CHAPTER 21: EXCHANGE RATES, THE BALANCE OF PAYMENTS, AND TRADE DEFICITS

FINANCING INTERNATIONAL TRADE

ü  U.S. Export Transaction

U.S. exports create a foreign demand for dollars, and the fulfillment of that demand increases and the supply of foreign currencies and by U.S. ranks and available to U.S. buyers.

ü  U.S. Import Transaction

U.S. imports create a domestic demand for foreign currencies and the fulfillment of that demand reduces the supplies of foreign currencies held by U.S. banks and available to U.S. consumers.

THE BALANCE OF PAYMENTS

-          Is the sum of all the transactions that take place between the residents and residents of all foreign nations. The statement shows all the payments a nation receives from foreign countries and all the payments it makes to them.

ü  Current Account

ü  Balance on Goods

-          Is the difference between its exports and its imports of goods.

ü  Balance on Services

-          Is the difference between U.S. exports of goods and services and U.S. imports of goods and services.

Trade deficit – unfavorable balance of trade

Trade surplus – favorable balance of trade

ü  Balance on Current Account

-          Is the sum of all the transactions of current account.

Net investment income – represents the difference between (1) the interest and dividend payments foreigners paid the United States for the U.S. exported capital and (2) the interest and dividends the United States paid for the use of foreign capital invested in the United States.

ü  Capital Account

-          Summarizes the purchase or sale of real or financial assets and the corresponding flows of monetary payments that accompany them.

ü  Official Reserves Account

-          These reserves can be drawn on to make up any net deficit in the combined current and capital accounts.

ü  Payments Deficits and Surpluses

Balance-of-payments deficits and surpluses – they are referring to imbalances between the current and capital accounts that cause a drawing down or building up of foreign currencies.

FLEXIBLE EXCHANGE RATES

2 Types of Exchange-rate Systems:

·         Flexible/Floating exchange-rate system – through which demand and supply determine exchange rates in which no government intervention occurs.

·         Fixed-exchange rate system – through which government determine exchange rates and make necessary adjustments in their economies to maintain these rates.

Demand-for-pounds curve – is downward-sloping because all British goods and services will be cheaper to the United States if pounds become less expensive to the United States.

Supply-of-pounds curve – is upward-sloping because the British will purchase more U.S. goods when the dollar price of pounds rises.

ü  Depreciation and Appreciation

Depreciation – an estimate of the amount of capital worn out or used up in producing the gross domestic product.

Appreciation – an increase in the value of the dollar relative to the currency of other nation, so a dollar buys a larger amount of the foreign currency and thus of foreign goods.

ü  Determinants of Exchange Rates

·         Changes in Rates

·         Relative Income Changes

·         Relative Price-Level Changes

Purchasing-power-parity theory – holds that exchange rates equate the purchasing power of various currencies.

·         Relative Interest Rates

·         Speculation

ü  Flexible Rates and the Balance of Payments

Proponents of flexible exchange rates say that they have an important feature: They automatically adjust and eventually eliminate balance-of-payments deficits and surpluses.

ü  Disadvantages of Flexible Exchange Rates

·         Uncertainty and Diminished Trade

·         Terms-of-Trade Changes

·         Instability

FIXED EXCAHNGE RATES

ü  Use of Reserves

Currency Interventions – manipulations of market through the use of official reserves.

ü  Trade Policies

The fundamental problem is that these policies reduce the volume of the world trade and change its makeup from what is economically desirable.

ü  Exchange Controls and Rationing

There are major objections to exchange controls:

·         Distorted Trade

·         Favoritism

·         Restricted Choice

·         Black Markets

INTERNATIONAL EXCAHNGE-RATE SYSTEMS

3 exchange-rate systems:

ü  Fixed-rate system

ü  Modified fixed-rate system

ü  Modified flexible-rate system

Ø  The Gold Standard: Fixed Exchange Rates

Under this system, each nation must

·         Define its currency in terms of quantity of gold

·         Maintain a fixed relationship between its stock of gold and its money supply

·         Allow gold to be freely exported and imported

·         Gold Flows

Under the gold standard, the potential free flow of gold between nations resulted in fixed exchange rates.

·         Domestic Macroeconomic Adjustments

When currency demand or supply changes, the gold standard requires domestic macroeconomic adjustments to maintain the fixed exchange rate.

·         Collapse of the Gold Standard

Devaluation – deliberate action by government to reduce the international value of its currency.

Ø  The Bretton Woods System/ Adjustable-peg System

The conference that produced a commitment to a modified fixed-exchange-rate system.

·         IMF and Pegged Exchange Rates

Under the Bretton Woods system there were three main source of the needed pounds:

·         Official Reserves

·         Gold Sales

·         IMF borrowing

·         Fundamental Imbalances: Adjusting the Peg

The Bretton Woods remedy was correction by devaluation, that is, by an “orderly” reduction of the nation’s pegged exchange rate.

·         Demise of the Bretton Woods System

The problem culminated in 1971 when the United States ended its 37-year-old policy of exchanging gold for dollars at $35 per ounce. It severed the link between gold and the international value of the dollar, thereby “floating” the dollar and letting market forces determine its value. The floating of the dollar withdrew U.S. support from the Bretton Woods System of fixed exchange rates, and, in effect, ended the system.

·         The Current System: The Managed Float

Managed floating exchange rates – the current international exchange-rate system is an “almost” flexible system. The system permits nations to buy and sell foreign currency to stabilize short-term changes in exchange rates or to correct exchange-rate imbalances that are negatively affecting the world economy.

RECENT U.S. TRADE DEFICITS

ü  Implications of U.S. Trade Deficits

·         Increased Current Consumption

Increased U.S. Indebtedness