Chapter 21: The Balance of Payments, Exchange Rates, and Trade Deficits

The Balance of Payments, Exchange Rates, and Trade DeficitsMcGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.International TransactionsInternational tradeBuy/sell current goods or servicesImports and exportsInternational asset transactionsBuy/sell real or financial assetsBuy stockSell your house to a foreignerRequires currency exchangeLO1Balance of PaymentsSum of international financial transactionsCurrent accountBalance on goods and servicesNet investment incomeNet transfersBalance on current account LO2Balance of PaymentsCapital and financial accountCapital accountFinancial accountBalance of payments accounts sum to zeroCurrent account deficits generate asset transfers to foreignersOfficial reservesLO2Balance of PaymentsLO2Official ReservesForeign currencies, certain reserves with the IMF, and stocks of goldOwned by government or central bankUsed as balancing mechanism in balance of paymentsLO2Flexible Exchange RatesDemand for poundsSupply of poundsMarket equilibriumIncrease in dollar price of poundsDollar depreciatesPound appreciates Decrease in dollar price of poundsDollar appreciatesPound depreciatesLO3Q0Dollar Price of 1 PoundQuantity of PoundsPFlexible Exchange RatesThe Market for Foreign Currency (Pounds)D1S1DollarAppreciates(PoundDepreciates)DollarDepreciates(PoundAppreciates)ExchangeRate: $2 = £1$2$3$1Q1LO3Flexible Exchange RatesDeterminants of exchange ratesFactors that shift demand/supplyChanges in tastesRelative income changesRelative price-level changesPurchasing-power-parity theoryRelative interest ratesRelative expected returns on assetsSpeculationLO3Q0Dollar Price of 1 PoundQuantity of PoundsPFlexible Exchange RatesThe Market for Foreign Currency(Pounds)D1S1ExchangeRate: $2 = £1$2$3$1Q1D2ExchangeRate: $3 = £1BalanceOf PaymentsDeficitQ2xabcLO3Flexible Exchange RatesEliminate balance of payments deficit or surplusDisadvantages of flexible exchange ratesVolatility Uncertainty and diminished tradeTerms-of-trade changesInstabilityLO4Fixed Exchange RatesGovernment interventionUse of reservesTrade policiesExchange controls and rationingDistorted tradeFavoritismRestricted choiceBlack marketsMacroeconomic adjustmentsLO4The Managed FloatGold standard: 1879-1934Fixed exchange rate systemBretton Woods: 1944-1971Fixed exchange rate system indirectly tied to goldManaged float: 1971-presentLO4The Managed FloatDependence on foreign exchange marketsOccasional interventionIn support of managed floatConcerns with managed floatLO4U.S. Trade DeficitLarge and persistentCauses of trade deficitsHigh U.S. growth (relatively)ChinaPrice of oilLow U.S. saving rateImplications of trade deficitsIncreased current consumptionIncreased indebtednessLO5