International Finance

International Finance -- measures of international transactions, and determination of exchange rates in the US.

Measures of International Finance

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

Current AccountCapital AccountOfficial Settlements Balance

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 current account transactions.

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

The Current Account: Characteristics

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

Net income generated to Americans as a result of international transactions.

The Capital Account

Capital Account =

{New Foreign Purchases of

US Assets}

- {New US Purchases of

Foreign Assets}Capital Account =

{Capital Inflows}

- {Capital Outflows}

The Official Settlements Balance

Official Settlements Balance = Current Account + Capital Account

Represents “net total dollar inflows” after all international transactions have been completed during a flow period.

Recorded as change in official reserve assets at the International Monetary Fund (IMF)

The Recent US Record -- International Transactions

Current Account < 0Capital Account > 0Official Settlements Balance 0Example -- 2000 (Billions of $)

-- Current Account = -$435

-- Capital Account = $399

-- Settlements Balance = -$36

A Quick review About Exchange Rates

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)

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

Exchange Rate Regimes

Fixed (Pegged) Exchange Rates -- exchange rates are fixed by the government, unless changed by economic policy.

Floating Exchange Rates -- exchanged rates determined by natural forces in the foreign exchange market.

The Foreign Exchange Market & the Exchange Rate

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 Important Foreign Exchange Concepts

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

The same exchange rate holds for all transactions – purchases or sales of goods, services and financial assets.

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 exchange rate (e), 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 exchange rate (e), with other causes (shift variables) as well.

Foreign Exchange Market EquilibriumEquilibrium exchange rate (foreign

currency)/(US$) -- “price of dollars.”

At equilibrium, total dollar inflows equal total dollar outflows.

Therefore, at equilibrium, the Official Settlements Balance = 0 automatically without any need for policy.

Major Causes of Exchange Rate Movements

US Interest Rates (r*)Interest Rates of Other Nations (rW)

Speculation -- Expectations of future exchange rate changes.

US Interest Rates and Exchange Rate Movements

Suppose r*.This causes substitution away from

foreign assets into US assets.The demand for dollars increases (D$

curve shifts rightward) and the supply of dollars decreases (S$ curve shifts leftward).

As a result e*.

Foreign Interest Rates and Exchange Rate Movements

Suppose rW.This causes substitution away from US

assets into foreign assets.The demand for dollars decreases (D$

curve shifts leftward) and the supply of dollars increases (S$ curve shifts rightward).

As a result e*.

Speculation and Exchange Rate MovementsConstantly fluctuating exchange rate

creates opportunities to make capital gains from timed purchases or sales of currency.

Incentive to buy dollars when exchange rate is low, then sell dollars when exchange rate rises.

Creates “speculative bubble” behavior -- like stock market.

Floating Exchange Rates

Advantages

-- No loss of official reserves at the IMF, market equilibrium current account + capital account = 0.

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

Floating Exchange Rates (Continued)

Disadvantages

-- Fluctuating exchange rate is disruptive to International Trade.

-- 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.

Fixed Exchange Rates (Continued)Disadvantages

-- Federal Reserve must intervene constantly in the foreign exchange market money supply decreases or loss of official reserves.

-- Fed might be forced into contractionary monetary policy to raise US interest rates and increase e* to the target 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, to stop large movement in e*.