PPT

CHAPTER 20:

International Finance

• Explain what is meant by a balance of trade deficit as well as its importance.

• Explain why the US changed from being a lender to being a borrower in the mid-1980s.

• Explain how the foreign exchange value of the dollar is determined.

In this Chapter we will . . .

• Balance of Payments Accounts• Definition: the record of all payments from/to

residents of a country to or from residents of other countries.

• Categories of the balance of payment accounts:1) Current Account:

- records payments for imports/exports of goods and services, net interest and other factor payments from abroad, and net unilateral [unrequited] transfers.

2) Capital Account:- records foreign investments/loans into the US minus US investments/loans abroad.

3) Official Settlements Account:- records the change in official reserves in the US.

Balance of Payments Accounts• The current and capital accounts are financial

accounts

• Items therefore enter the accounts according to who gets the payment: exports are positives, because a US resident is paid; imports are negatives, a foreigner is paid; investment in the US from abroad is +, spending by Japanese tourists in Orlando is +, etc -- the payment comes in.

U.S. Balance of Payments Accounts in 1999, $ billions

Current accountImports of goods and services -1,221Exports of goods and services +956Net factor income from abroad –18Net transfers (mostly private) –48Current account balance –331

Capital accountForeign investment in the United States +711U.S. investment abroad -442Statistical discrepancy +12Capital account balance +281

Official settlements accountIncrease in official reserves (both US +50

and foreign held in the US)

The Balance of Payments:1975-1996

• Balance of Payments Accounts (cont.)• The balance of payments accounts

add up to zero.• In 1999 we had a “trade deficit” as we

imported more goods than we sold abroad (exported).

• We paid for the deficit by:1) Borrowing net from abroad which

translates into a capital account surplus.2) Investing less abroad than foreigners

invested in the US.

• Balance of Payments Accounts (cont.)• A country that in aggregate over its

entire history has borrowed more from the rest of the world than it has lent is a debtor country.• A partial list of debtor countries:

- Mexico- Brazil- The United States

• Balance of Payments Accounts (cont.)• Is there any reason to be concerned that

the US is a debtor country?

- No, if the borrowing is financing investment that is generating economic growth and higher income.

- Yes, if the money is being used to finance consumption.• This could result in higher interest

payments to foreigners and lower consumption sometime in the future.

Is the US a debtor?• The official data show the US as a debtor

• This is dubious; actual loans are fairly accurately measured, but ‘direct investment’ -- e.g. the value of General Motors’ or Ford’s investments in Europe and Australia -- is very hard to estimate.

• Much US foreign direct investment is older than most foreign direct investment in the US -- so probably more valuable; estimates of US foreign assets are probably too low.

• The US has a large current account deficit, why?• Our discussion of national income and product

accounting taught us that expenditures and income are equal, when properly measured.

• Expenditure = C + I + G + X - M• Income [uses of income] = C + S + T

• Balance of Payments Accounts (cont.)

C + I + G + X - M = C + S + T

- or -

(X - M) = (S - I) + (T - G)- or -

• This says that a balance of trade deficit

• Balance of Payments Accounts (cont.)

(X - M) = (S - I) + (T - G)

(X - M) < 0 is due to:

1) A government sector deficit: (T - G) < 0and/or

2) A private sector deficit: (S - I) < 0

Numbers for 1999 [approximate, national income account estimates]

Variables

Exports X 956

Imports M 1221

Gov’nment purchases G 1,536

Net Taxes T 1,710

Investment I 1,670

Saving S 1,231

SymbolsUnited States

in 1999(billions of dollars)

Net Exports, the Government Budget, Saving and Investment

Net Exports X - M = 956 – 1221 = -265

Government sector T - G = 1,710 – 1,536 = +174

Private sector S - I = 1,231 – 1,670 = –439

Surpluses and deficits, 1999

Net Exports, the Government Budget, Saving, and InvestmentNational accounts Y = C + I + G + X – M

= C + S + T

Rearranging X – M = (S – I) + (T – G)

Net exports X – M –265

equals:

Government sector T – G +174

plus

Private sector S – I –439

Overall balance [+174 -439] = -265 = ‘Net exports’

Relationship among surpluses and deficits

The Twin Deficits

Borrowing for what? Is the U.S. Borrowing for Consumption or

Investment?• Net exports were –$265 billion in 1999

• Governments in the US buy structures (e.g. highways, schools, dams) worth more than $200 billion/year.

• Governments also spend on education and health care—increases human capital.

• Looks like mostly investment, not consumption.

