

• Speculation

Flexible rates and the balance of payments

• Flexible exchange rates automatically adjust and eventually eliminate balance-of-payments deficits or surpluses

Disadvantages of flexible exchange rates

• Caused by flexible exchange rates being volatile and changing quickly in a short amount of time

• Uncertainty and diminished trade - The risks and uncertainties associated with flexible exchange rates may discourage the flow of trade

  • Anticipated profit can turn into a substantial loss

• Terms of trade changes - A decline in the international value of its currency will worsen a nation’s terms of trade

• Instability - Flexible exchange rates may destabilize the domestic economy because wide fluctuations stimulate and then depress industries producing exported goods

Fixed exchange rates

• With the rate fixed, a shift in demand or supply will threaten the fixed-exchange-rate system, and government must intervene to ensure that the exchange rate is maintained

• Currency interventions - Governments manipulate an exchange rate through the use of official reserves

  • If a country encounters persistent and sizable deficits for an extended period, it may exhaust its reserves, and thus be forced to abandon fixed exchange rates

• Trade policies

  • A nation can try to control the flow of trade and finance directly

  • Discouraging or encouraging imports or exports

  • Reduce the volume of world trade and change its makeup from what is economically desirable

• Exchange controls - The government requires that all currency from another country obtained by US exporters must be sold to the federal government

  • Would restrict the value of U.S. imports to the amount of foreign exchange earned by U.S. exports

• Domestic macroeconomic adjustments

  • Domestic stabilization policies to eliminate the shortage of foreign currency

The current exchange rate system

• Managed floating exchange rates - Exchange rates among major currencies are free to float to their equilibrium market levels, but nations occasionally use currency interventions in the foreign exchange market to stabilize or alter market exchange rates

• Nations occasionally intervene in the foreign exchange market by buying or selling large amounts of specific currencies

• Nations collectively intervene to try to stabilize currencies

• Proponents’ view

  • Trade under the managed float has grown tremendously over the past several decades

  • The system has weathered severe economic turbulence

• Critics’ view

  • Excessive volatility of exchange rates under the managed float threatens the prosperity of economies that rely heavily on exports

  • Guidelines concerning what each nation may or may not do with its exchange rates are not specific enough to keep the system working in the long run