Unlock document.
This document is partially blurred.
Unlock all pages and 1 million more documents.
Get Access
Chapter 21 - The Balance of Payments, Exchange Rates, and Trade Deficits
CHAPTER TWENTY-ONE
THE BALANCE OF PAYMENTS, EXCHANGE RATES, AND
TRADE DEFICITS
CHAPTER OVERVIEW
This chapter addresses several important aspects of international trade. The chapter begins with a brief
discussion about the balance of payments. Next, this balance of payments is explained and examined in
greater detail. Exchange rates and balance of payments adjustments under each exchange rate system
are then analyzed. The section concludes with a discussion of the advantages and disadvantages of each.
Finally, the chapter looks at the trade deficits of recent years and examines the causes and effects of these
deficits.
The supplement to this chapter discusses the history of major policies and exchange rate systems,
beginning with the gold standard and concluding with the Bretton Woods system.
WHAT’S NEW
There are minor revisions to the Learning Objectives.
There are four more Quick Reviews to help the students retain the appropriate information.
All relevant tables and graphs have been updated.
INSTRUCTIONAL OBJECTIVES
After completing this chapter, students should be able to:
1. Explain and identify the various components of the balance of payments.
2. Identify trade and balance of payments deficits or surpluses when given appropriate data.
3. Explain how a nation finances a “deficit” and what it does with a “surplus.”
4. Explain how exchange rates are determined in a flexible system.
5. Explain how U.S. exports create a demand for dollars and a supply of foreign exchange; and how
U.S. imports create a demand for foreign exchange and a supply of dollars.
6. Explain how flexible exchange rates eliminate balance of payments disequilibria.
7. List five determinants of exchange rates.
8. List three disadvantages of flexible exchange rates.
9. List four ways a nation could control exchange rates under a fixed-rate system.
10. Describe the causes and two effects of a trade deficit.
11. Define and identify terms and concepts listed at the end of the chapter.
12. (Content Option for Instructors 2) Describe a system based on the gold standard, the Bretton
Woods system, and a managed float exchange rate system.
21-1
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
Chapter 21 - The Balance of Payments, Exchange Rates, and Trade Deficits
COMMENTS AND TEACHING SUGGESTIONS
1. The Wall Street Journal reports exchange rates daily. A good exercise is to have students learn to
use these tables. There is great disparity among students’ understanding of such information.
Those who have traveled in other countries understand the basics of foreign exchange, while others
have not thought about the idea before.
2. New instructors often have difficulty relating international trade concepts such as the principle of
comparative advantage and exchange rate determination. Remember: Exchange rates are an
application of supply and demand. If you carefully label the axes on your graph during the lecture,
you can avoid confusing students. Try to focus on the demand side of only one currency at a time,
and don’t jump back and forth from looking at the exchange rate for dollars and another currency at
the same time. For example, if the focus is on the dollar, measure the exchange rate or price in
“foreign currency per dollar” on the vertical axis, and quantity of dollars on the horizontal axis.
That is, treat dollars like apples or any other commodity. When the demand shifts rightward, the
price or exchange rate will rise; when the demand shifts leftward, the price or exchange rate will
decline. Conversely, if the supply shifts rightward, the exchange rate will fall, and if the supply
shifts leftward, the exchange rate will rise.
3. A good topic for discussion or essay centers on the following questions. Is a trade deficit bad or
good? Is foreign investment in the U.S. harmful or beneficial? It should be easy for students to
find thoughtful, current articles on both sides of these issues in newspapers, magazines, and
journals available in most college libraries.
STUDENT STUMBLING BLOCKS
1. Some students seem to have great difficulty in understanding that units of other countries’
currencies are not equivalent to our dollar. For example, when some students hear that they can
receive 110 yen for one dollar, they believe that means they would be very rich in Japan. Many
have difficulty comprehending that one yen is worth about one cent. The confusion seems to lie in
their belief that the basic units of exchange should have equivalent values across countries. That is,
some seem to believe that a yen is a dollar is a pound is a euro, etc. Several examples are
necessary before the basics of exchange are understood.