Foreign Exchange Markets

• In the US, we use the US dollar as currency

• Most countries have their own currencies

• To exchange one currency for another, a price for one currency in terms of the other is needed -- hence “foreign exchange markets.”

• Exchange Rate Measures• The foreign exchange market is the market in

which the currency of one country is exchanged for the currency of another.

• The foreign exchange rate is the nominal price for which one currency is exchanged for another.

Perdollarquotes

= Foreign currencyUS Dollar = 111.33

YenUS Dollar =Ex: Japan 11/26/0

Perforeign

currencyquotes

= Foreign currencyUS Dollar = .00898

YenUS Dollar =Ex: Japan 11/26/0

Wall Street Journal 9/98

• Suppose you can buy a CD in Canada or in the US, where should you buy it?

• PUS = US $ 15.00• PCA = C$ 20.00 (CAN)

An Example:

• Exchange Rate Measures (cont.)

PUS = $ 15.00 PCA = C$ 20.00 (CAN)

PerUS

dollarquotes

= CAN DollarUS Dollare( ) = 1.51

PerCANdollarquotes

= US DollarCAN Dollare( ) = .65

• In order to make a decision, you must convert the Canadian CD to US dollars:

Price of CanadianCD in US

= PCAN US DollarCAN Dollare( )*

• Recall the price of the same CD in the U.S. was US $15.00.• Since the price of the US CD was more than the US Dollar price of the Canadian CD, you buy the CD in Canada.

C$20 (CAN) X C$1.00

(CAN)

$0.65 (US)

1 = $13.00 (US)

Reality Check• This ignores transaction costs

• Transaction costs on LARGE exchanges -- millions of $s -- are small, fractions of a %

• Transaction costs on small exchanges -- for tourists or travelers -- can be large; in North America and Western Europe, a fixed fee (say $5) per exchange plus commission of 1 or 2 per cent. Travelers be warned!

• Currency depreciation:- a currency depreciates if its value in terms of foreign currency goes down.

• That automatically means it costs more of the depreciated currency to buy a unit of the foreign currency - i.e. the price of the foreign currency has gone up in terms of domestic currency.

• Some Terminology:

• Currency depreciation: (an example)

• Example: Say that currently one US dollar is worth 2 DM (German currency),

or , 2$

DMe

• If the new exchange rate is

then one US dollar buys 1 DM.

1$

DMe

• The US dollar buys less and has thus depreciated.

Depreciation and Appreciation• One DM used to cost $0.50, 50 cents, but now it costs a

dollar -- the price of the DM in dollars has gone up, the price of the $ in DM has gone down (from DM2 to DM1)

• The DM appreciated, the $ depreciated.

• German goods, priced in DM, now cost more in $’s; so are more expensive compared to US goods, so German exports, [US imports], go down. US goods, priced in $’s, now cost fewer DM’s, US exports [German imports] go up.

• Exchange Rate Measures (cont.)

• The real exchange rate is the nominal exchange rate adjusted for prices

• That means we multiply the nominal exchange rate by the ratio of the US and foreign price indices:

Real Exchange Rate:

= e Foreign currencyUS Dollar( )Re Foreign

currencyUS Dollar( ) X PFCPUS

• The Demand for Dollarsis a derived demand -- it comes from holders of other currencies wanting US dollars to make payments in dollars -- e.g. to buy US goods, services, or assets.

• What determines the quantity of dollars demanded in the foreign exchange market?

• The exchange rate, the price of the $ in terms of the other currency.- other things remaining the same, an increase in the exchange rate reduces the quantity demanded (of dollars) and causes a movement along the demand curve (for dollars in the foreign exchange market).

• Quantity demanded for dollars (an example)

• Suppose the current exchange rate is - - - This means that 100

yen(Japanese currency) will

buy you $1.00.

100$

Yene

• The price of a dollar has gone up, so less willbe demanded.

• Suppose the exchange rate increases to 200 yen. Now someone in Japan hasto give up twice as many yen to get $1.00.

200$

Yene

100

1.3

The Demand for Dollars

Quantity (trillions of $ per day)

50

150

1.1 1.2 1.4 1.50

D

ExchangeRate

(Yen for $)

1.3

100

Other things remainingthe same, a rise in the exchange rate decreasesthe quantity of dollars demanded...

• Other determinants cause the demand for dollars curve to shift 1) Interest rates in the US and other countries.

Example: Suppose US interest rates go up. What will happen to the demand for the dollar?

• At the same exchange rate, Japanese investors will want to take advantage of the higher returns by investing more in (lending more to) the US.

• This means more US dollars will be purchased and the demand for dollars will shift to the right.

