Econ214 macroeconomics chapter 19

Prepared By Brock Williams
Chapter 19
The World of
International
Finance
When Mario Draghi took over as
President of the European Central
Bank in 2011, he inherited one of
the most difficult financial positions
the world had to offer.

Copyright ©2014 Pearson Education, Inc. All rights reserved. 19-2
Learning Objectives
1. Discuss how the price of foreign exchange is
determined by demand and supply.
2. Distinguish between the nominal exchange rate
and the real exchange rate.
3. Explain how the the current account, financial
account, and capital account are all related to one
another.
4. List the benefits and costs of a system of fixed
exchange rates compared to a system of flexible
exchange rates.
5. Discuss how international financial crisis can
emerge.

What Are Exchange Rates?
• exchange rate
The price at which currencies
trade for one another in the
market.
• euro
The common currency in
Europe.
• An increase in the value of a currency relative
to the currency of another nation is called an
appreciation of a currency.
• A decrease in the value of a currency relative
to the currency of another nation is called a
depreciation of a currency.
19.1 HOW EXCHANGE RATES ARE
DETERMINED

How Demand and Supply Determine Exchange Rates
 FIGURE 19.1
The Demand for and
Supply of U.S. Dollars
Market equilibrium
occurs where the
demand for U.S.
dollars equals the
supply.
DETERMINED (cont.)

Changes in Demand or Supply
 FIGURE 19.2
Shifts in the Demand for
U.S. Dollars
An increase in the
demand for dollars will
increase (appreciate) the
dollar’s exchange rate.
Higher U.S. interest rates
or lower U.S. prices will
increase the demand for
dollars.
DETERMINED (cont.)

 FIGURE 19.3
Shifts in the Supply of
U.S. Dollars
An increase in the supply
of dollars will decrease
(depreciate) the dollar
exchange rate.
Higher European interest
rates or lower European
prices will increase the
supply of dollars.
DETERMINED (cont.)

Let’s summarize the key facts about the foreign exchange market, using euros
as our example:
1 The demand curve for dollars represents the demand for dollars in
exchange for euros. The curve slopes downward. As the dollar
depreciates, there will be an increase in the quantity of dollars demanded
in exchange for euros.
2 The supply curve for dollars is the supply of dollars in exchange for euros.
The curve slopes upward. As the dollar appreciates, there will be an
increase in the quantity of dollars supplied in exchange for euros.
3 Increases in U.S. interest rates and decreases in U.S. prices will increase
the demand for dollars, leading to an appreciation of the dollar.
4 Increases in European interest rates and decreases in European prices
will increase the supply of dollars in exchange for euros, leading to a
depreciation of the dollar.
DETERMINED (cont.)

• real exchange rate
The price of U.S. goods and
services relative to foreign
goods and services, expressed
in a common currency.
R E A L - N O M I N A L P R I N C I P L E
What matters to people is the real value of money or income—its purchasing
power—not the face value of money or income.
19.2 REAL EXCHANGE RATES AND
PURCHASING POWER PARITY

 FIGURE 19.4
Real Exchange Rate and
Net Exports as Percent of
GDP, 1980–2011
The figure shows the real
exchange rate for the
United States compared
to its net exports as a
share of GDP.
Notice that, in general,
when the real (multilateral)
exchange rate increased,
U.S. net exports fell.
SOURCE: U.S.
Department of Commerce
and the Federal Reserve.
PURCHASING POWER PARITY (cont.)

• law of one price
The theory that goods easily tradable
across countries should sell at the
same price expressed in a common
currency.
• purchasing power parity
A theory of exchange rates whereby a
unit of any given currency should be
able to buy the same quantity of
goods in all countries.
PURCHASING POWER PARITY (cont.)

