Chapter Checklist

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CHAPTER CHECKLISTInternationalFinanceChapter211. Describe a country’s balance of paymentsaccounts and explain what determines theamount of international borrowing and lending.2. Explain how the exchange rate is determinedand why it fluctuates.Copyright 2002 Addison WesleyLECTURE TOPICS Financing International Trade The Exchange Rate21.1 FINANCING INTERNATIONAL TRADE Balance of Payment AccountsBalance of paymentsThe accounts in which a nation records itsinternational trading, borrowing, and lending.Current accountRecord of international receipts and payments—currernt account balance equals exports minusimports, plus net interest and transfers received fromabroad.1

21.1 FINANCING INTERNATIONAL TRADE21.1 FINANCING INTERNATIONAL TRADECapital accountRecord of foreign investment in the United Statesminus U.S. investment abroad.Official settlements accountRecord of the change in U.S. official reserves.U.S. official reservesThe government’s holdings of foreign currency.21.1 FINANCING INTERNATIONAL TRADE21.1 FINANCING INTERNATIONAL TRADE2

21.1 FINANCING INTERNATIONAL TRADEIndividual AnalogyAn individual’s current account records the income fromsupplying the services of factors of production and theexpenditures on goods and services.An example: In 2000, Joanne Worked and earned an income of 25,000. Had investments that paid an interest of 1,000.Her income of 25,000 is analogous to a country’s export.Her 1,000 of interest is analogous to a country’s interestfrom foreigners.21.1 FINANCING INTERNATIONAL TRADETo pay the 52,000 deficit, Joanne borrowed 50,000from the bank and used 2,000 that she had in herbank account.Joanne’s borrowing is analogous to a country’sborrowing from the rest of the world.The change in her bank account is analogous to thechange in the country’s official reserves.21.1 FINANCING INTERNATIONAL TRADEJoanne: Spent 18,000 buying goods and services to consume. Bought a house, which cost her 60,000.Joanne’s expenditure totaled 78,000.Her expenditure is analogous to a country’s imports.Her current account balance was 26,000 – 78,000, adeficit of 52,000.21.1 FINANCING INTERNATIONAL TRADE Borrowers and Lenders, Debtors and CreditorsNet borrowerA country that is borrowing more from the rest of the worldthan it is lending to the rest of the world.Net lenderA country that is lending more to the rest of the world thanit is borrowing from the rest of the world.3

21.1 FINANCING INTERNATIONAL TRADEDebtor nation21.1 FINANCING INTERNATIONAL TRADEA country that during its entire history has borrowedmore from the rest of the world than it has lent to it.Flows and Stocks Borrowing and lending are flows. Debts are stocks - amounts owed at a point in time.A debtor nation has a stock of outstanding debt to therest of the world that exceeds the stock of its ownclaims on the rest of the world.The flow of borrowing and lending changes the stockof debt.Creditor nationA country that has invested more in the rest of theworld than other countries have invested in it.21.2 THE EXCHANGE RATESince 1989, the total stock of U.S. borrowing from therest of the world has exceeded U.S. lending to the restof the world.21.2 THE EXCHANGE RATEForeign exchange marketForeign exchange rateThe market in which the currency of one country isexchanged for the currency of another.The price at which one currency exchanges foranother.The foreign exchange market that is made up ofimporters and exporters, banks, and specialist dealerswho buy and sell currencies.For example, in August 2000, one U.S. dollar bought108 Japanese yen. The exchange rate was 108 yenper dollar.This exchange rate can be expressed in terms ofcents per yen. In August 2000, the exchange rate wasa bit less than 1 cent per yen.4

