Chapter 17

Financing World Trade

Slide 34-2

Introduction

The price of one currency in terms of another is set by the interaction of supply and demand in

international financial markets.

Among the participants in these markets are governments seeking to change or maintain

exchange rates.

Slide 34-3

Did You Know That...

Exchange rates between currencies are a factor in determining the location of vehicle production?

The recent decline in the value of the dollar against the yen and the euro led foreign automakers to locate more vehicle assembly in the U.S.?

Slide 34-4

Balance of Trade– The value of goods and services bought and sold

in the world market

– The difference between exports and imports of goods

Balance of Payments– A summary record of a country’s economic

transactions with foreign residents and governments over a year

The Balance of Payments and International Capital Movements

Slide 34-5

Surplus (+) and Deficit (-) Items on the International Accounts

Surplus Items (+) Deficit Items (-)

Exports of merchandise Imports of merchandise

Private and government gifts from Private and governmental gifts to foreigners foreigners

Foreign use of domestically owned Use of foreign-owned transportation transportation

Foreign tourists’ expenditures in this country Tourism expenditures abroad

Foreign military spending in this country Military spending abroad

Interest and dividend receipts from foreigners Interest and dividends paid to foreigners

Sales of domestic assets to foreigners Purchases of foreign assets

Funds deposited in this country by foreigners Funds placed in foreign depository institutions

Sales of gold to foreigners Purchases of gold from foreigners

Sales of domestic currency to foreigners Purchases of foreign currency

Table 34-1

Slide 34-6

Accounting Identities

– Statements that certain numerical measurements are equivalent by accepted definition

The Balance of Payments and International Capital Movements

Slide 34-7

The Balance of Payments and International Capital Movements

When family expenditures exceed income, the family must do one of the following:

– Reduce its money holdings, or sell stocks, bonds, or other assets

– Borrow

– Receive gifts from friends or relatives

– Receive a public transfer from a government

Cannot continue indefinitely

Slide 34-8

Three categories of balance of payments transactions

– Current account transactions

– Capital account transactions

– Official reserve account transactions

The Balance of Payments and International Capital Movements

Slide 34-9

Current account transactions

– Merchandise trade transactions• Importing and exporting of merchandise• Balance = merchandise exports - merchandise

imports

The Balance of Payments and International Capital Movements

Slide 34-10

Current account transactions

– Service exports and imports• Invisible or intangible items

– Shipping– Insurance– Tourism– Banking– Income from investments

The Balance of Payments and International Capital Movements

Slide 34-11

Current account transactions

– Unilateral transfers• Gifts by citizens • Gifts by governments

The Balance of Payments and International Capital Movements

Slide 34-12

Balancing the current account

– Net exports plus unilateral transfers plus net investment income exceeds zero• Current account surplus

– Net exports plus unilateral transfers plus net investment income is negative• Current account deficit

The Balance of Payments and International Capital Movements

Slide 34-13

The Balance of Payments and International Capital Movements

A current account surplus means the import of money or money equivalent which means a capital account deficit

A current account deficit must be paid by the export of money or money equivalent which means a capital account surplus

Slide 34-14

Capital account transactions

– Deals with the buying and selling of real and financial assets

The Balance of Payments and International Capital Movements

Slide 34-15

Official reserve account transactions

– Foreign currencies

– Gold

– Special Drawing Rights (SDRs)• Reserve assets created by the International

Monetary Fund that countries can use to settle international payments

The Balance of Payments and International Capital Movements

Slide 34-16

Official reserve account transactions

– The reserve position in the International Monetary Fund

– Financial assets held by an official agency such as the U.S. Treasury Department

The Balance of Payments and International Capital Movements

Slide 34-17

The Balance of Payments and International Capital Movements

What affects the balance of payments?

– Relative rate of inflation

– Political stability

Slide 34-18

The Balance of Payments and International Capital Movements

What affects the balance of payments?

– Inflation among trading partners

– Political stability

Slide 34-19

Determining ForeignExchange Rates

Foreign Exchange Market

– The market for buying and selling foreign currencies

Exchange Rates

– The price of one currency in terms of another

Slide 34-20

Determining ForeignExchange Rates

Demand for and supply of foreign currency

– U.S. transactions involving imports constitute a supply of dollars and demand for some foreign currency

– The opposite is true for export transactions

Slide 34-21

Determining ForeignExchange Rates

The equilibrium foreign exchange rate

– Appreciation• An increase in the value of a currency in terms

of other currencies

– Depreciation• A decrease in the value of a currency in terms

of other currencies

Slide 34-22

International Example: South Africa’s Currency Appreciation

Gold and platinum are key South African exports.

