Chapter 6 -- International Finance and the Economy

Measures of international finance.Exchange rates, how they’re

determined, and effects upon economy.

Closer look at theory of Net Exports, and the role of exchange rates within them.

Measures of International Finance

Record of transactions between American residents and residents of other countries over a flow interval.

Current AccountCapital AccountBalance of Payments

The Current Account

Current Account =

{Exports + Foreign Transfers to US + Income earned from American holdings of investments abroad}

-- {Imports + US Transfers to Foreigners + Income earned from foreign investments in US}

The Current Account: InterpretationItems in the first set of { } -- current

account inflows, ways that dollars enter into the US from international transactions in the current account.

Items in the second set of { } -- current account outflows, ways that dollars leave the US from international transactions in the current account.

The Current Account: Characteristics

Comprehensive measure of the Balance of Trade (NX is a close approximation).

The Capital Account

Capital Account = {Net Foreign Purchases of US Assets by foreign residents} - {Net US Purchases of Foreign Assets by US residents}Capital Account = {Capital Account Inflows} - {Capital Account Outflows}

Can be interpreted as “net private borrowing” from the foreign sector.

The Balance of Payments (BOP)

Balance of Payments outcome = Current Account + Capital AccountRepresents “what’s left over” after all

international transactions between residents of the US (other than government) and residents of other countries (other than government) during a flow period.

Positive sign: Surplus, Negative Sign: Deficit

Balance of Payments deficits – financed by government borrowing from foreign sector.

The Recent US Record -- International Transactions

Current Account < 0Capital Account > 0, but less than |Current Account|Balance of Payments < 0

Negative Balance of Payments – financed by US borrowing from foreign sector.

Balance of Payments and Government Borrowing

Resulting equation:

BOP + (Net Government Borrowing from Foreign Sector) = 0

(Current Account + Capital Account) + (Net Government Borrowing from Foreign Sector) = 0

(Current Account) + (Total Net Borrowing from Foreign Sector) = 0

The Balance of Payments and the “Magic Equation”“Magic Equation”: S + (T – G) + (-NX) = I.

Balance of Payments equation: Current Account + (Total Net Borrowing from Foreign Sector) = 0.Also recall that NX (Current Account).

Substitute the two expressions into Macro Identity for (-NX)

S + (T – G) + (Total Net Borrowing from Foreign Sector) = I.

Exchange Rates

(Nominal) Exchange Rate (e’) -- the amount of foreign currency needed to be exchanged for one (US) dollar.

Also known as the “value of the dollar”.

Conversion Ratio, in units of (foreign currency)/(US dollar)

Types of Exchange Rates

Bilateral Exchange Rates -- exchange rates between the US and an individual country.

Multilateral (Trade Weighted) Exchange Rate -- weighted average of bilateral exchange rates expressed as an index (macro measure of exchange rate).

Exchange Rate Changes

e’ price of American goods and

services to foreigners price of foreign goods and

services to Americanse’ price of American goods and

services to foreigners price of foreign goods and

services to Americans

The Real Exchange Rate (e)

e = (P)(e’)

(Pf)

P = US Price Level

Pf = Foreign Price Level

Key cause of net exports.

The Real Exchange Rate: An Interpretation

e = (P)(e’)

(Pf)

Units of e:

= ($/Quantity)(Foreign Currency/$)

(Foreign Currency/Quantity)

= (Foreign Currency/Quantity)

(Foreign Currency/Quantity)

The Real Exchange Rate and Price Comparison

e = (P)(e’)

(Pf)

It consists of the ratio of the price level of American goods and services -- expressed in units of foreign currency -- to the price level of (corresponding) foreign goods and services.

The Real Exchange Rate and Net Exports

e (P, Pf, or e’) substitution away from the relatively more expensive US goods and services (US) Exports, (US) Imports NX

e (P, Pf , or e’) substitution into the relatively cheaper US goods and services Exports, Imports NX

Exchange Rate Regimes

Fixed (Pegged) Exchange Rates -- e’ fixed, unless changed by economic policy.

Floating Exchange Rates -- e’ determined by natural forces in the foreign exchange market.

Managed Float -- floating e’ with occasional Treasury/Federal Reserve intervention.

The Foreign Exchange Market -- Determination of e’

The Foreign Exchange Market -- the demand and supply for dollars for use in international transactions.

Concepts to Understand Foreign Exchange BehaviorItems (goods, services, financial

assets) are priced in a country’s home currency.

If one wishes to buy from another country, he/she must convert from their own currency to the currency of the country selling the item.

More Concepts: Foreign Exchange

The nominal exchange rate (e’) specifies the ratio of conversion.

One exchange rate (e’) is the conversion ratio for all foreign transactions (goods, services, financial assets) – Law of One Exchange Rate.

The Demand for Dollars

The Demand for Dollars -- foreigners demand for US dollars, to buy American goods, services, or financial assets.

Inversely related to the nominal exchange rate, with other causes (shift variables) as well.

The Supply of Dollars

The Supply of Dollars -- Americans supplying dollars to the foreign exchange market, in order to buy foreign goods, services, or financial assets.

Positively related to the nominal exchange rate, with other causes (shift variables) as well.

Foreign Exchange Market EquilibriumEquilibrium exchange rate (foreign

currency)/(US$) -- “price of dollars.”At equilibrium: Current Account + Capital Account = 0

At equilibrium, the Balance of Payments = 0.