2. There is a common belief that trade deficits are bad or “unfavorable” and that being a debtor nation
is always a problem. As with so much in economics, it is necessary to point out that this evaluation
depends on the situation and on whose point of view is being expressed. Trade deficits may be
good for consumers if they arise because Americans are obtaining quality imports at low prices.
Foreign investment that entails the selling of U.S. assets can be beneficial to U.S. future economic
growth and productivity. The effects of balance of payments deficits are not easy to understand or
analyze, and news articles that suggest alarm that the U.S. is the world’s largest debtor nation may
add to the confusion. During the 1800s and our greatest industrial expansion, the U.S. was also a
debtor nation, and it had very beneficial effects.
21-2
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
Chapter 21 - The Balance of Payments, Exchange Rates, and Trade Deficits
LECTURE NOTES
I. Learning objectives – After reading this chapter, students should be able to:
A. Explain how currencies of different nations are exchanged when international transactions
take place.
B. Analyze the balance sheet the United States uses to account for the international payments it
makes and receives.
C. Discuss how exchange rates are determined in currency markets that have flexible exchange
rates.
D. Describe the difference between flexible exchange rates and fixed exchange rates.
E. Explain the current system of managed floating exchange rates.
F. Identify the causes and consequences of recent large U.S. trade deficits.
II. International Financial Transactions
A. Foreign exchange markets (or currency markets) enable international transactions to take
place by providing markets for the exchange of national currencies.
B. An American export transaction is explained below.
1. U.S. firm is selling $300,000 worth of computers to British firm.
2. Imagine the exchange rate is $2 = 1 Br. pound, so the British firm must pay 150,000
pounds.
3. The British company has to convert 150,000 British pounds to $300,000 to buy the
American goods.
III. The Balance of Payments (Table 21.1 summarizes the balance for 2012)
A. A nation’s balance of payments is the sum of all transactions that take place between its
residents and the residents of all foreign nations. These transactions include merchandise
exports and imports, tourist expenditures, and interest plus dividends from the sale and
purchases of financial assets abroad. The balance of payments account is subdivided into two
components: the current account, and the capital and financial account.
B. Current Accounts is shown in top portion of Table 21.1. The main entries are:
1. The current account summarizes U.S. trade in currently produced goods and services.
2. The merchandise trade balance is the difference between its exports and imports of
goods.
3. The balance on goods and services, shown in (line 7) Table 21.1 is the difference between
U.S. exports of goods and services (items 1 and 4) and U.S. imports of goods and
services (items 2 and 5).
4. Balance on the current account is found by adding all transactions in the current account
(item 10, Table 21.1).
5. Global Perspective 21.1 gives the U.S. trade balances with select nations.
21-3
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
Chapter 21 - The Balance of Payments, Exchange Rates, and Trade Deficits
C. Capital and Financial Account:
1. The capital and financial account consists of the capital account and the financial
account.
2. The capital account summarizes the net flow of debt forgiveness. The negative sign (line
11) indicates that the U.S. forgave more debt than foreigners forgave debt owed by
Americans.
3. The financial account summarizes flows of payments from the purchase or sale of real or
financial assets, here and abroad.
a. A foreign firm may buy a real asset; say an office tower in the U.S., or a U.S.
government bond. Both kinds of transactions involve the “export” of the ownership
of U.S. assets from the United States in return for payments of foreign currency
(money “capital”) inflows. This is recorded as a positive flow in the financial
account. (Line 12)
b. If a U.S. firm buys an asset (real or financial) abroad, they are “importing”
ownership, and the negative sign reflects the outflow of funds. (Line 13)
4. The balance on the capital and financial account was $475 billion in 2012. (Line 15,
Table 21.1)
D. Why the Balance?
1. Balance of payments will always balance. The balance on the current account equals the
balance on the capital and financial account.
2. The deficit or surplus on the current account automatically creates an offsetting balance
in the capital and financial account.
a. If an American, John, buys $500 in watches from Henri who is Swiss, and Henri buys
$300 in shoes from John, John has a $200 deficit with Henri.
b. The money John receives from his exports is $200 short of the money he must pay
Henri.
c. To make up for this difference John pays Henri with his financial assets.