THE CHINESE YUAN AND BIG MACS
APPLYING THE CONCEPTS #1: How can the price of a Big Mac in
China shed light on the U.S.-Chinese currency tensions?
• The U.S. and China are at odds about the appropriate exchange rate between the
yuan and the dollar.
• Economist magazine checks the price of Big Macs around the world and
determines the appropriate exchange rate based on the differences in prices.
• A Big Mac in China is $1.83, but should be $3.49
A P P L I C A T I O N 1

• balance of payments
A system of accounts that measures
transactions of goods, services, income,
and financial assets between domestic
households, businesses, and
governments and residents of the rest of
the world during a specific time period.
• current account
The sum of net exports (exports
minus imports) plus net income received
from abroad plus net transfers from
abroad.
19.3 THE CURRENT ACCOUNT, THE
FINANCIAL ACCOUNT, AND THE CAPITAL
ACCOUNT

• financial account
The value of a country’s net sales
(sales minus purchases) of assets.
• capital account
The value of capital transfer and
transaction in nonproduced,
nonfinancial assets in the
international accounts.
ACCOUNT (cont.)

Rules for Calculating the Current, Financial, and Capital
Accounts
• Here is a simple rule for understanding transactions on the current,
financial, and capital accounts: Any action that gives rise to a
demand for foreign currency is a deficit item. Any action that gives
rise to a supply of foreign currency is a surplus item.
• The current, financial, and capital accounts of a country are linked
by a very important relationship:
current account + financial account + capital account = 0
ACCOUNT (cont.)

Accounts
ACCOUNT (cont.)

• net international investment position
Domestic holding of foreign assets
minus foreign holdings of domestic assets.
• sovereign investment fund
Assets accumulated by foreign
governments that are invested abroad.
ACCOUNT (cont.)
Accounts

WORLD SAVINGS AND U.S. CURRENT ACCOUNT
DEFICITS
APPLYING THE CONCEPTS #2: What factors may allow the
United States to continue running large trade deficits with
the rest of the world?
• The 2006 Economic Report of the President directly addressed whether the
United States can continue to run large current account deficits and, of course,
financial account surpluses. In the report, the government recognized that the
current account deficits would eventually be reduced. However, it also highlighted
a number of factors suggesting the deficits could continue for a long period of
time.
• For the United States to continue to run a current account deficit, other countries
in the world need to continue to purchase U.S. assets.
• In recent years, four major countries experienced circumstances that encouraged
them to save by purchasing assets from abroad: Japan, Germany, Russia, and
China.
• For the United States to continue to run trade deficits in the future, these or other
countries must want to continue to save more than they want to invest
domestically.

To set the stage for understanding exchange rate systems, let’s
recall what happens when a country’s exchange rate
appreciates—increases in value. There are two distinct effects:
1 The increased value of the exchange rate makes imports
less expensive for the residents of the country where the
exchange rate appreciated.
2 The increased value of the exchange rate makes U.S.
goods more expensive on world markets.
19.4 FIXED AND FLEXIBLE EXCHANGE
RATES

Fixing the Exchange Rate
• foreign exchange market intervention
The purchase or sale of currencies by government
to influence the market exchange rate.
 FIGURE 19.5
Government Intervention to
Raise the Price of the Dollar
To increase the price of
dollars, the U.S.
government sells Euros in
exchange for dollars.
This shifts the demand
curve for dollars to the
right.
RATES (cont.)

Fixed versus Flexible Exchange Rates
• flexible exchange rate system
A currency system in which exchange
rates are determined by free markets.
FLEXIBLE EXCHANGE RATE SYSTEM
• fixed exchange rate system
A system in which governments peg
exchange rates to prevent their
currencies from fluctuating.
FIXED EXCHANGE RATES
RATES (cont.)

