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Micro Mc. Eachern ECON 2010 -2011 20 CHAPTER International Designed by Amy Mc. Guire, Micro Mc. Eachern ECON 2010 -2011 20 CHAPTER International Designed by Amy Mc. Guire, B-books, Ltd. Chapter 20 Finance Copyright © 2010 by South-Western, a division of Cengage Learning. All rights reserved 1

Balance of Payments u International economic transactions u u u Flow of transactions – Balance of Payments u International economic transactions u u u Flow of transactions – period of time May not involve cash payments Double-entry bookkeeping u Credits § u Debits § LO 1 Chapter 20 u Inflow of receipts from the rest of the world Outflows of payments to the rest of the world Individual accounts Copyright © 2010 by South-Western, a division of Cengage Learning. All rights reserved 2

Balance of Payments u Merchandise trade balance: Trade in goods u Value of merchandise Balance of Payments u Merchandise trade balance: Trade in goods u Value of merchandise exports minus the value of merchandise imports u Credits: Value of U. S. merchandise exports u Debits: Value of U. S. merchandise imports u Surplus: exports exceed imports u Deficit: imports exceed exports LO 1 Chapter 20 Copyright © 2010 by South-Western, a division of Cengage Learning. All rights reserved 3

Merchandise Trade Balance u Reported monthly u Influences u u The stock market u Merchandise Trade Balance u Reported monthly u Influences u u The stock market u u Foreign exchange markets Financial markets Depends on u Economy’s relative strength u Economy’s competitiveness u Relative value of domestic currency LO 1 Chapter 20 Copyright © 2010 by South-Western, a division of Cengage Learning. All rights reserved 4

LO 1 Exhibit 1 U. S. Imports Have Exceeded Exports Since 1976, and the LO 1 Exhibit 1 U. S. Imports Have Exceeded Exports Since 1976, and the Trade Deficit Has Widened Chapter 20 Copyright © 2009 by South-Western, a division of Cengage Learning. All rights reserved 5

LO 1 Exhibit 2 U. S. Merchandise Trade Deficits in 2008 by Country or LO 1 Exhibit 2 U. S. Merchandise Trade Deficits in 2008 by Country or Grouping U. S. imports more goods from each of the world’s major economies than it exports to them. The largest U. S. trade deficit is with China, which exported five times more to the United States in 2008 than it imported from the United States. Chapter 20 Copyright © 2009 by South-Western, a division of Cengage Learning. All rights reserved 6

Balance of Payments u Balance on goods and services u U. S. service exports Balance of Payments u Balance on goods and services u U. S. service exports § u Credit in U. S. balance of payments U. S. service imports § Debit in U. S. balance of payments u Surplus services: exports exceed imports u Balance on goods and services § Net exports = exports minus imports LO 1 Chapter 20 Copyright © 2010 by South-Western, a division of Cengage Learning. All rights reserved 7

Balance of Payments u Net investment income u U. S. residents § Earn investment Balance of Payments u Net investment income u U. S. residents § Earn investment income § § u Credit in balance of payments Foreigners § Earn investment income § § LO 1 Chapter 20 u On assets owned abroad On assets owned in U. S. Debit in balance of payments Net investment income from abroad Copyright © 2010 by South-Western, a division of Cengage Learning. All rights reserved 8

Balance of Payments u Unilateral transfers u Money sent abroad § § Personal gifts Balance of Payments u Unilateral transfers u Money sent abroad § § Personal gifts sent abroad § Charitable donations § Chapter 20 Money sent to families abroad § LO 1 Foreign aid § u Government transfers to foreign residents Debit in the balance of payments Net unilateral transfers abroad Copyright © 2010 by South-Western, a division of Cengage Learning. All rights reserved 9

Balance of Payments u Balance on current account u u Net exports of goods Balance of Payments u Balance on current account u u Net exports of goods and services u u Net unilateral transfers Net income from assets owned abroad Financial account u International purchases of assets § § u Financial assets Real assets 2006, surplus in the financial account LO 1 Chapter 20 Copyright © 2010 by South-Western, a division of Cengage Learning. All rights reserved 10

Deficits and Surpluses u Credits on balance of payments (+) u u Debits on Deficits and Surpluses u Credits on balance of payments (+) u u Debits on balance of payments (-) u u Transactions requiring payments from foreigners to U. S. residents Transactions requiring payments to foreigners from U. S. residents Statistical discrepancy u “Fudge factor” LO 1 Chapter 20 Copyright © 2010 by South-Western, a division of Cengage Learning. All rights reserved 11

