Study Notes on International Finance Concepts

CHAPTER 19: ECONOMICS AND INTERNATIONAL FINANCE

Overview of Topics

In this lecture, the following topics will be covered:

  • Balance of Payments

  • The Foreign Exchange Market

  • Flexible Exchange Rates

  • Fixed Exchange Rates

  • The Current International Monetary System

Balance of Payments

  • Definition: Keeps track of a country’s flow of international trade, specifically measuring receipts and expenditures. A periodic statement, typically yearly, detailing the monetary value of all transactions between residents of one country and all other countries.

Debits and Credits in Balance of Payments

  • Debit: Any transaction that supplies the country’s currency in the foreign exchange market.

  • Credit: Any transaction that creates a demand for the country’s currency in the foreign exchange market.

Example Illustrations:

  • Debit Example: Jim, an American, supplies dollars in exchange for yen to purchase Japanese goods.

  • Credit Example: Svetlana, a Russian citizen living in Russia, supplies rubles to acquire dollars for purchasing U.S. goods.

Current Account

  • This account encapsulates all payments related to the purchase and sale of goods and services.

  • Components Include:

    • Exports

    • Imports

    • Net unilateral transfers abroad

Summary of Balance of Payments Items:

  1. Exports of goods and services

  2. Imports of goods and services

  3. Net unilateral transfers abroad

  4. Outflow of U.S. capital

  5. Inflow of foreign capital

  6. Increase in U.S. official reserve assets

  7. Increase in foreign official assets in the U.S.

  8. Statistical discrepancy

  • Current Account Balance: Summary statistic for exports, imports, and net unilateral transfers.

Detailed Example: U.S. Balance of Payments (Year Z)

  • Current Account:

    • Exports of goods and services: +$340 billion

    • Merchandise exports: +$220 billion

    • Services: +$30 billion

    • Income from U.S. assets abroad: +$90 billion

    • Imports of goods and services: -$390 billion

    • Merchandise imports: -$300 billion

    • Services: -$40 billion

    • Income from foreign assets in the U.S.: -$50 billion

  • Merchandise Trade Balance Calculation:

    • Difference: +$220 billion (Exports) - $300 billion (Imports) = -$80 billion

  • Net Unilateral Transfers Abroad: -$11 billion

  • Current Account Balance Calculation: +$340 billion (Exports) - $390 billion (Imports) - $11 billion (Net Transfers) = -$61 billion

Capital Account

  • Definition: Includes all payments related to the purchase and sale of assets and borrowing and lending activities.

  • Components: Outflow of U.S. capital and inflow of foreign capital.

  • Capital Account Balance: Summary statistic for outflow and inflow of capital.

Official Reserve Account

  • Comprises official reserve balances, including foreign currencies, gold, and special drawing rights (SDRs).

  • Critical for countries with deficits in their combined current and capital accounts.

International Monetary Fund (IMF)

  • An international organization overseeing the international monetary system, it does not control the world's money supply but holds currency reserves for member nations and provides loans to central banks.

Special Drawing Right (SDR)

  • An international form of money created by the IMF, represented as bookkeeping entries usable by nations to settle international accounts.

Statistical Discrepancy

  • An adjustment in the balance of payments for incomplete information, accounting for unobserved credits and debits.

Self-test Q&A Section

  1. If an American retailer buys Japanese cars from a Japanese manufacturer, is this transaction recorded as a debit or a credit?

    • Answer: Debit. This transaction represents a supply of U.S. dollars in exchange for yen, thus recorded as a debit.

  2. Given exports of goods and services equal $200 billion and imports equal $300 billion, what is the merchandise trade balance?

    • Answer: Lack of details; need distinct values for merchandise exports and imports.

  3. What's the difference between the merchandise trade balance and current account balance?

    • Answer: Merchandise trade balance covers fewer transactions than the current account.

Foreign Exchange Market

  • Definition: A marketplace where currencies of different countries are exchanged.

  • Exchange Rate: The price of one currency in terms of another determined within the foreign exchange market.

    • Example: When Americans demand pesos, they also supply U.S. dollars for exchange. Conversely, when Mexicans demand U.S. dollars, they supply pesos.

Flexible Exchange Rate System

  • Definition: Exchange rates determined by supply and demand forces for a currency.

  • Demand Curve: For example, the higher the dollar price for pesos, the lower the demand for pesos; lower prices increase demand.

  • Equilibrium: When quantity demanded equals quantity supplied at a given exchange rate.

Factors Affecting Equilibrium Exchange Rates

  • Differences in income growth rates

  • Differences in relative inflation rates

  • Changes in real interest rates

Purchasing Power Parity (PPP) Theory

  • Definition: Exchange rates will adjust based on relative price levels between two currencies.

  • Inflation Impact: An increase in U.S. price levels while Mexican levels remain constant increases the U.S. demand for pesos, causing the dollar to depreciate if the cycle continues.

Fixed Exchange Rate System

  • Definition: Currency fixed at a set rate against others, maintained by central bank intervention.

  • Overvaluation/Undervaluation: A currency is considered overvalued when priced above equilibrium. Conversely, undervalued currencies are priced below equilibrium.

Gold Standard

  • Definition: Fixes exchange rates through gold backing.

  • Requirements:

    • National currencies must be defined in terms of gold.

    • Commitment to convert currencies to gold at set rates.

    • Money supply linked to gold reserves.

Self-test Insights

  • Understanding the impact of overvalued/undervalued currencies on trade.

  • Evaluating how fixed exchange rates contribute to economic stability vs. volatility in trade practices.

Optimal Currency Area

  • Definition: A geographical area where fixed exchange rates or common currencies exist without compromising domestic economic goals.

Conclusion

This lecture provides a comprehensive overview of international finance, covering essential mechanisms and theories influencing global trade and exchange rates. The concepts discussed are critical for understanding the workings of the global economy and facilitate better decision-making regarding international economic strategies.