Example 1 -- Increase in US Interest Rates (i)Increase in i leads to substitution away

from foreign financial assets to US financial assets.

Foreigners substitute Demand for Dollars Increases (curve shifts rightward).

Americans Substitute Supply of Dollars (Abroad) Decreases (curve shifts leftward).

As a result, the equilibrium exchange rate (e’*) Increases.

Example 2 -- Increase in Foreign Interest Rates (if)

Increase in if leads to substitution away from US financial assets to foreign financial assets.

Foreigners substitute Demand for Dollars Decreases (curve shifts leftward).

Americans Substitute Supply of Dollars (Abroad) Increases (curve shifts rightward).

As a result, the equilibrium exchange rate (e’*) Decreases.

Speculation -- Expectations of Exchange Rate Changes

Example 3 -- consider the exchange rate in units of foreign currency (abbreviation -- fcu) per dollar.

e’ = (5 fcu)/($1), and you expect (correctly) that it will decrease in the future to (4 fcu)/($1).

Response -- sell dollars now, buy them back when “cheaper.”

Capital Gains in the Foreign Exchange MarketContinue example, start with $100.Step #1 -- buy foreign currency at the

current exchange rate.

(100$)[(5 fcu)/($1)] = 500 fcu.Step #2 -- convert back to dollars

when e’ decreases in the future.

(500 fcu)[($1)/(4 fcu)] = $125.Capital gain of $25.

Floating Exchange Rates

Advantages-- At market equilibrium, Balance of

Payments = 0, i.e. current account + capital account = 0.

-- Federal Reserve does not need to participate in foreign exchange market, it can use the money supply to focus solely on domestic policy.

Floating Exchange Rates (Continued)

Disadvantages

-- Fluctuating exchange rate is disruptive to International Trade (exchange rate risk).

-- Exchange rates can fluctuate a great deal, especially due to speculation (speculative bubbles).

Fixed Exchange Rates

Advantages

-- exchange rate is constant, stability in International Trade (exchange rate risk = 0).

Fixed Exchange Rates (Continued)

Disadvantages

-- Federal Reserve must intervene constantly in the foreign exchange market to keep BOP = 0 loses control of money supply.

-- Or country faces distorted Balance of Payments position (negative or positive)

-- Fed might be forced into contractionary monetary policy to raise i* and increase e’* to the fixed rate.

Exchange Rate Regimes -- Overall

Ideal system: floating exchange rates which do not exhibit much movement.

Actual system (US): Managed Float -- floating exchange rates with occasional Federal Reserve intervention.

Exchange Rates and the Macro Models

Review concepts:

-- Real exchange rate (e),

e = (P)(e’)/(Pf).

-- Real exchange rate is inversely

related to net exports,

i.e. e NX.

Causes of Net Exports -- Fixed and Floating e’

Foreign Output or Income (Yf)

US Output or Income (Y)Barriers to Trade

Causes of Net Exports, Continued

Real Exchange Rate (e)

-- US Price Level (P),

P e NX -- Foreign Price Level,

Pf e NX

-- Nominal Exchange Rate (e’)

e’ e NX

Further Decomposition -- Causes of Net ExportsReal Exchange Rate (e) ... -- Nominal Exchange Rate (e’) (a) US interest rate (i) i e’* e NX (b) Foreign interest rate (if)

if e’* e NX (c) Expectations of Future e’

Exchange Rates and the IS-LM Model

Note -- causes (a), (b), and (c) apply only to floating exchange rates.

Fixed Exchange Rates and the IS-LM Model -- e’ inflexible, cause of autonomous Net Exports, shifts IS curve.

Floating Exchange Rates and the IS-LM ModelSince the nominal interest rate is a

cause of the nominal exchange rate and Net Exports, this behavior affects the slope of the IS curve.

Under floating exchange rates:

i* C, I, NX.Additional response to interest rate

change greater elasticity flatter IS curve.

Floating Exchange Rates and Policy Effectiveness

Flatter IS curve under floating exchange rates makes fiscal policy less effective and monetary policy more effective.

Recent Developments – Exchange Rates

1971-73: US Transitions From System of Fixed Exchange Rates to Floating Exchange Rates Against Major Industrialized Economies.

2006-: US pressuring China to convert from Fixed Exchange Rate Regime to purely Floating Exchange Rate (How Much Will Yuan/$ Exchange Rate Decrease as a Result?).

Recent Developments -- International Trade

Movement toward reducing or removing trade barriers

-- General Agreement on Tariffs

and Trade (GATT)

-- Replaced by World Trade

Organization (WTO)

Free Trade Agreements Involving the US

-- North American Free Trade

Agreement (NAFTA), 1994.

-- Central American Free Trade

Agreement (CAFTA), 2005.

-- Free Trade Agreement of the

Americas (FTAA), Proposed.

More Developments

Creation of the European Union -- economic bonding of major European countries.

-- removing barriers to trade

among member nations

-- common currency (Euro)

-- one central bank for the

community

Challenges to the European Union

Uniform currency equivalent to fixed exchange rate regime among member nations.

To avoid large scale foreign borrowing associated with fixed exchange rates and BOP < 0, need for coordinated economic policies among members.

Will nations with large budget deficits and very sluggish economies (e.g. Greece) accede to Germany’s fiscal-discipline based economy?