The increased demand for these commodities has also increased the demand for South African rand.

As interest rates in South Africa became relatively higher, the demand for South African financial assets also increased.

Slide 34-23

International Example: South Africa’s Currency Appreciation

The result of these changes has been an appreciation of the rand.

The dollar price of the rand has doubled since the end of 2001.

Slide 34-24

Determining ForeignExchange Rates

Market determinants of exchange rates

– Changes in real interest rates

– Changes in productivity

– Changes in product preferences

– Perceptions of economic stability

Slide 34-25

The Gold Standard and the International Monetary Fund

Gold Standard

– An international monetary system in which nations fix their exchange rates in terms of gold

– All currencies are fixed in terms of all others, and any balance of payments deficits or surpluses can be made up by shipments of gold

Slide 34-26

The Gold Standard and the International Monetary Fund

Gold standard

– A balance of payments deficit• More gold flowed out than flowed in• Equivalent to an restrictive monetary policy

– A balance of payments surplus• More gold flowed in than out• Equivalent to an expansionary monetary policy

Slide 34-27

The Gold Standard and the International Monetary Fund

Problems with the gold standard

– A nation gives up control of its monetary policy

– New gold discoveries often caused inflation

Slide 34-28

The Gold Standard and the International Monetary Fund

Bretton Woods and the International Monetary Fund

– 1944—representatives of capitalist countries met in Bretton Woods, New Hampshire• Created a new international payment system

to replace the gold standard

Slide 34-29

The Gold Standard and the International Monetary Fund

End of the old IMF

– On August 15, 1971, President Richard Nixon suspended the convertibility of the dollar into gold.

– On December 18, 1971, the United States devalued the dollar relative to the currencies of 14 major industrial nations.

Slide 34-30

Current Foreign Exchange Rate Arrangements

Figure 34-7

Slide 34-31

Fixed versus Floating Exchange Rates

To maintain a fixed exchange rate, the central bank of a country can buy and sell currencies.

It must use its own foreign exchange reserves to engage in these financial market transactions.

Slide 34-32

A Fixed Exchange Rate

Figure 34-8

The Bank of Malaysia buysringgit with dollars shifting the demand for ringgit to the right

• The supply of ringgit shifts to the right as Thai residents demand more U.S. goods

• The value of the ringgit will fall

Slide 34-33

International Example:Central Banks’ Currencies of Choice

A central bank allocates foreign exchange reserves based on its perception of which currencies will be needed most frequently to alter the demand for its own currency.

The U.S. dollar is the currency most commonly held in foreign exchange reserves; but the euro, the Japanese yen, and the British pound also comprise a measurable portion of these accounts.

Slide 34-34

Fixed Exchange Rates

Pros and cons of fixed exchange rates

– Pros• Limiting foreign exchange risk

– The possibility that changes in the value of a nation’s currency will result in variations in market value of assets

Slide 34-35

Fixed Exchange Rates

Pros and cons of fixed exchange rates

– Cons• A country’s residents can avoid foreign

exchange risk by hedging– A financial strategy that reduces the chance

of suffering losses arising from foreign exchange risk

Slide 34-36

The Dirty Float and Managed Exchange Rates

Dirty Float

– A system between flexible and fixed exchange rates in which central banks occasionally enter foreign exchange markets to influence rates

Slide 34-37

Managed Exchange Rates

What do you think?

– Is it possible to “manage” foreign exchange rates?

One study concludes that neither the Fed nor the central banks of the other G7 can successfully influence exchange rates in the long run.

Slide 34-38

Issues and Applications: Japan’s Finance Ministry Learns a New Currency Trick

As the value of the dollar has declined against the Japanese yen in recent years, American consumers must pay more for Japanese-made goods.

In response, the Japanese government began buying dollars on the foreign exchange market.

Of late, the government has been using private banks to implement the foreign exchange transactions needed to arrest the yen appreciation.

Copyright © 2005 Pearson Addison-Wesley. All rights

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Key Terms and Concepts

appreciation

balance of payments

balance of trade

capital account transactions

depreciation

derived demand

fixed exchange rate system

floating (flexible) exchange rate system

foreign exchange market

foreign exchange risk

trade deficit

unilateral transfers