• Other determinants cause the demand for dollar curve to shift (cont.)

2) relative prices in the United States and other countries [affects X and M, which require currency transactions].

3) GDP in the foreign country [affect our exports -- income effect]

4) the expected future exchange rate [affects asset holdings -- foreigners won’t hold $’s if they expect the value to fall]

D2

D1

Changes in the Demand for Dollars

Quantity (trillions of dollars per day)

Exch

ange

rate

(yen

per

dol

lar)

50

100

150

1.1 1.2 1.3 1.4 1.50

D0

Increase in thedemand for dollars

Decreasein thedemand fordollars

Summary: Changes in the Demand for Dollars

• The U.S interest rate differential increases

• Japanese prices rise, relative to US prices.

• Japanese GDP rises.

• The expected future exchange rate rises

• The U.S. interest rate differential decreases

• Japanese prices fall, relative to US prices.

• Japanese GDP falls.

• The expected future exchange rate falls

The demand for dollarsincreases if:

The demand for dollarsdecreases if:

• The Supply of Dollarsis derived -- it arises from holders of dollars wanting foreign currency to make payments in foreign currency -- e.g. to buy goods, services, or assets abroad.

• What determines the quantity of dollars supplied in the foreign exchange market?

• The exchange rate, i.e. the $’s price - other things remaining the same, if the exchange rate rises, the quantity of dollars supplied increases and causes a movement along the supply curve (of dollars in the foreign exchange market).

• Quantity supplied of dollars (an example)

• Suppose the current exchange rate is - - - And, further,

suppose that 1.3 trillion dollars are supplied.

100$

Yene

• Japanese goods are cheaper so you will supply more dollars in order to get the yen needed to purchase the cheaper Japanese goods.

• If the exchange rate increases to 200 yen. One dollar buys

more yen. 200$

Yene

Other things remainingthe same, a rise in the exchange rate increasesthe quantity of dollars supplied...

S

100

1.3

The Supply of Dollars

Quantity (trillions of $ per day)

50

150

1.1 1.2 1.4 1.50

ExchangeRate

(Yen for $)

1.3

100

• Other determinants cause the supply of dollars curve to shift 1) Interest rates in the US and other countries.

2) relative prices in the United States and other countries.

3) GDP in the US

4) the expected future exchange rate

[reasoning is all symmetric to the demand curve shifts -- supply of $’s is demand for Yen if we just consider these two currencies]

S2

S1

The Supply of Dollars

Quantity (trillions of dollars per day)

Exch

ange

rate

(yen

per

dol

lar)

50

100

150

1.1 1.2 1.3 1.4 1.50

S0

Decrease in thesupply of dollars

Increase in thesupply of dollars

Summary: Changes in the Supply of Dollars

• The U.S interest rate differential decreases

• Japanese price level falls relative to the US price level.

• U.S. GDP increases.

• The expected future exchange rate falls

• The U.S. interest rate differential increases

• Japanese price level increases, relative to the US price level.

• US GDP decreases.

• The expected future exchange rate rises

The supply of dollarsincreases if:

The supply of dollarsdecreases if:

Equilibrium Exchange Rate:• The equilibrium exchange rate

occurs where the quantity of dollars demanded is just equal to the quantity of dollars supplied.

100

1.3Quantity (trillions of $ per day)

50

150

1.1 1.2 1.4 1.50

ExchangeRate

(Yen for $)

D

S

1.3

100

Surplus at150 yen per dollar

Shortage at50 yen per dollar

Equilibrium at100 yen per dollar

Equilibrium Exchange Rate

An Application: Interest rates fluctuate up.

Quantity of $0

S1

D1

e1

Q1

• If the US interest rate goes up, what will happen to the dollar?

$

Yene

• With higher interest rates in the US, investors abroad demand more dollars with which to invest in the US.• With higher interest rates in the US, investors in the US are less willing to buy foreign currency (supply dollars) and more willing to invest at higher interest rates at home.

D2

S2

An Application: Interest rates fluctuate up.

Quantity of $0

S1

D1

e1

Q1

$

Yene

D2

S2

e2

Q2 =

• The equilibrium exchange rate occurs where the quantity of dollars demanded is just equal to the quantity of dollars supplied.• The new equilibrium results in a higher exchange rate (yen for $).• Prediction: The dollar should appreciate in relation to the yen.

• Suppose the Japanese yen is rising w/respect to the US dollar.

An Application: Foreign Exchange Intervention.

Quantity of $0

S1

D1

e1

Q1

• Foreign exchange intervention is when a govt. tries to maintain an exchange rate in the foreign exchange model.