E. Official Reserves, Payments Deficits and Payments Surpluses:
1. Official reserves include foreign currencies and stocks of gold held by government.
2. To create the overall balance of payments, sometimes official reserves must be sold,
drawing down its stock of official reserves. When this happens it’s called a balance of
payments deficit.
3. Selling official reserves is reflected with a “+” on the balance of payments statement.
4. When there’s a balance of payments surplus, government buys foreign official reserves,
creating a negative entry in the U.S. purchases of foreign assets ensuring the balance of
payments balances.
5. The U.S. has persistently large current account deficits that must be offset by capital and
financial account surpluses, and these are of greater concern (as discussed later in the
chapter).
21-4
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
Chapter 21 - The Balance of Payments, Exchange Rates, and Trade Deficits
IV. Flexible Exchange Rates
A. Freely floating exchange rates are determined by the forces of demand and supply. Figure
21.1 (Key Graph) illustrates the exchange rate (price) for British pounds in American dollars.
1. The demand for any currency is downsloping because as the currency becomes less
expensive, people will be able to buy more of that nation’s goods and, therefore, want
larger quantities of the currency.
2. The supply of any currency is upsloping because as its price rises, holders of that
currency can obtain other currencies more cheaply and will want to buy more imported
goods and, therefore, will give up more of their currency to obtain other currencies.
3. As with other commodities, the intersection of the supply and demand curves for a
currency (pounds in Figure 21.1) will determine the price or exchange rate. In the
example it is $2 to 1 pound.
B. Depreciation means the value of a currency has fallen; it takes more units of that country’s
currency to buy another country’s currency. $3 for 1 pound would be a depreciation of the
dollar, compared to the original example of $2 per pound.
C. Appreciation means the value of a currency or its purchasing power has risen; it takes less of
that currency to buy another country’s currency. $1 = 1 pound would be an appreciation of
the dollar relative to the pound.
D. Determinants of exchange rates are the forces that cause the demand or supply curves to shift.
1. Changes in tastes or preferences for a country’s products would shift the demand for the
currency as well.
2. Relative income changes will cause changes in the demand and supply of currencies.
Rising incomes increase the demand for imports, which increases the supply of that
country’s currency and the demand for other country’s currencies.
3. Relative inflation rate changes will cause changes in the demand and supply of
currencies. If American inflation is higher relative to British inflation, this will increase
the demand for British goods and pounds; conversely, it will reduce the supply of pounds
as British purchase fewer American goods. The theory of purchasing-power-parity
asserts that exchange rates will change to maintain a uniform price in one currency, e.g.,
dollars, for each product across countries.
4. Changes in relative real interest rates will affect the demand and supply of currencies.
Higher U.S. interest rates attract foreign savings; hence, they raise the demand for dollars
and reduce the supply of dollars as U.S. investment dollars may remain in this country.
5. Speculation is another determinant. If one believes the value of a currency is about to
fall, it will increase the supply of that currency and reduce its demand. Likewise, if one
believes the value of a currency is about to rise, it will increase its demand and reduce its
supply as people want to hold that currency. Note that such predictions can be
self-fulfilling prophecies, since the change in demand is in the direction of the prediction.
(Table 21.2 summarizes the determinants of exchange rates)
21-5
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
Chapter 21 - The Balance of Payments, Exchange Rates, and Trade Deficits
E. Theoretically, flexible rates have the virtue of automatically correcting any imbalance in the
balance of payments. If there is a deficit in the balance of payments, this means that there
will be a surplus of that currency and its value will depreciate. As depreciation occurs, prices
for goods and services from that country become more attractive and the demand for them
will rise. At the same time, imports become more costly as it takes more currency to buy
foreign goods and services. With rising exports and falling imports, the deficit is eventually
corrected (Figure 21.2 illustrates this).
F. There are some disadvantages to flexible exchange rates.
1. Uncertainty and diminished trade may result if traders cannot count on future prices of
exchange rates, which affect the value of their planned transactions. (However, see Last
Word for this chapter for ways in which traders can avoid risk.)
2. Terms of trade may be worsened by a decline in the value of a nation’s currency.
3. Unstable exchange rates can destabilize a nation’s economy. This is especially true for
nations whose exports and imports are a substantial part of their GDPs.
