econ214 macroeconomics chapter 19

Prepared By Brock Williams

Chapter 19

The World of International

Finance

When Mario Draghi took over as President of the European Central Bank in 2011, he inherited one of

the most difficult financial positions the world had to offer.

Copyright ©2014 Pearson Education, Inc. All rights reserved. 19-2

Learning Objectives

1. Discuss how the price of foreign exchange is determined by demand and supply.

2. Distinguish between the nominal exchange rate and the real exchange rate.

3. Explain how the the current account, financial account, and capital account are all related to one another.

4. List the benefits and costs of a system of fixed exchange rates compared to a system of flexible exchange rates.

5. Discuss how international financial crisis can emerge.


What Are Exchange Rates?• exchange rate

The price at which currencies trade for one another in the market.

• euroThe common currency in Europe.

• An increase in the value of a currency relative to the currency of another nation is called an appreciation of a currency.

• A decrease in the value of a currency relative to the currency of another nation is called a depreciation of a currency.

19.1 HOW EXCHANGE RATES ARE DETERMINED


How Demand and Supply Determine Exchange Rates

FIGURE 19.1The Demand for and Supply of U.S. Dollars

Market equilibrium occurs where the demand for U.S. dollars equals the supply.

19.1 HOW EXCHANGE RATES ARE DETERMINED (cont.)


Changes in Demand or Supply

FIGURE 19.2Shifts in the Demand for U.S. Dollars

An increase in the demand for dollars will increase (appreciate) the dollar’s exchange rate.

Higher U.S. interest rates or lower U.S. prices will increase the demand for dollars.



Changes in Demand or Supply

FIGURE 19.3Shifts in the Supply of U.S. Dollars

An increase in the supply of dollars will decrease (depreciate) the dollar exchange rate.

Higher European interest rates or lower European prices will increase the supply of dollars.



Let’s summarize the key facts about the foreign exchange market, using euros as our example:

1 The demand curve for dollars represents the demand for dollars in exchange for euros. The curve slopes downward. As the dollar depreciates, there will be an increase in the quantity of dollars demanded in exchange for euros.

2 The supply curve for dollars is the supply of dollars in exchange for euros. The curve slopes upward. As the dollar appreciates, there will be an increase in the quantity of dollars supplied in exchange for euros.

3 Increases in U.S. interest rates and decreases in U.S. prices will increase the demand for dollars, leading to an appreciation of the dollar.

4 Increases in European interest rates and decreases in European prices will increase the supply of dollars in exchange for euros, leading to a depreciation of the dollar.

19.1 HOW EXCHANGE RATES ARE DETERMINED (cont.)Changes in Demand or Supply


• real exchange rateThe price of U.S. goods and services relative to foreign goods and services, expressed in a common currency.

R E A L - N O M I N A L P R I N C I P L E

What matters to people is the real value of money or income—its purchasing

power—not the face value of money or income.

19.2 REAL EXCHANGE RATES AND PURCHASING POWER PARITY


FIGURE 19.4Real Exchange Rate and Net Exports as Percent of GDP, 1980–2011

The figure shows the real exchange rate for the United States compared to its net exports as a share of GDP.

Notice that, in general, when the real (multilateral) exchange rate increased, U.S. net exports fell.

SOURCE: U.S. Department of Commerce and the Federal Reserve.

19.2 REAL EXCHANGE RATES AND PURCHASING POWER PARITY (cont.)


• law of one priceThe theory that goods easily tradable across countries should sell at the same price expressed in a common currency.

• purchasing power parityA theory of exchange rates whereby aunit of any given currency should beable to buy the same quantity ofgoods in all countries.

19.2 REAL EXCHANGE RATES AND PURCHASING POWER PARITY (cont.)


THE CHINESE YUAN AND BIG MACSAPPLYING THE CONCEPTS #1: How can the price of a Big Mac in China

shed light on the U.S.-Chinese currency tensions?

• The U.S. and China are at odds about the appropriate exchange rate between the yuan and the dollar.

• Economist magazine checks the price of Big Macs around the world and determines the appropriate exchange rate based on the differences in prices.

• A Big Mac in China is $1.83, but should be $3.49

A P P L I C A T I O N 1


• balance of paymentsA system of accounts that measurestransactions of goods, services, income, and financial assets between domestic households, businesses, and governments and residents of the rest of the world during a specific time period.

• current accountThe sum of net exports (exportsminus imports) plus net income receivedfrom abroad plus net transfers fromabroad.

19.3 THE CURRENT ACCOUNT, THE FINANCIAL ACCOUNT, AND THE CAPITAL ACCOUNT


• financial accountThe value of a country’s net sales(sales minus purchases) of assets.

• capital accountThe value of capital transfer andtransaction in nonproduced,nonfinancial assets in theinternational accounts.

19.3 THE CURRENT ACCOUNT, THE FINANCIAL ACCOUNT, AND THE CAPITAL ACCOUNT (cont.)


Rules for Calculating the Current, Financial, and Capital Accounts

• Here is a simple rule for understanding transactions on the current, financial, and capital accounts: Any action that gives rise to a demand for foreign currency is a deficit item. Any action that gives rise to a supply of foreign currency is a surplus item.

• The current, financial, and capital accounts of a country are linked by a very important relationship:

current account + financial account + capital account = 0



Rules for Calculating the Current, Financial, and Capital Accounts



• net international investment positionDomestic holding of foreign assetsminus foreign holdings of domestic assets.

• sovereign investment fundAssets accumulated by foreign governments that are invested abroad.

19.3 THE CURRENT ACCOUNT, THE FINANCIAL ACCOUNT, AND THE CAPITAL ACCOUNT (cont.)Rules for Calculating the Current, Financial, and Capital Accounts


WORLD SAVINGS AND U.S. CURRENT ACCOUNT DEFICITS

APPLYING THE CONCEPTS #2: What factors may allow the United States to continue running large trade deficits with

the rest of the world?

