copyright © 2008 pearson addison-wesley. all rights reserved. chapter 35 exchange rates and the...

Copyright © 2008 Pearson Addison-Wesley. All rights reserved.

Chapter 35

Exchange Rates and the Balance of Payments

35-2Copyright © 2008 Pearson Addison-Wesley. All rights reserved.

In this chapter you will learn to

1. Describe the components of the U.S. balance of payments and explain why the balance of payments must always balance.

3. Describe the various factors that cause fluctuations in the exchange rate.

2. Describe the demand for and supply of foreign currency.

4. Explain why a current account deficit is not necessarily undesirable.

5. Describe the theory of purchasing power parity (PPP) and its limitations.

6. Explain how flexible exchange rates can dampen the effects of external shocks.


The Balance of Payments

The Current Account

• Records payments and receipts arising from international trade in goods and services

- trade account

- capital-service account

Debit item = payment of money from the U.S. Credit item = receipt of money for the U.S.


The Capital Account

• Records payments and receipts arising from trade in long-term and short-term assets

- foreign direct investment

- portfolio investment

- includes purchases of foreign currency by the government or central bank

Debit item = purchase of assets by the U.S. Credit item = sale of assets by the U.S.


Table 35.1 U.S. Balance of Payments, 2006 (billions of dollars)


The Balance of Payments Must Balance

Let CA be the current account balance, and KA be the capital account balance:

Balance of Payments = CA + KA = 0

Consider a CA surplus: exports exceed imports

the “extra” earnings must be used to acquire foreign assets

KA deficit (capital outflow)


Consider a CA deficit: imports exceed exports

the “extra” purchases can only be financed if we sell assets to foreigners

KA surplus (capital inflow)

The Balance of Payments Must Balance


The term balance of payments deficit (or surplus) makes no sense if taken literally.

Yet the terms are often used. So what do they mean?

A deficit usually refers to a situation where the government (or central bank) is selling foreign-exchange reserves.

But in this case (as always) the balance of payments is balanced.

A Balance of Payments Deficit?


Summary

1. The current account shows all transactions in goods and services between the U.S. and the rest of the world.

2. The capital account shows all transactions in assets between the U.S. and the rest of the world.

3. All transactions involving a payment from the U.S. appear as a debit item. All transactions involving a receipt to the U.S. appear as a credit item.

4. The balance of payments-the sum of the current account and the capital account must, by definition, always be zero.


APPLYING ECONOMIC CONCEPTS 35.1

A Student’s Balance of Payments with the Rest of the World

Balance of Payments


The Foreign-Exchange Market

Trade between countries normally requires the exchange of one currency for another.

The exchange rate is the number of units of domestic currency required to purchase one unit of foreign currency.

For example, the current Canadian-US exchange rate is approximately 1.32 — it takes $1.32 Canadian to purchase one U.S. dollar.


A depreciation of the domestic currency is a rise in the exchange rate:

- it takes more units of domestic currency to purchase one unit of foreign currency

An appreciation of the domestic currency is a fall in the exchange rate:

- it takes fewer units of domestic currency to purchase one unit of foreign currency



A demand for foreign currency implies a supply of U.S. dollars to the FX market.

Conversely, a supply of foreign currency implies a demand for U.S. dollars in the FX market.

In the model that follows, we think about the U.S.-dollar price of the euro as the exchange rate.



Figure 35.1 The Foreign-Exchange Market


The Demand for Foreign Exchange

A depreciation of the U.S. dollar reduces the quantity of foreign currency demanded. Why?

Foreign goods, services and assets become more expensive to Americans when the U.S. dollar depreciates:

Americans reduce their foreign purchases and thus reduce their demand for foreign currency


The Demand Curve for Foreign Exchange

The demand curve for foreign exchange is negatively sloped when it is plotted against the exchange rate:

- an appreciation of the U.S. dollar increases the quantity of foreign exchange demanded

- a depreciation of the U.S. dollar decreases the quantity of foreign exchange demanded


The Determination of Exchange Rates

Perfectly flexible exchange rates are determined solely by market forces, without interventions by central banks.

A central bank may attempt to fix or peg the exchange rate at a particular value:

- it must intervene to buy or sell foreign currency

Managed floats and adjustable pegs are intermediate cases.


Figure 35.2 Fixed and Flexible Exchange Rates

In the absence of intervention by the central bank, the exchange rate adjusts to clear the foreign-exchange market.


Fixed Exchange Rates

Central banks must intervene in the foreign-exchange market if they wish to fix the exchange rate:

- if excess demand for FX, then the central bank must sell from its reserves

- if excess supply of FX, then the central bank must accumulate more reserves


China’s Pegged Exchange Rate


Figure 35.3 Changes in Exchange Rates


Two specific changes to consider in foreign exchange:

1. Changes in Import or Domestic Prices

- If the price level in one country is rising relative to the price level in another country, the equilibrium value of its currency will be falling relative to that of the other country.

2. Capital Movements

- A movement of financial capital appreciates the currency of the capital-importing country and depreciates the currency of the capital-exporting country.

