21The Balance of Payments, Exchange

Rates, and Trade Deficits

McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

International Transactions

• International trade• Buy/sell current goods or services• Imports and exports

• International asset transactions• Buy/sell real or financial assets• Buy stock• Sell your house to a foreigner

• Requires currency exchange

LO1 21-2

Balance of Payments

• Sum of international financial transactions

• Current account

• Balance on goods and services

• Net investment income

• Net transfers

• Balance on current account

LO2 21-3

Balance of Payments

• Capital and financial account• Capital account• Financial account

• Balance of payments accounts sum to zero

• Current account deficits generate asset transfers to foreigners

• Official reserves

LO2 21-4

Balance of Payments

LO2 21-5

Official Reserves

• Foreign currencies, certain reserves with the IMF, and stocks of gold

• Owned by government or central bank

• Used as balancing mechanism in balance of payments

LO2 21-6

U.S. Trade Balances

LO2 21-7

Flexible Exchange Rates

• Demand for pounds

• Supply of pounds

• Market equilibrium

• Increase in dollar price of pounds

• Dollar depreciates

• Pound appreciates

• Decrease in dollar price of pounds

• Dollar appreciates

• Pound depreciatesLO3 21-8

Q0

Do

llar

Pri

ce o

f 1

Po

un

d

Quantity of Pounds

P

Flexible Exchange Rates

The Market for Foreign Currency (Pounds)

D1

S1

DollarAppreciates(PoundDepreciates)

DollarDepreciates(PoundAppreciates)

ExchangeRate: $2 = £1

$2

$3

$1

Q1

LO3 21-9

Flexible Exchange Rates

• Determinants of exchange rates• Factors that shift demand/supply

• Changes in tastes• Relative income changes• Relative price-level changes

•Purchasing-power-parity theory• Relative interest rates• Relative expected returns on assets• Speculation

LO3 21-10

Q0

Do

llar

Pri

ce o

f 1

Po

un

d

Quantity of Pounds

P

Flexible Exchange Rates

The Market for Foreign Currency(Pounds)

D1

S1

ExchangeRate: $2 = £1

$2

$3

$1

Q1

D2

ExchangeRate: $3 = £1

BalanceOf Payments

Deficit

Q2

x a

b

c

LO3 21-11

Flexible Exchange Rates

• Eliminate balance of payments deficit or surplus

• Disadvantages of flexible exchange rates• Volatility • Uncertainty and diminished trade• Terms-of-trade changes• Instability

LO4 21-12

Flexible Exchange Rates

LO4 21-13

Fixed Exchange Rates

• Government intervention• Use of reserves

• Trade policies• Exchange controls and rationing

• Distorted trade• Favoritism• Restricted choice• Black markets

• Macroeconomic adjustments

LO4 21-14

The Managed Float

• Gold standard 1879-1934

• Fixed exchange rate system

• Bretton Woods 1944-1971

• Fixed exchange rate system indirectly tied to gold

• Managed float 1971-present

LO4 21-15

The Managed Float

• Dependence on foreign exchange markets

• Occasional intervention

• In support of managed float

• Concerns with managed float

LO4 21-16

U.S. Trade Deficit

• Large and persistent• Causes of trade deficits

• High U.S. growth (relatively)• China• Price of oil• Low U.S. saving rate

• Implications of trade deficits• Increased current consumption• Increased indebtedness

LO5 21-17

0-50

-100-150-200-250-300-350-400-450-500-550-600-650-700-750-800-850-900

2001 2002 2003 2004 2005 2006 2007 2008 2009

2001 2002 2003 2004 2005 2006 2007 2008 2009

0-50

-100-150-200-250-300-350-400-450-500-550-600-650-700-750-800-850-900

Goods and Services

Goods

Bill

ion

s o

f D

olla

rsB

illio

ns

of

Do

llars

Balance of Trade

Balance on Current Account

U.S. Trade Deficits

LO5 21-18

Speculation in Currency Markets

• Positive or negative influence?

• Contributes to currency market fluctuations

• Self-fulfilling expectations

• Smoothing short-term fluctuations

• Absorbing risk

• Futures market at work

• Positive role played overall

LO5 21-19