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38The 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 38-2
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 38-3
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 38-4
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 38-6
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 depreciatesLO3 38-7
Q0
Do
llar
Pri
ce o
f 1
Po
un
d
Quantity of Pounds
P
Flexible Exchange Rates
The Market for Foreign Currency (Pounds)
D1
S1
DollarAppreciates(PoundDepreciates)
DollarDepreciates(PoundAppreciates)
ExchangeRate: $2 = £1
$2
$3
$1
Q1
LO3 38-8
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 38-9
Q0
Do
llar
Pri
ce o
f 1
Po
un
d
Quantity of Pounds
P
Flexible Exchange Rates
The Market for Foreign Currency(Pounds)
D1
S1
ExchangeRate: $2 = £1
$2
$3
$1
Q1
D2
ExchangeRate: $3 = £1
BalanceOf Payments
Deficit
Q2
x a
b
c
LO3 38-10
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 38-11
Fixed Exchange Rates
• Government intervention• Use of reserves
• Trade policies• Exchange controls and rationing
• Distorted trade• Favoritism• Restricted choice• Black markets
• Macroeconomic adjustments
LO4 38-12
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 38-13
The Managed Float
• Dependence on foreign exchange markets
• Occasional intervention
• In support of managed float
• Concerns with managed float
LO4 38-14