• The 2006 Economic Report of the President directly addressed whether the United States can continue to run large current account deficits and, of course, financial account surpluses. In the report, the government recognized that the current account deficits would eventually be reduced. However, it also highlighted a number of factors suggesting the deficits could continue for a long period of time.

• For the United States to continue to run a current account deficit, other countries in the world need to continue to purchase U.S. assets.

• In recent years, four major countries experienced circumstances that encouraged them to save by purchasing assets from abroad: Japan, Germany, Russia, and China.

• For the United States to continue to run trade deficits in the future, these or other countries must want to continue to save more than they want to invest domestically.



To set the stage for understanding exchange rate systems, let’s recall what happens when a country’s exchange rate appreciates—increases in value. There are two distinct effects:

1 The increased value of the exchange rate makes importsless expensive for the residents of the country where theexchange rate appreciated.

2 The increased value of the exchange rate makes U.S. goods more expensive on world markets.

19.4 FIXED AND FLEXIBLE EXCHANGE RATES


Fixing the Exchange Rate• foreign exchange market intervention

The purchase or sale of currencies by governmentto influence the market exchange rate.

FIGURE 19.5Government Intervention toRaise the Price of the Dollar

To increase the price of dollars, the U.S. government sells Euros in exchange for dollars.

This shifts the demand curve for dollars to the right.

19.4 FIXED AND FLEXIBLE EXCHANGE RATES (cont.)


Fixed versus Flexible Exchange Rates

• flexible exchange rate systemA currency system in which exchangerates are determined by free markets.

FLEXIBLE EXCHANGE RATE SYSTEM

• fixed exchange rate systemA system in which governments pegexchange rates to prevent theircurrencies from fluctuating.

FIXED EXCHANGE RATES



• balance of payments deficitUnder a fixed exchange rate system, a situation inwhich the supply of a country’s currency exceeds thedemand for the currency at the current exchange rate.

BALANCE OF PAYMENTS DEFICITS AND SURPLUSES

• balance of payments surplusUnder a fixed exchange rate system, a situation inwhich the demand of a country’s currency exceeds the supply for the currency at the current exchange rate.

• devaluationA decrease in the exchange rate to which a currency ispegged under a fixed exchange rate system.

• revaluationAn increase in the exchange rate to which a currency is pegged under a fixed exchange rate system.

19.4 FIXED AND FLEXIBLE EXCHANGE RATES (cont.)Fixed versus Flexible Exchange Rates


The U.S. Experience with Fixed and Flexible Exchange Rates

Exchange Rate Systems Today

Fixed exchange rate systems provide benefits, but they require countries to maintain similar economic policies—especially to maintain similar inflation rates and interest rates.

Higher prices in the United States cause the U.S. real exchange rate to rise. This increase in the real exchange rate over time causes a trade deficit to emerge.

The flexible exchange rate system has worked well enough since the breakdown of Bretton Woods.

Some economists believe that the world will eventually settle into three large currency blocs: the euro, the dollar, and the yen.



A TROUBLED EURO

APPLYING THE CONCEPTS #3: What are the fundamental causes for the problems with the Euro?

• When the euro was launched in 1999, the vision of its founders was to use the monetary union to further unify Europe economically and politically. They envisioned a large economic market, comparable to the United States. They believed that by moving to a single currency with agreements on a number of fiscal rules that they could achieve economic stability and growth.

• Unfortunately, this vision proved to be naïve. Under the umbrella of the euro, financial investors throughout the world poured funds into Spain and Ireland fueling an unsustainable housing boom and also lending excessive amounts to the governments of Greece, Italy, and Portugal that faced severe budget challenges.

• When the housing boom collapsed and the worldwide recession of 2007 increased budgetary pressures, it became clear that the banks and governments of these countries could not easily pay their debts. Moreover, with a single currency for the euro area, countries could not make adjustments through depreciation of their currency. The options facing Europe were bleak: either large-scale financial transfers from Germany and other successful countries, or sharp cutbacks in budgets and prolonged unemployment to reduce wage levels.

• What became apparent was that the United States did not just have a single currency; it also had a unified fiscal system that provided transfers to states and regions in economic distress. Monetary union without a corresponding fiscal system cannot be easily sustained.



• Hardly a year goes by without some international financial crisis.

• Even when a country takes strong, institutional steps to peg its currency, a collapse is still possible.

19.5 MANAGING FINANCIAL CRISES


THE ARGENTINE FINANCIAL CRISIS

APPLYING THE CONCEPTS #4: What are the causes offinancial collapses that occur throughout the globe?

During the late 1980s, Argentina suffered from hyperinflation. As part of its financial reforms, it pegged its currency to the U.S. dollar, making pesos “convertible” into dollars. To issue pesos, the central bank had to have an equal amount of dollars, or its equivalent in other hard currencies, on hand. Some economists believed this reform would bring stability to the financial system. Unfortunately, they were proved wrong.

Several problems developed:

• As the dollar appreciated, Argentina began to suffer from a large trade deficit.

• Wage increases also pushed up the real exchange rate.

• Argentina had to borrow extensively in dollar-denominated loans.

Eventually, Argentina was forced to default on its international debt in 2002 and freeze bank accounts. The hopes of the reforms in the early 1990s had become a bitter memory.



balance of payments

balance of payments deficit

balance of payments surplus

capital account

current account

devaluation

euro

exchange rate

financial account

fixed exchange rate system

flexible exchange rate system

foreign exchange market intervention

law of one price

net international investment position

purchasing power parity

real exchange rate

revaluation

sovereign investment funds

K E Y T E R M S