• The Fed could intervene in the market to “prop up” the dollar.

$

Yene

D2• Without intervention, the exchange rate will fall to e2.

e2

D1

e1

An Application: Foreign Exchange Intervention.

Quantity of $0

S1

Q1

• In order for the Fed to intervene and attempt to maintain the exchange rate between dollars and yen at e1, it would have to demand (buy) dollars to shift the demand curve back to D1

$

Yene

D2

e2

D1

e1

Reality Check• Nowadays, intervention rarely works

• The volume of foreign exchange transactions is of the order of $2 trillion a day

• This is massively larger than any country’s foreign exchange reserves, so in most cases intervention alone is inadequate -- it does not shift the curves enough.

Changes in the Exchange RateWhy the Exchange Rate is Volatile

• Supply and demand are not independent of each other.• A change in the expected future exchange rate or U.S.

interest rate differential changes both supply and demand.

• Day-to-day movements in exchange rates are dominated by the large amounts of internationally mobile liquid capital and changes in sentiment -- i.e. expectations about the future

S94

Exchange Rate Fluctuations

Quantity (trillions of dollars per day)

Exch

ange

rate

(yen

per

dol

lar)

84

100

0 Q0

D94

S95

D95

1994 to 1995

S97

D97

Exchange Rate Fluctuations

Quantity (trillions of dollars per day)

Exch

ange

rate

(yen

per

dol

lar)

84

0 Q0

S95

D95

123

1995 to 1997

The Exchange Rate

Exchange Rate Expectations Three influences on expectations that affect the

international value of a currency are:

1) Purchasing power parity ideas

2) Interest rate parity expectations

3) Other influences on expectations about future exchange rates [e.g. political developments]

Influences on the Exchange Rate1) Purchasing Power Parity

• Money is worth what it will buy.• Purchasing power parity means equal value of

money as purchasing power -- the idea that, ceteris paribus, $1 ought to buy the same amount of real goods and services anywhere.

• PPP is misleading -- much of output is nontradable -- most services, most low value-to-mass or -to-bulk, or perishable, goods (e.g. haircuts, restaurant meals, fresh bread, housing, bricks, cement, gravel, etc)

Purchasing Power ParityIf prices [of traded goods] increase in Canada (for

example) and other countries but remain constant in the United States, people will generally expect that the value of the U.S. dollar is too low and will expect it to rise.• Supply of and demand for dollars change

• The exchange rate should tend to change -- eventually. It may take some time, because buying habits and supply chains don’t change instantaneously, and other influences are at work.

Influences on the Exchange Rate2) Interest Rate Parity

• “Money is worth what it can earn.”

• Interest rate parity means equal interest rates -- i.e., ceteris paribus, interest rates should be the same everywhere.

• Again, they aren’t -- because risk differentials differ, there are transactions costs investing in other currencies, and because possible future changes in exchange rates have to be taken into account.

Interest Rate ParityIf the rate of return on the dollar is higher in the United States than the rate of return on local currencies in other countries, the demand for U.S. dollars rises and the exchange rate rises until interest rates are closer to equal.If you are the treasurer of a multinational (e.g. Ford),

you will put your liquid funds (cash) in the market (and the currency) where you expect the biggest return, ceteris paribus [e.g. allowing for risk].

3) Other Influences on Exchange Rates

• The problem is, small differentials in interest rates [a percent or two a year] can be swamped by small changes in exchange rates [a few percent right now]

• So expectations about likely future changes in exchange rates tend to be much more powerful influences on supply and demand to foreign exchange markets in the short run than fundamentals like relative price levels and interest rate differentials.

Example: ‘Speculation’ & ‘Runs’

• Suppose an exchange rate was stable for a long time -- e.g. $1 = 25 Thai Baht

• Suppose lots of foreign investment goes into Thailand at that rate

• Then suppose some bad financial and political things happen in Thailand -- the property market goes bad, some finance houses and banks get in trouble

‘Speculation’ & ‘Runs’• A few investors figure the exchange rate might

fall, and withdraw their money from Thailand

• This increases demand for $’s and supply of baht, so the price of baht falls -- i.e. more baht per dollar

• Others notice, and think they had better get dollars before the price of dollars gets even higher in baht

‘Speculation’ & ‘Runs’• You get a ‘rush for the exit’ -- and the

exchange rate collapses [July 1997: $1 = 25 baht; December 1997: $1 = 43 baht]

• Conclusion: If there is a lot of so-called ‘liquid capital’ -- money that can be exchanged and transferred quickly -- exchange rates may be very volatile, i.e. can change a lot quickly.