The Balance of Payments, Exchange Rates, and Trade Deficits

Chapter 21

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21-2

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

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21-3

Balance of Payments

• Sum of international financial transactions• Current account• Balance on goods and services• Net investment income• Net transfers• Balance on current account

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21-4

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

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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

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21-6

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

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21-7

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

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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

ExchangeRate: $2 = £1

$2

$3

$1

Q1

D2

ExchangeRate: $3 = £1

BalanceOf Payments

Deficit

Q2

x a

b

c

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21-9

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

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21-10

Fixed Exchange Rates

• Government intervention• Use of reserves

• Trade policies• Exchange controls and rationing• Distorted trade• Favoritism• Restricted choice• Black markets

• Macroeconomic adjustments

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21-11

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

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21-12

The Managed Float

• Dependence on foreign exchange markets• Occasional intervention• In support of managed float• Concerns with managed float

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21-13

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

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21-14

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

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