Lecture Economics (19/e) - Chapter 38: The balance of payments, exchange rates, and trade deficits

After completing this chapter, students will be able to: Explain how currencies of different nations are exchanged when international transactions take place, analyze the balance sheet the United States uses to account for the international payments it makes and receives,...

The Balance of Payments, Exchange 

Rates, and Trade Deficits

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• International trade

• Buy/sell current goods or services

• Imports and exports

• International asset transactions

• Buy/sell real or financial assets

• Buy stock

• Sell your house to a foreigner

• Requires currency exchange

• Sum of international financial

transactions

• Current account

• Balance on goods and services

• Net investment income

• Net transfers

• Balance on current account

• Capital and financial account

• Capital account

• Financial account

• Balance of payments accounts sum

to zero

• Current account deficits generate

asset transfers to foreigners

• Official reserves

Balance of Payments

• Foreign currencies, certain reserves with the IMF, and stocks of gold

• Owned by government or central

bank

• Used as balancing mechanism in

balance of payments

• Demand for pounds

• Supply of pounds

• Market equilibrium

• Increase in dollar price of pounds

• Dollar depreciates

• Pound appreciates

• Decrease in dollar price of pounds

• Dollar appreciates

• Pound depreciates

0

Quantity of Pounds

P

Flexible Exchange Rates

The Market for Foreign Currency

(Pounds)

D 1

S 1

Dollar Appreciates (Pound

Depreciates)

Dollar Depreciates (Pound

Appreciates)

Exchange Rate: $2 = £1

$2

$3

$1

• Determinants of exchange rates

• Factors that shift demand/supply

• Changes in tastes

• Relative income changes

• Relative price-level changes

• Purchasing-power-parity theory

• Relative interest rates

• Relative expected returns on assets

• Speculation

0

Quantity of Pounds

P

Flexible Exchange Rates

The Market for Foreign Currency

(Pounds)

D 1

S 1

Exchange Rate:

$2 = £1

$2

$3

$1

D 2

Exchange Rate:

$3 = £1

Balance

Of Payments Deficit

b c

• Eliminate balance of payments

deficit or surplus

• Disadvantages of flexible exchange rates

• Volatility

• Uncertainty and diminished trade

• Terms-of-trade changes

• Instability

• Government intervention

• Use of reserves

• Trade policies

• Exchange controls and rationing

• Distorted trade

• Favoritism

• Restricted choice

• Black markets

• Macroeconomic adjustments

• Gold standard: 1879-1934

• Fixed exchange rate system

• Bretton Woods: 1944-1971

• Fixed exchange rate system indirectly tied to gold

• Managed float: 1971-present

• Dependence on foreign exchange

markets

• Occasional intervention

• In support of managed float

• Concerns with managed float

• Large and persistent

• Causes of trade deficits

• High U.S growth (relatively)

• China

• Price of oil

• Low U.S saving rate

• Implications of trade deficits

• Increased current consumption

• Increased indebtedness