chapter 32 exchange rates, balance of payments, and international debt gottheil — principles of...

Chapter 32Chapter 32

EXCHANGE RATES, BALANCE EXCHANGE RATES, BALANCE OF PAYMENTS, AND OF PAYMENTS, AND INTERNATIONAL DEBTINTERNATIONAL DEBT

Gottheil — Principles of Economics, 7e© 2013 Cengage Learning1

Economic PrinciplesEconomic Principles

© 2013 Cengage Learning Gottheil — Principles of Economics, 7e2

Exchange rates

Foreign exchange markets

Appreciation and depreciation of currencies

Floating and fixed exchange rates

Economic PrinciplesEconomic Principles


Arbitrage

Devaluation

Balance of payments

International debt and debt service

The Foreign Exchange Market: The The Foreign Exchange Market: The Buying and Selling of CurrenciesBuying and Selling of Currencies


Foreign exchange market

• A market in which currencies of different nations are bought and sold.



Exchange rate

• The number of units of foreign currency that can be purchased with one unit of domestic currency.



1. Suppose that a kite costs 40 yaps, and the exchange rate is 10 yaps to the dollar. What is the dollar price of the kite?

• 40 yaps/10 = 4 dollars


EXHIBIT 1 FOREIGN EXCHANGE MARKET

Exhibit 1: Foreign Exchange MarketExhibit 1: Foreign Exchange Market


At $2 per yap, is the foreign exchange market in Exhibit 1 in equilibrium, or is there an excess demand or excess supply of yaps?• Since the equilibrium price is $3 per

yap, at $2 per yap there would be an excess demand for yaps.

Exhibit 1: Foreign Exchange MarketExhibit 1: Foreign Exchange Market


At $4 per yap, is the foreign exchange market in Exhibit 1 in equilibrium, or is there an excess demand or excess supply of yaps?• Since the equilibrium price is $3 per

yap, at $4 per yap there would be an excess supply of yaps.

The Foreign Exchange Market:The Foreign Exchange Market:The Buying and Selling of CurrenciesThe Buying and Selling of Currencies


• When the price of a foreign currency declines, the quantity of that foreign currency demanded increases.

2. Why is the demand curve for foreign currency downward-sloping?



• For example, if a dollar can buy more yaps than before, then a dollar can also buy more yap-priced goods and services than before.





• As a result, Americans wish to exchange dollars for more yaps in order to buy more yap-priced goods, increasing the quantity of yaps demanded in the foreign exchange market.



• When the price of a foreign currency rises, then the purchasing power of the foreign currency rises when it comes to buying imported goods and services.

3. Why is the supply curve for foreign currency upward-sloping?




• For example, if it takes more dollars to buy a yap, then it takes fewer yaps to buy a dollar, and so the price of American goods are cheaper for people who use the yap.




• As a result, people who use yaps wish to exchange more yaps for dollars in order to buy more American goods, increasing the quantity of yaps supplied in the foreign exchange market.



4. Which of the following will cause an increase in the demand for yaps?

a. Decreasing American incomes

b. Increasing yap-priced interest rates

c. Increasing American interest rates



a. Decreasing American incomes

b. Increasing yap-priced interest rates

c. Increasing American interest rates

4. Which of the following will cause an increase in the demand for yaps?


EXHIBIT 2 EFFECT OF AN INCREASE IN THE DEMAND FOR YAPS ON THE DOLLARS-FOR-YAPS RATE OF EXCHANGE

Exhibit 2: Effect of an Increase in the Exhibit 2: Effect of an Increase in the Demand for Yaps on the Dollars-for-Demand for Yaps on the Dollars-for-

Yaps Rate of ExchangeYaps Rate of Exchange


1. After the increase in demand from D1 to D2, Is there excess supply, excess demand, or equilibrium at an exchange rate of $3 per yap?

• There is excess demand of (70 – 30) = 4,000 yaps.

Exhibit 2: Effect of an Increase in the Exhibit 2: Effect of an Increase in the Demand for Yaps on the Dollars-for-Demand for Yaps on the Dollars-for-



2. After the increase in demand from D1 to D2, what is the new equilibrium exchange rate?

• The new equilibrium exchange rate is $5 per yap.



