Exchange Rates, The Balance of Payments, and Trade Deficits

Chapter 38

Monetary Exchange Video

• http://www.youtube.com/watch?v=xwtgByffoUw&feature=colike

Financing International Trade

• Best Buy wants to buy 1 million Samsung TVs– Japan, who produces the TVs, wants to be paid in

Yen—how does Best Buy pay them?– Best Buy will have to purchase Yen from a foreign

exchange market (these markets are found in larger cities or areas with large tourism populations)

– Once completed they can purchase the TVs using Yen

Financing International Trade

• Current exchange rates are:• British Pound = $1.57• Euro = $1.34• Swiss Franc = $1.09• Australian Dollar = $1.02• Canadian Dollar = $0.98• Chinese Yuan = $0.16• Mexican Peso = $0.07• Japanese Yen = $0.012• Vietnamese Dong = $0.00005 (1 of our dollars = 21K of theirs)

Financing International Trade

• Let’s look at the example again…– Best Buy wants to buy $1,000,000,000 worth of

product from Japan’s Samsung division• How many Yen will it take to make the purchase?• 1,000,000,000 x 0.12 = 120,000,000,000

– It will take ¥120,000,000,000 to equal $1M

– Japan will sell the $1M check they got from Best Buy to an exchange bank in order to get the ¥120M that it is worth• NOTE: The exchange bank does not provide this service for

free—just like the stock market, there is a fee for trading

Financing International Trade

• Business transactions are not the only reason that currencies need to be exchanged– Vacations– Purchasing stocks/investments– Loan payments

Balance of Payments

• A balance of payments is the sum of all transactions that take place between its residents and foreigners– This balance sheet is divided into three categories:• Current Account—U.S. trade in currently produced

goods/services• Capital Account—purchase/sell of assets (stocks,

factories, equipment)• Official Reserves Account—The nation’s stock of foreign

currencies that are held in the Federal Reserve system

2010 Balance of Payments

1. Goods and services exported = $1.837T2. Goods and services imported = $2.337T3. Balance on goods/services = - $ 500B4. Capital accounts transaction = -$152M5. Official Reserves Account– US owned assets in foreign countries are the same as

imports when balancing the books (a hotel in Japan owned by an American)

– Likewise foreign owned assets in the US are considered exports (a Canadian owning a business in the US)

2010 Balance of Payments

• US owned assets abroad = -$1.005T• Foreign owned assets in US = $1.246T– Official Reserves Balance = $241B

1. Balance on goods/services = -$ 500B2. Capital accounts transaction = -$152M3. Official Reserves Balance = $241B4. Basic Balance of Payments = -$499B• All BOPs have to equal $0 so how does this -

$499B turn into $0 (where does the money come from)?

Flexible Exchange Rates

• There are two types of exchange rates:– Flexible (floating): demand and supply of currency

determines the exchange rate (no government involvement)

– Fixed: government sets the exchange rate and makes changes to the economy to insure those rates stay accurate/consistant

Flexible Exchange Rates

Dol

lar p

rice

per £

Quantity of £

$1.57

S £

D £

$4.00

$0.25

Qe

• The exchange rate would be wherever the supply curve intersects the demand curve• Here it would be

$1.57 dollars = 1 £

• When using the Flexible Exchange Rate system the price is subject to change based on the demand or supply of the product

Flexible Exchange Rates

• What could cause the supply or demand of a currency to change?– Change in taste: British

tea declines in popularity in the US• What happens to the

British Pound? U.S. dollar?

• It now takes less U.S. dollar to purchase a British pound

• Dollar appreciates, Pound depreciates

Dol

lar p

rice

per £

Quantity of £

$1.57

S £

D £

$4.00

$0.25

Qe

D £2

Q2

$0.90

Flexible Exchange Rate

• Your turn!• In each of the scenarios draw the corresponding graph:1. Change in relative income: Britain encounters a recession

& reduces imports while the US increases input2. Relative prices: Britain experiences a 3% inflation rate

compared to Canada’s 10% rate3. Change in interest rates: US interest rates go up, the

British do no raise their rates4. Speculation: Currency traders believe the US dollar will

have greater inflation than the British Pound

Pitfalls of Flexible Exchange Rates

• Uncertainty and Diminished Trade– Because you don’t know what is going to happen, you

might be discouraged to engage in trade• Terms-of-Trade Changes– An increase in the dollar price per British pound could

mean that the US has to export more to get the same amount of pounds

• Instability– Wild fluctuations can depress industries and cause a

nightmare for making decisions with fiscal and monetary policy

Fixed Exchange Rates

• In a fixed system two countries agree on a fixed rate between them– Britain and the US agree that the ration will be 2

US dollars = 1 British pound• Problem: What if demand for the pound goes

up?– If demand goes up (meaning the pound should be

more valuable) but the price doesn’t change a SHORTAGE of British pound will occur

Fixed Exchange Rates

• How do you adjust for this scenario?• There are 4 possible solutions:– Use of Reserves—if you need to meet the demand

without changing the price, take some of the money that was in reserve (not in circulation) and put it in circulation

– Trade Policies—If the US is facing a shortage of British pound they can discourage imports from Britain (in other words, put a tariff on British goods to prevent trade)

Fixed Exchange Rates

• Other techniques for controlling shortages:– Exchange controls and rationing—the US

government could require that all pounds being brought into circulation in the US has to go through the Federal Government first. Therefore, they can control how much is allowed in the nation• There are 4 issues that come with this option

Fixed Exchange Rates

• Four objections to exchange controls:– Distorted trade—would disrupt the natural flow of

trade and thus interrupt comparative advantage– Favoritism—in other words, nations who support

certain candidates could get “favored nation” status

– Restricted choice—Freedom of choice would be limited since the government is blocking access to certain goods/countries

– Black markets—duh…

Fixed Exchange Rates

• A final attempt to deal with concerns is:– Domestic macroeconomic adjustments• In other words use monetary and fiscal policy to adjust

the inflation value of your money

And now…a video

• http://www.learner.org/series/econusa/unit28/