Deficits and Surpluses u Foreign exchange § u Current account deficit u Foreign exchange Deficits and Surpluses u Foreign exchange § u Current account deficit u Foreign exchange paid exceeds foreign exchange received § u Currency of another country Needs net inflow in the financial account Current account surplus u Foreign exchange received exceeds foreign exchange paid § Net outflow in the financial account LO 1 Chapter 20 Copyright © 2010 by South-Western, a division of Cengage Learning. All rights reserved 12

LO 1 Exhibit 3 U. S. Balance of Payments for 2007 (billions of dollars) LO 1 Exhibit 3 U. S. Balance of Payments for 2007 (billions of dollars) Chapter 20 Copyright © 2009 by South-Western, a division of Cengage Learning. All rights reserved 13

Foreign Exchange Rates and Markets u Foreign exchange u Foreign money u To carry Foreign Exchange Rates and Markets u Foreign exchange u Foreign money u To carry out international transactions u Exchange rate u Price (measured in one country’s currency) of buying one unit of another country’s currency u Determined on foreign exchange market LO 2 Chapter 20 Copyright © 2010 by South-Western, a division of Cengage Learning. All rights reserved 14

Foreign Exchange Rates and Markets u Foreign exchange market u Buy and sell foreign Foreign Exchange Rates and Markets u Foreign exchange market u Buy and sell foreign exchange u Exchange rate of euro u Number of dollars – to purchase one euro u Dollar depreciation; weakening u Increase in number of dollars for one euro u Dollar appreciation; strengthening u Decrease in number of dollars for one euro u Determined by demand supply LO 2 Chapter 20 Copyright © 2010 by South-Western, a division of Cengage Learning. All rights reserved 15

Demand for Foreign Exchange u Demand curve u Inverse relationship u Dollar price of Demand for Foreign Exchange u Demand curve u Inverse relationship u Dollar price of euro u Quantity of euros demanded u Assumed constant u Income; preferences (U. S. consumers) u Expected inflation (U. S. and euro area) u Price of goods (euro area) u Interest rates (U. S. and euro area) LO 2 Chapter 20 Copyright © 2010 by South-Western, a division of Cengage Learning. All rights reserved 16

Supply of Foreign Exchange u Supply curve u Positive relationship u Dollar price of Supply of Foreign Exchange u Supply curve u Positive relationship u Dollar price of euro u Quantity of euros supplied u Assumed constant u Income, taxes (euro area) u Expected inflation (euro area and U. S. ) u Interest rates (euro area and U. S. ) LO 2 Chapter 20 Copyright © 2010 by South-Western, a division of Cengage Learning. All rights reserved 17

Exhibit 4 LO 2 Exchange rate (dollars per euro) The Foreign Exchange Market S Exhibit 4 LO 2 Exchange rate (dollars per euro) The Foreign Exchange Market S $1. 30 1. 25 1. 20 D 0 800 The fewer dollars needed to purchase 1 unit of foreign exchange, the lower the price of foreign goods, the greater the quantity of foreign goods demanded, and the greater the quantity of foreign exchange demanded. The D curve slopes downward. Foreign exchange (millions of euros) An increase in in the exchange rate makes US products cheaper foreigners. The increases demand for US goods implies an increase in the quantity of foreign exchange supplied. The S curve slopes upward. Chapter 20 Copyright © 2009 by South-Western, a division of Cengage Learning. All rights reserved 18

Determining the Exchange Rate u Equilibrium exchange rate u Demand intersects the supply u Determining the Exchange Rate u Equilibrium exchange rate u Demand intersects the supply u Floating exchange rate u Adjust freely u Increase in demand foreign exchange u Increase of equilibrium exchange rate u Euro increases in value (appreciates) u Dollar falls value (depreciates) LO 2 Chapter 20 Copyright © 2010 by South-Western, a division of Cengage Learning. All rights reserved 19

LO 2 Exhibit 5 Exchange rate (dollars per euro) Effect on the Foreign Exchange LO 2 Exhibit 5 Exchange rate (dollars per euro) Effect on the Foreign Exchange Market of an Increased Demand for Euros The intersection of the demand curve foreign exchange, D, and the supply curve foreign exchange, S, determines the exchange rate. At an exchange rate of $1. 25 per euro, the quantity demanded of euros equals the quantity supplied. S $1. 27 1. 25 D’ D 0 Chapter 20 800 820 An increase in the demand for euros from D to D’ increases the exchange rate from $1. 25 to $1. 27 per euro. Foreign exchange (millions of euros) Copyright © 2009 by South-Western, a division of Cengage Learning. All rights reserved 20

Arbitrageurs and Speculators u Arbitrageurs u Dealers u Simultaneously: buy low and sell high Arbitrageurs and Speculators u Arbitrageurs u Dealers u Simultaneously: buy low and sell high u Little risk u Ensure equality of exchange rates on different markets u Speculators u Buy low; sell high later u Riskier LO 2 Chapter 20 Copyright © 2010 by South-Western, a division of Cengage Learning. All rights reserved 21

