Chapter 21 - The balance of payments, exchange rates, and trade deficits. After reading this chapter, you should 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, discuss how exchange rates are determined in currency markets,. | The Balance of Payments, Exchange Rates, and Trade Deficits McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. International Transactions 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 LO1 Balance of Payments Sum of international financial transactions Current account Balance on goods and services Net investment income Net transfers Balance on current account LO2 Balance of Payments 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 LO2 Balance of Payments LO2 Official Reserves 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 LO2 Flexible Exchange Rates 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 LO3 Q 0 Dollar Price of 1 Pound Quantity of Pounds P Flexible Exchange Rates The Market for Foreign Currency (Pounds) D1 S1 Dollar Appreciates (Pound Depreciates) Dollar Depreciates (Pound Appreciates) Exchange Rate: $2 = £1 $2 $3 $1 Q1 LO3 Flexible Exchange Rates 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 LO3 Q 0 Dollar Price of 1 Pound Quantity of Pounds P Flexible Exchange Rates The Market for Foreign Currency (Pounds) D1 S1 Exchange Rate: $2 = £1 $2 $3 $1 Q1 D2 Exchange Rate: $3 = £1 Balance Of Payments Deficit Q2 x a b c LO3 Flexible Exchange Rates Eliminate balance of payments deficit or surplus Disadvantages of flexible exchange rates Volatility Uncertainty and diminished trade Terms-of-trade changes Instability LO4 Fixed Exchange Rates Government intervention Use of reserves Trade policies Exchange controls and rationing Distorted trade Favoritism Restricted choice Black markets Macroeconomic adjustments LO4 The Managed Float Gold standard: 1879-1934 Fixed exchange rate system Bretton Woods: 1944-1971 Fixed exchange rate system indirectly tied to gold Managed float: 1971-present LO4 The Managed Float Dependence on foreign exchange markets Occasional intervention In support of managed float Concerns with managed float LO4 . Trade Deficit Large and persistent Causes of trade deficits High . growth (relatively) China Price of oil Low . saving rate Implications of trade deficits Increased current consumption Increased indebtedness LO5