21.2 THE EXCHANGE RATE21.2 THE EXCHANGE RATECurrency depreciationThe value of the foreign exchange rate fluctuates.The fall in the value of one currency in terms ofanother currency.For example, if the exchange rate falls from 108 yenper dollar to 105 yen per dollar, the U.S. dollardepreciates.Sometimes the U.S. dollar depreciates and sometimesit appreciates. Why?Currency appreciationThe rise in the value of one currency in terms ofanother currency.For example, if the exchange rate falls from 108 yenper dollar to 110 yen per dollar, the U.S. dollarappreciates.21.2 THE EXCHANGE RATE Demand in the Foreign Exchange MarketThe foreign exchange rate is a price and like allprices, demand and supply in the foreign exchangemarket determine its value.21.2 THE EXCHANGE RATE The Law of Demand for Foreign ExchangeThe quantity of dollars demanded in the foreignexchange market is the amount that traders plan tobuy during a given period at a given exchange rate.Other things remaining the same, the higher theexchange rate, the smaller is the quantity of dollarsdemanded.The quantity of dollars demanded depends on: The exchange rate Interest rates in the United States and othercountries The expected future exchange rateThe exchange rate influences the quantity of dollarsdemanded for two reasons: Exports effect Expected profit effect5

21.2 THE EXCHANGE RATE21.2 THE EXCHANGE RATEExports EffectThe larger the value of U.S. exports, the larger is thequantity of dollars demanded on the foreign exchangemarket.Expected Profit EffectThe larger the expected profit from holding dollars, thegreater is the quantity of dollars demanded in theforeign exchange market.The lower the exchange rate, the cheaper are U.S.made goods and services to people in the rest of theworld, the more the United States exports, and thegreater is the quantity of U.S. dollars demanded topay for them.But the expected profit depends on the exchange rate.21.2 THE EXCHANGE RATEFigure 20.1 shows thedemand for dollars.The lower the exchange rate, other things remainingthe same, the larger is the expected profit fromholding dollars and the greater is the quantity ofdollars demanded.21.2 THE EXCHANGE RATE Changes in the Demand for Dollars1. IfAny influence that changes the quantity of U.S. dollarsthat people plan to buy in the foreign exchange marketother than the exchange rate changes the demand forU.S. dollars and shifts the demand curve for dollars.2. IfThese influences are: Interest rates in the United States and other countries Expected future exchange ratethe exchange raterises, the quantity ofdollars demandeddecreases along thedemand curve for dollars.the exchange rate falls,the quantity of dollarsdemanded increasesalong the demand curvefor dollars.6

21.2 THE EXCHANGE RATEInterest Rates in the United States and Other CountriesU.S. interest rate differentialThe U.S. interest rate minus the foreign interest rate.Other things remaining the same, the larger the U.S. interestrate differential, the greater is the demand for U.S. assetsand the greater is the demand for dollars on the foreignexchange market.21.2 THE EXCHANGE RATEFigure 20.2shows changesin the demandfor dollars.1. An increase inthe demandfor dollars2. A decrease inthe demand fordollars.21.2 THE EXCHANGE RATEThe Expected Future Exchange RateOther things remaining the same, the higher theexpected future exchange rate, the greater is thedemand for dollars.The higher the expected future exchange rate, thelarger is the expected profit from holding dollars, sothe larger is the quantity of dollars that people plan tobuy on the foreign exchange market.21.2 THE EXCHANGE RATE Supply in the Foreign Exchange MarketThe quantity of U.S dollars supplied in the foreignexchange market is the amount that traders plan to sellduring a given time period at a given exchange rate.The quantity of U.S. dollars supplied depends on manyfactors, but the main ones are: The exchange rate Interest rates in the United States and othercountries The expected future exchange rate7