Purchasing Power Parity u Purchasing power parity PPP theory u For unrestricted trade u Purchasing Power Parity u Purchasing power parity PPP theory u For unrestricted trade u Trading goods u Exchange rate between two currencies u Adjust in long run to reflect price differences between the two currency regions u Given basket of goods u Same price around the world LO 2 Chapter 20 Copyright © 2010 by South-Western, a division of Cengage Learning. All rights reserved 22

Purchasing Power Parity u PPP theory u Does not explain exchange rates at a Purchasing Power Parity u PPP theory u Does not explain exchange rates at a particular point in time u Trade barriers u Central bank intervention u Products not traded u Product differentiation LO 2 Chapter 20 Copyright © 2010 by South-Western, a division of Cengage Learning. All rights reserved 23

Case Study LO 2 The Big Mac Index Chapter 20 u Market basket: one Case Study LO 2 The Big Mac Index Chapter 20 u Market basket: one Mc. Donald’s Big Mac u Price in local currency u $ (exchange rate) u Overvalued currencies: Euro: 22% u Undervalued currencies: Yuan: 57% u Differences u Rent u Taxes, trade barriers u Wages Copyright © 2010 by South-Western, a division of Cengage Learning. All rights reserved 24

Case Study LO 2 The Big Mac Index In Late June 2007, a Big Case Study LO 2 The Big Mac Index In Late June 2007, a Big Mac Cost More in the U. S. Than in Most Other Countries Source: Based on a survey in “The Big Mac Index: Sizzling, ” Economist, 7 July 2007. Local prices are converted into U. S. dollars using the prevailing exchange rate. Chapter 20 Copyright © 2010 by South-Western, a division of Cengage Learning. All rights reserved 25

Flexible Exchange Rates u Floating exchange rates u Determined by demand supply u Balance Flexible Exchange Rates u Floating exchange rates u Determined by demand supply u Balance of payment accounts u Current or financial accounts u Debit entries • Increase D foreign exchange Ø $ depreciation u Credit entries • Increase S of foreign exchange Ø $ appreciation LO 3 Chapter 20 Copyright © 2010 by South-Western, a division of Cengage Learning. All rights reserved 26

Fixed Exchange Rates LO 3 Chapter 20 u Pegged exchange rates u Government intervention; Fixed Exchange Rates LO 3 Chapter 20 u Pegged exchange rates u Government intervention; Central Bank u Sell euros, buy dollars – keep euro’s value down u Sell dollars, buy euros – keep euro’s value up u Increase pegged exchange rate: devaluation u Decrease pegged exchange rate: revaluation u Restriction on imports u Policies to slow the economy u Foreign exchange control Copyright © 2010 by South-Western, a division of Cengage Learning. All rights reserved 27

International Monetary System u 1879 -1914: Gold Standard u Currencies convert into gold at International Monetary System u 1879 -1914: Gold Standard u Currencies convert into gold at fixed rate u Collapsed during WWI u 1944: Bretton Woods Agreement u Exchange rates – fixed in terms of dollars u Dollar standard u Fixed rate u Dollars exchanged for gold u International Monetary Fund (IMF) LO 4 Chapter 20 Copyright © 2010 by South-Western, a division of Cengage Learning. All rights reserved 28

International Monetary System u Late 1960 s: U. S. Inflation u Overvalued dollar u International Monetary System u Late 1960 s: U. S. Inflation u Overvalued dollar u 1971 u U. S. merchandise imports exceeded merchandise exports u Gold outflow u Washington meeting: $ devalued 8% u 1972 u U. S. trade deficit: tripled LO 4 Chapter 20 Copyright © 2010 by South-Western, a division of Cengage Learning. All rights reserved 29

International Monetary System u 1973 u $ devalued 10% u Dollars exchanged for German International Monetary System u 1973 u $ devalued 10% u Dollars exchanged for German marks u Bretton Woods system collapsed u Current system u Managed float u Freely floating exchange rate u Sporadic intervention by central banks LO 4 Chapter 20 Copyright © 2010 by South-Western, a division of Cengage Learning. All rights reserved 30

Case Study LO 4 What about China? Chapter 20 u U. S. trade deficit Case Study LO 4 What about China? Chapter 20 u U. S. trade deficit with China: u $233 billion in 2006; 20% annual increase u China: devaluated Yuan; boosted U. S. $ u Chinese products – Cheaper abroad u Stimulate exports u Tax rebates, subsidies u Foreign products – More expensive in China u Discourages imports u Quotas, tariffs u Increased Chinese production; job creation Copyright © 2010 by South-Western, a division of Cengage Learning. All rights reserved 31