I. Introduction
A. Objectives
1. Explain how international trade is financed
2. Describe a country's balance of payments accounts
3. Explain what determines the amount of international borrowing and lending.
4. Explain how the foreign exchange value of a country's currency is determined.
5. Explain the effect of changes in the exchange rate
6. Explain why interest rates can vary so much from one country to another.
B. Topics to be covered
II. Financing International Trade
A. The balance of payments accounts records a country's international trading, borrowing, and lending.
B. There are three parts to a country's balance of payments:
1. The current account,
2. the capital account, and
3. the official settlements account.
4. These components must sum to zero.
C. The current account keeps track of:
1. the receipts from sales of goods and services to foreigners,
2. payments for goods and services made to foreigners, and
3. gifts and other transfer payments made between foreigners and domestic agents.
D. The capital account reports all international borrowing and lending transactions.
E. The official settlements account shows the increase or decrease in a county's holdings of foreign currencies.
*****************************************************************
A. In 1990 the United States had a current account deficit--it imported more than it exported.
1. An excess of imports over exports is financed by borrowing from abroad, which is recorded in the capital account.
2. This is similar to the case of an individual, where consumption in excess of income is financed by borrowing.
B. A net borrower is a country borrowing more from the rest of the world than it is lending to it;
C. A net lender is a country lending more to foreigners than it is borrowing from them.
1. Most countries are net borrowers;
2. Large net lenders include:
a. oil-rich countries (such as Venezuela) and
b. some developed economies (such as Japan).
2. The United States has been a net borrower since 1983.
D. A debtor nation is a country that owes more to foreigners than foreigners owe to it;
E. A creditor nation is one that has invested more in the rest of the world than other countries have invested in it.
1. The largest debtor nations are developing countries.
2. The United States is a debtor nation.*******************************************************************
A. Aggregate expenditure, Y, can be divided into C+I+G+EX-IM.
Y = C + I + G + EX - IM
B. Moreover, aggregate income, which equals aggregate expenditure, can be divided into C+S+T.
Y = C + S + T
C. Equating these yields
0 = (I-S) + (G-T) + (EM-IM),
or rearranging gives
(EX-IM) = (T-G) + (S-I).
D. These terms have the following meanings:
1. EX - IM equals the current account,
2. T - G is public saving, the excess of government revenue over government expenditure, and
3. S - I is the private sector surplus, private saving in excess of private investment.
E. Thus the current account equals:
1. the government's surplus plus
2. the private sector's surplus.
F. The twin deficits are the current account balance and government budget deficit.
1. The two tend to move together but not perfectly
a. since government actions that create a deficit may also affect private sector saving and/or investment.
G. Policies designed to eliminate a current account deficit must take account of the government's budget deficit
1. since this effects the current account deficit.
**************************************************************
A. International borrowing is a problem if the borrowing is used to increase consumption;
1. it is not a problem if the borrowing finances more investment since
2. in this case output expands and allows the nation to repay the loans and the interest.
3. In the United States apparently most of the borrowing has gone toward productive investment.
III. Foreign Exchange and the Dollar
A. To buy goods from a foreign country generally requires using that country's money.
B. The foreign exchange market is the market where "the currency of one country is exchanged for the currency of another."
C. The foreign exchange rate is the price at which one currency trades for another.
*******************************************************************
A. The government can run the foreign exchange market in three ways:
1. fixed exchange rate,
2. flexible exchange rate, and
3. managed exchange rate.
B. A fixed exchange rate is where the country's central bank holds the exchange rate steady at some fixed value.
C. A flexible exchange rate is an exchange rate where the value is determined by the forces of supply and demand without any central bank intervention.
D. A managed exchange rate is one where the central bank takes actions to effect the value of the exchange rate but does not try to peg the exchange to a certain fixed value.
E. Events since 1945:
1. At the end of World War II, most countries fixed their exchange rate to the U.S. dollar and
a. the dollar was fixed to gold.
2. Since 1971 most exchange rates have been either flexible or managed.
3. From 1975 to 1991, the dollar tended to depreciate against the Japanese yen.
F. Currency depreciation is the fall in value of one currency in terms of another.
1. On a trade-weighted basis (where the weight on each country's exchange rate is the importance of that country in U.S. trade) the dollar appreciated--rose in value-- from 1980 to 1985 and then
2. depreciated afterward.
IV. Determination of the Foreign Exchange Rate
A. The foreign exchange rate is determined by the demand and supply of a country's financial assets.
B. The quantity of U. S. dollar assets, is also called the quantity of dollars,
1. It is "the stock of financial assets denominated in U.S. dollars minus the stock of financial liabilities denominated in U.S. dollars.
C. Three points about this definition are important:
1. This is a stock not a flow.
2. The quantity of dollars is denominated in U. S. dollars.
a. If the U. S. government borrows yen, it is not part of the quantity of dollars since the loan is in terms of yen.