21.2 THE EXCHANGE RATE21.2 THE EXCHANGE RATETraders supply U.S. dollars in the foreign exchangemarket when they buy other currencies.Imports EffectThe larger the value of U.S. imports, the larger is thequantity of foreign currency demanded to pay for theseimports.Other things remaining the same, the higher theexchange rate, the greater is the quantity of U.S.dollars supplied in the foreign exchange market.When people buy foreign currency, they supply dollars. The Law of Supply of Foreign ExchangeOther things remaining the same, the higher theexchange rate, the cheaper are foreign-made goodsand services to Americans. So the more the UnitedStates imports, and the greater is the quantity of U.S.dollars supplied on the foreign exchange market.The exchange rate influences the quantity of dollarssupplied for two reasons: Imports effect Expected profit effect21.2 THE EXCHANGE RATEExpected Profit EffectThe larger the expected profit from holding a foreigncurrrency, the greater is the quantity of that currencydemanded and so the greater is the quantity of dollarsin the foreign exchange market.21.2 THE EXCHANGE RATEFigure 20.3 shows thesupply of dollars.1. Ifthe exchange raterises, the quantity ofdollars suppliedincreases along thesupply curve for dollars.The expected profit depends on the exchange rate.Other things remaining the same, the higher theexchange rate, the larger is the expected profit fromselling dollars and the greater is the quantity of dollarssupplied in the foreign exchange market.2.If the exchange ratefalls, the quantity ofdollars supplieddecreases along thesupply curve for dollars.8

21.2 THE EXCHANGE RATE Changes in the Supply of DollarsAny influence that changes the quantity of U.S. dollarsthat people plan to sell in the foreign exchange marketother than the exchange rate changes the supply ofU.S. dollars and shifts the supply curve for dollars.These influences are: Interest rates in the United States and other countries Expected future exchange rate21.2 THE EXCHANGE RATEThe Expected Future Exchange RateOther things remaining the same, the higher theexpected future exchange rate, the smaller is theexpected profit from selling U.S. dollars today, so thesmaller is the supply of dollars today.21.2 THE EXCHANGE RATEInterest Rates in the United States and OtherCountriesThe larger the U.S. interest rate differential, the smalleris the demand for foreign assets and so the smaller isthe supply of U.S. dollars on the foreign exchangemarket.21.2 THE EXCHANGE RATEFigure 20.4shows changesin the supply ofdollars.1. An increase inthe supply ofdollars.2. A decrease inthe supply ofdollars.9

21.2 THE EXCHANGE RATE Market EquilibriumDemand and supply in the foreign exchange marketdetermines the exchange rate.If the exchange rate is too low, there is a shortage ofdollars.If the exchange rate is too high, there is a surplus ofdollars.At the equilibrium exchange rate, there is neither ashortage nor a surplus.21.2 THE EXCHANGE RATE3. If the exchange rate is100 yen per dollar,there is neither ashortage nor a surplusof dollars and theexchange rate remainsconstant.The market isin equilibrium.21.2 THE EXCHANGE RATEFigure 20.5 shows theequilibrium exchange rate.1. If the exchange rate is120 yen per dollar, thereis a surplus of dollarsand the exchange ratefalls.2. If the exchange rate is80 yen per dollar, thereis a shortage of dollarsand the exchange raterises.21.2 THE EXCHANGE RATE Changes in the Exchange RateThe predictions about the effects of changes in thedemand for and supply of dollars are exactly the sameas for any other market.An increase in the demand for dollars with no changein supply raises the exchange rate.A increase in the supply of dollars with no change indemand lowers the exchange rate.10

21.2 THE EXCHANGE RATEWhy the Exchange Rate Is VolatileSometimes the dollar appreciates and sometimes itdepreciates, but the quantity of dollars traded eachday barely changes.Why?The main reason is that demand and supply are notindependent in the foreign exchange market.21.2 THE EXCHANGE RATEFigure 20.6(a) shows whythe dollar depreciatedbetween 1994 and thesummer of 1995.1.Traders expected thedollar to depreciate—the demand for U.S.dollars decreased andthe supply of U.S.dollars increased.2. The dollar depreciated.21.2 THE EXCHANGE RATEA Depreciating Dollar: 1994–1995Between 1994 and the summer of 1995, the dollardepreciated against the yen. The exchange rate fellfrom 100 yen to a low of 84 yen per dollar.An Appreciating Dollar: 1995 –1998Between 1995 and 1998, the dollar appreciatedagainst the yen. The exchange rate rose from 84 yento 130 yen per dollar.21.2 THE EXCHANGE RATEFigure 20.6(b) shows whythe dollar appreciatedbetween 1995 and 1998.1.Traders expected thedollar to appreciate—the demand for U.S.dollars increased andthe supply of U.S.dollars decreased.2. The dollar appreciated.11

