Lec Topic 7 BoP and exchange rates

ECC1100 Principles of Macroeconomics

Topic 7: International Finance and the Exchange Rate

  • Overview of the interplay between domestic and global economies.

Readings/References

  • Stevenson and Wolfers: Chapter 16

  • Holden, Stevenson, and Wolfers: Chapter 16

Learning Objectives

  1. Understand connections between domestic and global economies.

  2. Analyze prices quoted in different currencies.

  3. Analyze currency markets and forecast nominal exchange rates.

  4. Assess impacts of exchange rates and relative prices on exports and imports.

  5. Track global money flows using current and financial accounts.

International Trade

Exports and Imports

  • Exports: Goods/services produced domestically sold to foreign buyers.

  • Imports: Goods/services produced in foreign countries purchased by domestic buyers.

Global Financial Flows

Financial Inflows and Outflows

  • Financial Inflows: Investments by foreigners in the domestic economy.

  • Financial Outflows: Investments by the domestic economy in foreign countries.

  • Trends indicate increasing foreign ownership and significant global financial linkages.

Trade and Financial Flows

  • Globalization has major implications for the U.S. economy; technological advancements leading to reduced costs of transportation and communication have facilitated substantial growth in trade and financial flows.

Exchange Rates

Definition and Implications

  • Nominal Exchange Rate: Price of a country's currency in terms of another's.

    • Example: U.S. dollar at 120 yen.

  • Currency Appreciation and Depreciation:

    • Appreciation: Currency becomes more expensive; imports cheaper, exports pricier.

    • Depreciation: Currency becomes cheaper; imports pricier, exports cheaper.

Currency Fluctuation Index

  • NDisplay trends in currency value over time relative to trading partners.

Market Dynamics of Currency

Demand and Supply of U.S. Dollars

  • Demand for U.S. Dollars: Driven by foreign purchases and investments in the U.S.

  • Supply of U.S. Dollars: Driven by U.S. purchases of imports and foreign investments.

  • The exchange rate is determined by the intersection of supply and demand of dollars in the foreign exchange market.

Forecasting Exchange Rate Movements

  • Assess whether supply or demand curves are shifting and predict how equilibrium exchange rates will shift.

  • Example: Tariffs can impact the demand for dollars and, consequently, exchange rates.

Government Intervention

  • Countries may fix exchange rates or use managed exchange rates leading to trade frictions and varying degrees of currency stability.

Current Account and Financial Account

Definitions

  • Current Account Balance: Difference between income received from abroad and income paid abroad.

  • Financial Account Balance: Difference between financial inflows and outflows in an economy.

Saving, Investment, and Current Account

  • Current account deficits indicate spending beyond means, reflecting an imbalance between savings and investment—potentially signaling valuable future investments or unsustainable living.

Summary of Balance of Payments

  • Current account reflects income flows; financial account reflects financial flows. Current account deficits are not always a concern unless repayment seems unlikely.