3. The supply of dollars is a net supply, that is, assets minus liabilities.
D. The quantity of dollars equals the government debt held outside the Fed plus the monetary base.
1. This quantity changes when:
a. the federal government has a deficit or surplus and when
b. the Fed buys or sells assets denominated in a foreign currency.
**************************************************************
A. The demand for dollars follows the law of demand,:
1. The quantity of dollar assets demanded increases when the price of dollars in terms of foreign currency falls.
B. There are two reasons why the law of demand applies:
1. The lower the value of the dollar,
a. the greater the demand for U.S. exports and hence
b. the greater the quantity demanded of U. S. Dollars with which to buy U. S. exports.
2. The lower the value of the dollar,
a. the greater its expected rate of appreciation and therefore
b. the greater the demand for dollars.
C. The demand curve for U. S. dollars can shift for four reasons:
1. Changes in the volume of dollar financed trade.
a. An increase shifts the demand curve to the right.
2. The interest rate on dollar assets.
a. An increase in the U.S. interest rate shifts the demand curve for U.S. dollars to the right.
3. The interest rate on foreign assets.
a. An increase in foreign interest rates shifts the demand for U.S. dollars to the left.
4. The expected future value of the dollar.
a. If the dollar is expected to appreciate, the demand curve for U.S. dollars shifts to the right.
*****************************************************************
A. The shape of the supply curve of dollar assets depends on the exchange rate regime.
1. With a fixed exchange rate,
a. the supply curve of dollars is horizontal at the selected exchange rate.
2. Under a managed exchange rate,
a. the supply curve of dollars is upward sloping.
3. If the exchange rate is flexible,
a. the supply curve of dollars is vertical.
G. The supply of dollar assets shifts for two reasons:
1. The government's budget.
a. If the government runs a deficit, the supply curve shifts right.
2. The Fed's monetary policy.
a. If the Fed expands the monetary base, the supply curve shifts to the right.
***************************************************************
A. The equilibrium exchange rate is determined by the intersection of the demand for U. S. dollars and supply of U.S. dollars.
B. This is illustrated to the right for the case of a managed exchange rate.
1. The exchange rate equals E.
C. With a fixed exchange rate,
1. a change in the demand for dollars means the Fed must alter the supply of dollars to accommodate the change.
2. For instance, a decrease in the demand for dollars requires that the Fed buy dollars by selling some of its foreign exchange holdings.
3. Thus fluctuations in the demand for dollars results in fluctuations in official holdings of foreign exchange.
D. With a flexible exchange rate,
1. foreign exchange reserves are unaffected by changes in demand for dollars;
E. with a managed exchange rate,
1. foreign exchange holdings are affected by changes in demand for dollars but
2. less strongly than under a fixed exchange rate.
F. Changes in the supply of dollars also can affect the demand for dollars,
1. thereby causing large swings in the foreign exchange rate.
1. For instance, from 1981 to 1986 the Fed cut back on the monetary base and caused a sharp rise in interest rates.
a. As illustrated to the right, the reduction in the monetary base shifted the supply of dollars left and the increase in interest rates shifted the demand curve right.
b. The exchange rate rose dramatically from E to E'.
2. The reverse occurred in 1985 and 1986 when a large government budget deficit and easy Fed policy increased the supply of U. S. dollars while lower U. S. interest rates lowered the demand.
a. The result was a large depreciation of the dollar.
IV. Arbitrage, Prices, and Interest Rates
A. Arbitrage consists of buying at a low price and reselling at a higher price in order to make a profit.
1. Arbitrage affects exchange rates, prices, and interest rates.
B. Related to arbitrage is the law of one price, namely that "any given commodity will be available at a single price."
1. If a product can be purchased more cheaply in one country than in another, arbitragers will:
a. buy the good where it is cheap and
b. resell it where it is expensive.
2. These actions
a. increase the price where it is initially low and
b. reduce it where it is initially high,
c. thereby restoring the law of one price.
C. Purchasing power parity occurs when "money has equal value across countries";
D. that is, when money can buy equal amounts of goods in different countries.
1. Purchasing power parity holds when the law of one price holds for all goods.
2. Purchasing power parity applies:
a. only to traded goods,
b. not to nontraded goods.
E. Interest rate parity occurs when interest rates, adjusted for risk, are the same across countries.
1. Interest rates in different countries apparently are quite different.
a. But this neglects the fact that interest rates in a foreign country are in terms of the foreign currency not U. S. dollars.
2. When a foreign bond is purchased, at its maturity the proceeds must be translated back to dollars.
a. This can be done using a forward contract, an agreement made today amount the price at which a specified amount of foreign currency can be changed into U.S. dollars at some future date.
b. The exchange rate in this agreement is the forward exchange rate.
3. The return from buying a bond issued in the U. S. and the return from taking dollars, converting them into foreign currency, buying a foreign bond, and entering into a forward contract to exchange the foreign currency back to dollars are virtually identical.
a. This supports the notion of interest rate parity.
V. Summary of the Lecture
Key ConceptsReview Questions