21.2 THE EXCHANGE RATE Exchange Rate ExpectationsWhy do exchange rate expectations change?There are two forces: Purchasing power parity Interest rate parityPurchasing Power ParityEqual value of money—a situation in which moneybuys the same amount of goods and services indifferent currencies.21.2 THE EXCHANGE RATEThe value of money is determined by the price level.If prices in the United States rise faster than those ofother countries, people will generally expect theforeign exchange value of the U.S. dollar to fall.Demand for U.S. dollars will decrease and supply willincreases.21.2 THE EXCHANGE RATESuppose that a Big Mac costs 4 (Canadian) inToronto and 3 (U.S.) in New York.If the exchange rate is 1.33 Canadian per U.S. dollar,then the two monies have to same value—you canbuy a Big Mac in Toronto or New York for either 4(Canadian) or 3 (U.S.).But if a Big Mac in New York rises to 4 and theexchange rate remains at 1.33 Canadian per U.S.dollar, then money buys more in Canada than in theUnited States.Money does not have equal value.21.2 THE EXCHANGE RATEIf prices in the United States rise more slowly thanthose of other countries, people will generally expectthe foreign exchange value of the U.S. dollar to rise.Demand for U.S. dollars will increase and supply willdecreases.The U.S. dollar exchange rate will rise.The U.S. dollar exchange rate will fall.The U.S. dollar depreciates.The U.S. dollar appreciates.12

21.2 THE EXCHANGE RATEInterest Rate ParityInterest Rate ParityEqual interest rates—a situation in which the interestrate in one currency equals the interest rate in anothercurrency when exchange rate changes are taken intoaccount.21.2 THE EXCHANGE RATESuppose a Canadian dollar deposit in a Toronto bankearns 5percent a year and the U.S. dollar deposit inNew York earns 3% percent a year.If people expect the Canadian dollar to depreciate by2 percent in a year, then the expected fall in the valueof the Canadian dollar must be subtracted to calculatethe net return on the Canadian dollar deposit.The net return on the Canadian dollar deposit is 3percent (5 percent minus 2 percent) a year. Interestrate parity holds.21.2 THE EXCHANGE RATEAdjusted for risk, interest rate parity always hold.Traders in the foreign exchange market move theirfunds into the currencies that earn the highest return.This action of buying and selling currencies bringsabout interest rate parity.21.2 THE EXCHANGE RATE The Fed in the Foreign Exchange MarketThe Fed’s actions influence the U.S. interest rate, sothe Fed’s actions influence the U.S. dollar exchangerate.If U.S. interest rate rises relative to those in othercountries, the U.S. dollar exchange rate rises.But the Fed can intervene directly in the foreignexchange market.By changing the supply of U.S. dollars, it can try tosmooth out fluctuations in the exchange rate.13

21.2 THE EXCHANGE RATEIt can buy or sell dollars and try to smooth outfluctuations in the exchange rate.21.2 THE EXCHANGE RATEFigure 20.7 shows foreignmarket intervention.Suppose that the Fed’starget exchange rate is100 yen per dollar.1. If demand increases fromD0 to D1, the Fed sellsdollars to increase supply.21.2 THE EXCHANGE RATEFigure 20.7 shows foreignmarket intervention.2. If demand decreases fromD0 to D2, the Fed buysdollars to decrease supply.Persistent intervention onone side of the marketcannot be sustained.ChapterThe End20Copyright 2002 Addison Wesley14

The fall in the value of one currency in terms of another currency. For example, if the exchange rate falls from 108 yen per dollar to 105 yen per dollar, the U.S. dollar depreciates. Currency appreciation The rise in the value of one currency in terms of another currency. For example, if the exchange rate falls from 108 yen

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