• balance of payments deficit
Under a fixed exchange rate system, a situation in
which the supply of a country’s currency exceeds the
demand for the currency at the current exchange rate.
BALANCE OF PAYMENTS DEFICITS AND SURPLUSES
• balance of payments surplus
Under a fixed exchange rate system, a situation in
which the demand of a country’s currency exceeds the
supply for the currency at the current exchange rate.
• devaluation
A decrease in the exchange rate to which a currency is
pegged under a fixed exchange rate system.
• revaluation
An increase in the exchange rate to which a currency is
pegged under a fixed exchange rate system.
RATES (cont.)
Fixed versus Flexible Exchange Rates

The U.S. Experience with Fixed and Flexible
Exchange Rates
Exchange Rate Systems Today
Fixed exchange rate systems provide benefits, but they require
countries to maintain similar economic policies—especially to
maintain similar inflation rates and interest rates.
Higher prices in the United States cause the U.S. real exchange
rate to rise. This increase in the real exchange rate over time
causes a trade deficit to emerge.
The flexible exchange rate system has worked well enough
since the breakdown of Bretton Woods.
Some economists believe that the world will eventually settle
into three large currency blocs: the euro, the dollar, and the
yen.
RATES (cont.)

A TROUBLED EURO
APPLYING THE CONCEPTS #3: What are the fundamental
causes for the problems with the Euro?
• When the euro was launched in 1999, the vision of its founders was to use the monetary union to
further unify Europe economically and politically. They envisioned a large economic market,
comparable to the United States. They believed that by moving to a single currency with
agreements on a number of fiscal rules that they could achieve economic stability and growth.
• Unfortunately, this vision proved to be naïve. Under the umbrella of the euro, financial investors
throughout the world poured funds into Spain and Ireland fueling an unsustainable housing boom
and also lending excessive amounts to the governments of Greece, Italy, and Portugal that faced
severe budget challenges.
• When the housing boom collapsed and the worldwide recession of 2007 increased budgetary
pressures, it became clear that the banks and governments of these countries could not easily
pay their debts. Moreover, with a single currency for the euro area, countries could not make
adjustments through depreciation of their currency. The options facing Europe were bleak:
either large-scale financial transfers from Germany and other successful countries, or sharp
cutbacks in budgets and prolonged unemployment to reduce wage levels.
• What became apparent was that the United States did not just have a single currency; it also had
a unified fiscal system that provided transfers to states and regions in economic distress.
Monetary union without a corresponding fiscal system cannot be easily sustained.

• Hardly a year goes by without some international
financial crisis.
• Even when a country takes strong, institutional steps
to peg its currency, a collapse is still possible.
19.5 MANAGING FINANCIAL CRISES

THE ARGENTINE FINANCIAL CRISIS
APPLYING THE CONCEPTS #4: What are the causes of
financial collapses that occur throughout the globe?
During the late 1980s, Argentina suffered from hyperinflation. As part of its financial
reforms, it pegged its currency to the U.S. dollar, making pesos “convertible” into
dollars. To issue pesos, the central bank had to have an equal amount of dollars, or
its equivalent in other hard currencies, on hand. Some economists believed this
reform would bring stability to the financial system. Unfortunately, they were proved
wrong.
Several problems developed:
• As the dollar appreciated, Argentina began to suffer from a large trade deficit.
• Wage increases also pushed up the real exchange rate.
• Argentina had to borrow extensively in dollar-denominated loans.
Eventually, Argentina was forced to default on its international debt in 2002 and
freeze bank accounts. The hopes of the reforms in the early 1990s had become a
bitter memory.

balance of payments
balance of payments deficit
balance of payments surplus
capital account
current account
devaluation
euro
exchange rate
financial account
fixed exchange rate system
flexible exchange rate system
foreign exchange market
intervention
law of one price
net international investment position
purchasing power parity
real exchange rate
revaluation
sovereign investment funds
K E Y T E R M S

Econ214 macroeconomics chapter 19

Recommandé

Recommandé

Contenu connexe

Tendances

Tendances (20)

En vedette

En vedette (20)

Similaire à Econ214 macroeconomics chapter 19

Similaire à Econ214 macroeconomics chapter 19 (20)

Plus de BHUOnlineDepartment

Plus de BHUOnlineDepartment (20)

Dernier

Dernier (20)

Econ214 macroeconomics chapter 19