Changes in Exchange Rates


Structural Changes

Structural changes in the economy can affect the exchange rate.

For example, the discovery of exportable oil or natural gas will increase exports and appreciate the domestic currency.

Anything that changes the patterns of trade will generally also change exchange rates.


The Volatility of Exchange Rates

Exchange rates are one of the most volatile of all macroeconomic variables, in large part because of heavy speculation and reaction to news.

Is this a sign of efficient markets, or inefficient ones?


Three Policy Issues

1. Are current account deficits “bad” and surpluses “good”?

2. Is there a “correct” value for the U.S. dollar?

3. Should countries fix their exchange rates?


News and the Exchange Rate


Consider a country with a current account deficit:

- it is either borrowing from the rest of the world

- or it is selling other assets to foreigners

This is not necessarily undesirable.

Current Account Deficits and Surpluses

LESSONS FROM HISTORY 35.1

Mercantilism, Then and Now


Figure 35.4 U.S. Current Account Balance, 1960–2005


To see this, recall from Chapter 20 that GDP is equal to :

GDP = Ca + Ia + Ga + NXa

where the subscript “a” denotes actual (rather than desired) expenditure.

Causes of a Current Account Deficit


GNP is equal to GDP plus R, the net investment income received from abroad:

GNP = GDP + R

= Ca + Ia + Ga + NXa + R

The current account balance (CA) is simply NXa + R.

We therefore get:

GNP = Ca + Ia + Ga + CAa



Now consider that we have a given amount of GNP that can be consumed, saved, or paid in taxes:

GNP = Ca + Sa + Ta

By equating the last two equations and omitting the subscripts for simplicity, we get:

C + I + G + CA = C + S + T

CA = S + (T - G) - I



This equation says that the current account in any year is exactly equal to the excess of national saving over domestic investment.

CA = (S – I) + (T – G)

which says that the CA is equal to the government budget surplus plus the excess of private saving over investment.

We can rearrange the equation slightly to get:



Consider a few possible causes:

- an increase investment

- a decrease in domestic saving

- an increase in the government’s budget deficit

Whether the rise in the current account deficit is desirable depends on its underlying cause.

Is It Undesirable to Have a Current Account Deficit?


Is There a “Correct” Value for the U.S. Dollar?

With a flexible exchange rate, market forces determine the value of the exchange rate.

The free-market equilibrium exchange rate is the “correct” exchange rate:

- in the sense that it accurately represents the market value of the dollar

- this in turn reflects its scarcity on FX markets


Purchasing Power Parity (PPP):

- a theory that the exchange rate is equal to relative price levels

If PU and PJ are the price levels of the U.S. and Japan, and e is the U.S.-dollar price of yen, then the theory of PPP predicts that:

PU = e PJ

But some economists argue that the U.S. dollar is sometimes “overvalued” and sometimes “undervalued.”

What do they mean?

Purchasing Power Parity


Does This Theory Work Empirically?

The PPP exchange rate is the value of e that makes the previous equation hold:

ePPP PU / PJ

If the PPP theory is supported by the data, we should observe that the actual e and ePPP move closely together.


Figure 35.5 Actual and PPP Exchange Rates, 1980-2006


Why Doesn’t PPP Appear to Hold?

1. Nontraded Goods

PPP will not generally hold when applied to large baskets of goods (like the CPI or GDP deflator)

2. Different Baskets and Relative Price Changes

PPP will not hold if countries’ baskets of goods differ and there are changes in relative prices


But if PPP does not hold, it is difficult to justify the idea that a particular currency is “overvalued” or “undervalued”:

- the “right” value is the value produced by the free, competitive FX market

None of this suggests that today’s “right” value will be unchanged tomorrow:

- due to shocks of various kinds, the “right” value for the exchange rate will be constantly adjusting

Why Doesn’t PPP Appear to Hold?


Flexible versus Fixed Exchange Rate

What are the benefits of having a fixed exchange rate?

What are the benefits of having a flexible exchange rate?

Benefits of Fixed Exchange Rates

- exchange-rate risk is eliminated

more international trade?

more economic “gains from trade”?


Benefits of Flexible Exchange Rates

- the exchange rate can act as a “shock absorber”

dampening the effects on output and employment

Example: Consider a reduction in the world’s demand for U.S. exports — say computer chips.

Surprisingly, it is difficult to find much evidence of this effect in the data.



Figure 35.6 Flexible Exchange Rates as a Shock Absorber


With either exchange-rate regime, there will be a negative AD shock, and thus a short-run decline in real GDP.

But with flexible exchange rates, the depreciation of the dollar will dampen the effect of the shock (net exports will fall by less), thus reducing the shift of the AD curve.

This is the sense in which flexible exchange rates act like “shock absorbers.”



EXTENSIONS IN THEORY 35.1

Optimal Currency Areas

Summing Up

Advocates of a fixed exchange rate emphasize the uncertainty faced by U.S. exporters and importers.

Advocates of a flexible exchange rate emphasize the shock-absorption benefits.

copyright © 2008 pearson addison-wesley. all rights reserved. chapter 35 exchange rates and the...

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