Unit-5 Macro Review

Foreign Exchange & Balance of Payments

Determinants of Exchange RatesDeterminants of Exchange Rates

1. Changes in Consumer Tastes2. Relative Income Changes3. Relative Inflation4. Relative Real Interest Rates5. Speculation & Investment

U.S. Income Rises

Demand Imports

DemandForeign Currency

Market forForeign Exchange

Dollar Depreciates

Foreign Currency Appreciates

Where people go to “swap” currencies

Euro Priceof a dollar

Qty of Dollars

D1

S1

----------------------------

.75 Euro

Q1

Graphing Exchange Rates

If U.S. Price Level Falls =>

D2

U.S. goods look “cheap” => Europeans ↑U.S. exports => Demand for dollars ↑ => Dollar appreciates

Dollar Priceof a Euro

Qty of Euros

D1

S1

----------------------------

1.3 $

Q1

S2

Dollars Euros

Market forForeign Exchange

Balance of PaymentsBalance of Payments• Current Account

– Considered U.S. Trade Balance– Exports – Imports (NX) & Investment Income (bond interest, stock dividends)

• Financial Account – Foreign purchase of US assets – U.S. purchase of foreign assets

– Assets = Stocks, bonds, factories, land, etc…

– Example: Financial Act. Surplus = Money flows into US

If one account is positive the otherMust be negative.

They generally sum to ZERO!

USA has a current account deficit with China &

Financial Account Surplus

Example:

China & Balance of Payments

Imports > Exports

Current Account Deficit

China buys U.S. Bonds

Financial Account Surplus

Official ReservesFed holds quantities of foreign currency called reservesUsed to offset discrepancy in current account vs. financial account

If both accounts doNot sum to zero,

reserves are used toOffset minor

difference

Practice Test