5. Which of the following will cause a decrease in the supply of yaps?

a. Decreasing American tastes for yap-priced goods

b. Decreasing yap-priced interest rates

c. Decreasing yap-priced incomes



5. Which of the following will cause a decrease in the supply of yaps?

a. Decreasing American tastes for yap-priced goods.

b. Decreasing yap-priced interest rates.

c. Decreasing yap-priced incomes.


EXHIBIT 3 EFFECT OF AN INCREASE IN THE SUPPLY OF YAPS ON THE DOLLARS-FOR-YAPS RATE OF EXCHANGE

Exhibit 3: Effect of an Increase in the Exhibit 3: Effect of an Increase in the Supply of Yaps on the Dollars-for-Supply of Yaps on the Dollars-for-



1. After the increase in supply from S1 to S2, is there excess supply, excess demand, or equilibrium at an exchange rate of $3 per yap?

• There is an excess supply of (50 – 30) = 20,000 yaps.

Exhibit 3: Effect of an Increase in the Exhibit 3: Effect of an Increase in the Supply of Yaps on the Dollars-for-Supply of Yaps on the Dollars-for-



2. After the increase in supply from S1 to S2, what is the new equilibrium exchange rate?

• The new equilibrium exchange rate is $2 per yap.

Floating Exchange RatesFloating Exchange Rates


Floating exchange rate

• An exchange rate determined strictly by the demands and supplies for a nation’s currency.



Appreciation

• A rise in the price of a nation’s currency relative to foreign currencies.



Depreciation

• A fall in the price of a nation’s currency relative to foreign currencies.



1. Complete the sentence:

When journalists say that the dollar has “weakened,” they mean that the dollar has _____ in value.



1. Complete the sentence:

When journalists say that the dollar has “weakened,” they mean that the dollar has depreciated in value.



2. If the dollar has appreciated in value relative to the yap, then which of the following is true:

a. The exchange rate has more yaps per dollar than before.

b. The exchange rate has fewer yaps per dollar than before.

Tourists at the MallTourists at the Mall


Has the U.S. dollar appreciated or depreciated in value relative to the Japanese yen between 1960 and 1996?• Depreciated in value

Tourists at the MallTourists at the Mall


Has the U.S. dollar appreciated or depreciated in value relative to the Japanese yen between 1960 and 1996?• In 1960 the exchange rate was 358 yen per

dollar. By 1996 there were only 131 yen per dollar.



Arbitrage

• The practice of buying a foreign currency in one market at a low price and selling it in another at a higher price.



3. How might floating exchange rates make international trade riskier?

• Suppose that the price of an internationally traded good changes during the time between when a purchase is negotiated and the product is delivered.

Exhibit 4: Trade under Free and Exhibit 4: Trade under Free and Fixed Exchange RatesFixed Exchange Rates


2. If there is a system of fixed exchange rates, then what happens if the demand for a foreign currency increases?

• Since the exchange rate cannot change, an increase in demand will create excess demand for the foreign currency.



• The yap government will need to exchange some of its own yaps for dollars on the foreign exchange market.

3. If there is excess demand for yaps under a system of fixed exchange rates, what will the yap government need to do to eliminate the excess demand for the yap?



• This will increase the supply of yaps on the foreign exchange market and eliminate the excess demand.




• In order for the yap government to do this, it must have sufficient stock of yaps to exchange for dollars.


Exhibit 4: Trade Under Free and Exhibit 4: Trade Under Free and Fixed Exchange RatesFixed Exchange Rates


4. Continuing the yap example, what might the yap government be forced to do if it did not have a sufficient quantity of yaps on reserve to eliminate the excess demand?

• The yap government might be forced to borrow yaps from another country, or even agree to increase the exchange rate ($ per yap).



Foreign exchange reserves

• The stock of foreign currencies a government holds.



Devaluation

• Government policy that lowers the nation’s exchange rate; its currency instantly is worth less in the foreign exchange market.