V. Fixed Exchange Rates
A. Fixed exchange rates are those that are pegged to some set value, such as gold or the U.S.
dollar.
B. Official reserves are used to correct an imbalance in the balance of payments, since exchange
rates cannot fluctuate to bring about automatic balance. This is called currency intervention.
C. Trade policies directly controlling the amount of trade and finance might be used to avoid
imbalance in trade and payments.
D. Exchange controls and rationing of currency have been used in the past but are objectionable
for several reasons.
1. Controls distort efficient patterns of trade.
2. Rationing involves favoritism among importers.
3. Rationing reduces freedom of consumer choice.
4. Enforcement problems are likely as “black market” rates develop.
E. Domestic macroeconomic adjustments may be more difficult under fixed rates. For example,
a persistent deficit of trade may call for tight monetary and fiscal policies to reduce prices,
which raises exports and reduces imports. Such contractionary policies can also cause
recessions and unemployment, however.
21-6
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
Chapter 21 - The Balance of Payments, Exchange Rates, and Trade Deficits
VI. The Current Exchange Rate System: The “Managed Float” System
A. The current system is really a “managed float” exchange rate system in which governments
attempt to prevent rates from changing too rapidly in the short term. For example, in 1987,
the then G-7 nations—U.S., Germany, Japan, Britain, France, Italy, and Canada—agreed to
stabilize the value of the dollar, which had declined rapidly in the previous two years. They
purchased large amounts of dollars to prop up the dollar’s value. The G8 nations (add Russia
to the list above) meet regularly to assess economic conditions and coordinate economic
policy.
1. In support of the managed float.
a. Trade has expanded and not diminished under this system as some predicted it might.
b. Flexible rates have allowed international adjustments to take place without domestic
upheaval when there has been economic turbulence in some areas of the world.
2. Concerns with the managed float.
a. Much volatility occurs without the balance of payments adjustments predicted.
b. There is no real system in the current system. It is too unpredictable.
VII. Recent U.S. Trade Deficits
A. In 2012 the U.S. trade deficit in goods and services was $539.51 billion, and the current
account deficit in U.S. was $735.31 billion. (Figure 21.4)
B. Causes of the trade deficit.
1. From 2001 to 2007, the U.S. economy grew more rapidly than the economies of several
major trading nations. This growth of income has boosted U.S. purchases of foreign
goods. In contrast, Japan, and some European nations, suffered recessions or slow
income growth during this period.
2. Large trade deficits with China have emerged ($298 billion in 2012, which is double the
combined deficits with Mexico, Germany and Japan). With China’s fixed exchange rate
of its currency and its low standard of living have contributed to the U.S. deficit with
China.
3. Rapidly rising oil prices, because of the large percentage of oil imported by the U.S.,
have increased the trade deficit with OPEC.
4. Until the recession of 2007 – 2009, a declining savings rate and the rising investment rate
in the U.S. have contributed to U.S. trade deficits and an increase in foreign investment in
the U.S.
C. Implications of U.S. trade deficits
1. A trade deficit means that the U.S. is receiving more goods and services as imports from
abroad than it is sending out as exports. The gain in present consumption may come at
the expense of reduced future consumption.
2. A trade deficit is considered “unfavorable” because it must be financed by borrowing
from the rest of the world, selling off assets or dipping into foreign currency reserves. In
2004, foreigners owned $2.5 billion more assets in the U.S. than Americans owned in
foreign assets.
21-7
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
Chapter 21 - The Balance of Payments, Exchange Rates, and Trade Deficits
3. Therefore, the current consumption gains delivered by U.S. trade deficits could mean
permanent debt, permanent foreign ownership, or large sacrifices of future consumption.
These sacrifices may be minimized if higher economic growth results as foreign
investment expands our capital base.
VIII. LAST WORD: Speculation in Currency Markets
A. Are speculators a positive or a negative influence? Speculators sometimes contribute to
exchange rate volatility. The expectation of currency appreciation or depreciation can be self-
fulfilling.
1. If speculators expect the Japanese yen to appreciate, they sell other currencies to buy yen.
The increase in demand for yen and in supply of other currencies will boost its value,
which may attract still other speculators to buy yen. The rise in yen value is partly a
result of expectations.