4. In which of the following would a country most likely be forced into a devaluation of its currency:

a. The excess supply of its currency in the foreign exchange market exceeds its foreign exchange reserves.

b. The excess demand for its currency in the foreign exchange market exceeds its foreign exchange reserves.



Import controls

• Tariffs and quotas used by government to limit a nation’s imports.



Exchange controls

• A system in which government, as the sole depository of foreign currencies, exercises complete control over how these currencies can be used.



International Monetary Fund (IMF)

• An international organization formed to make loans of foreign currencies to countries facing balance of payments problems.

Balance of PaymentsBalance of Payments


Balance of payments

• An itemized account of a nation’s foreign economic transactions.



Balance on current account

• A category that itemizes a nation’s imports and exports of goods and services, income receipts and payments on investment, and unilateral transfers.


EXHIBIT 5 THE U.S. BALANCE OF PAYMENTS ACCOUNT: 2010 ($ billions)

Source: Survey of Current Business (Washington, D.C.: U.S. Department of Commerce, June 2011).

Exhibit 5: The U.S. Balance of Exhibit 5: The U.S. Balance of Payments Account: 2010Payments Account: 2010


In which of the following categories of the U.S. balance of payments did the U.S. run a surplus in 2010?a. Balance of trade

b. Balance on current account

c. Balance on capital account


EXHIBIT 6 U.S. BALANCE OF TRADE: 1960–2007

Source: U.S. Census Bureau, Foreign Trade Statistics.

Exhibit 6: U.S. Balance of Exhibit 6: U.S. Balance of Trade: 1960–2007Trade: 1960–2007


Until the mid-1990s, the balance deficit was often less than $100 billion. Note the sharp plunge in the balance of trade from the late 1990s through to 2007, reaching $819 billion by 2007.

Exhibit 6: U.S. Balance of Exhibit 6: U.S. Balance of Trade: 1960–2007Trade: 1960–2007


That said, what has been the overall trend in the U.S. balance of trade since the mid-1970s?• Since the mid-1970s, the U.S. balance of

trade has been in deficit.



What is an example of an export of services?

• When a U.S. engineering firm provides engineering design services for a project in another country.



Unilateral transfers

• Transfers of currency made by individuals, businesses, or government of one nation to individuals, businesses, or governments in other nations, with no designated return.



Balance on capital account

• A category that itemizes changes in the foreign asset holdings of a nation and that nation’s asset holdings abroad.

What is a Balance of Payments What is a Balance of Payments Problem?Problem?


Do trade imbalances always create problems?

• No. For example, a country may have a balance of trade deficit because it is importing capital equipment necessary for it to produce valuable exports in the future.

How Deficits on Current How Deficits on Current Account DevelopAccount Develop


• Foreign purchases of U.S. stocks and bonds increases the demand for U.S. dollars.

If foreigners make huge investments in U.S. stocks and bonds, how might this affect the current account?



• Increased demand for the U.S. dollar increases the value of the dollar relative to other currencies.

If foreigners make huge investments in U.S. stocks and bonds, how might this affect the current account?



If foreigners make huge investments in U.S. stocks and bonds, how might this affect the current account? • A high-valued dollar makes imports cheap for

Americans, but makes American exports expensive for foreigners in other countries.



If foreigners make huge investments in U.S. stocks and bonds, how might this affect the current account? • Consequently imports increase and exports

decline, causing a current account deficit.

International DebtInternational Debt


International debt

• The total amount of outstanding IOUs a nation is obligated to repay other nations and international organizations.


EXHIBIT 7 DEBT SERVICE OF SELECTED COUNTRIES, AS A PERCENTAGE OF EXPORTS: 2010

Source: OECD Stat Extracts, July, 2011.

Exhibit 7: Debt Service of Exhibit 7: Debt Service of Selected Countries, as a Selected Countries, as a

Percentage of Exports: 2010Percentage of Exports: 2010


What causes countries such as Angola to have such high debt service as a percentage of their exports?• The amount of international debt held by these

countries is quite large relative to the value of their exports, making repayment difficult.

chapter 32 exchange rates, balance of payments, and international debt gottheil — principles of...

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