2. Eventually, the yen’s value may soar too high relative to economic realities, the
speculative “bubble” bursts, and the yen can plummet for the same self-fulfilling reasons,
as speculators sell yen to buy other currencies.
B. Speculation can have positive effects in foreign exchange markets.
1. Speculators may be useful in smoothing out temporary fluctuations. If there is a
temporary decline in demand, speculators take advantage of the dip in value by buying
the currency; this props up demand, strengthening the value again. If there is a
temporarily strong demand, which artificially raises the value of a currency, speculators
will sell to take advantage of the price hike, and this will reduce the inflated value.
2. Speculators also absorb risks that others do not want to bear. International transactions in
goods and services can be risky if exchange rates change. Buyers and sellers in
international trade can reduce the risk of exchange rate changes in foreign transactions by
hedging or buying the needed currency with forward contracts. This is where a buyer or
seller protects against a change in future exchange rates in the futures market. Foreign
exchange is bought or sold at contract prices fixed now, for delivery at a specified future
date.
3. The example given is of an American importer who agrees to buy 10,000 Swiss watches
to be delivered and paid for in three months. The price is 75 francs per watch, or $50 per
watch at the exchange rate on the date of the sale. If the franc were to appreciate from
1.5 francs per dollar to 1 franc per dollar in three months, the importer would have to pay
$75 per watch instead of $50 per watch.
a. Hedging can reduce the importer’s risk of having the franc appreciate.
b. The importer can purchase the 750,000 francs needed by signing a futures contract,
agreeing to pay a specified amount (maybe $500,000 plus some allowance for fees)
for those francs in three months.
c. Speculators accept such contracts. In this case, the speculator would be betting that
the value of the franc would fall vs. the dollar, and at the end of the three months, the
speculator would take the $500,000 and obtain more than the 750,000 francs for it.
The importer will have the 750,000 francs, and the speculator will have profited by
having excess francs. Of course, if the franc appreciates, the speculator loses on this
deal. In other words, the speculator has assumed the risk from the importer—and as
a result may profit or lose.
21-8
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
Chapter 21 - The Balance of Payments, Exchange Rates, and Trade Deficits
Content Option for Instructors 2 (COI2): Previous International Exchange Rate
Systems
A. The gold standard was the international system used during the 1879-1934 period. It
provided for fixed exchange rates in terms of a certain amount of currency for an ounce of
gold. Under this system, each nation must:
1. Maintain a fixed relationship between the stock of gold and the money supply.
2. Gold flows would maintain the fixed rate. If the dollar appreciated, gold would flow into
the U.S.; if it depreciated, gold would flow out. These flows would keep the value of the
currencies at their fixed rates.
3. If gold flowed into a country, its money supply would increase because the gold/money
ratio is fixed. Therefore, when the dollar appreciated, the U.S. money supply would
increase proportionately to the gold increase. A rise in the money supply would cause
U.S. incomes and prices to rise and would increase our demand for foreign goods, while
the demand for U.S. exports declined. Such a change in the balance of trade would cause
the dollar to depreciate again. In other word, a gold standard causes domestic
adjustments. This is its major disadvantage.
4. The advantages are stable exchange rate and automatic adjustments in balance of
payments.
5. The worldwide Depression of the 1930s ended the gold standard, because improving
economic conditions became the main goal of national policies.
B. The Bretton Woods system was enacted following World War II by the leading industrialized
western nations. It had two main features.
1. The International Monetary Fund (IMF) was created to hold and lend official reserves.
Included in official reserves was a new kind of international governmental currency
called Special Drawing Rights (SDRs).
2. Pegged exchange rates were initiated, which were adjustable when a fundamental
imbalance was recognized. The rates were maintained by government intervention in the
supply and demand of currencies.
a. Governments could spend or purchase currencies directly.
b. Gold could be bought or sold by governments.
c. IMF borrowing could take place from the required accounts that nations had at the
International Monetary Fund.
3. The pegged rates could be changed (adjusted) when there were persistent problems with
the balance of payments using the existing rate. A persistent deficit could lead to
devaluation (depreciation).
4. The Bretton Woods system was abandoned as nations acquired more and more dollars,
and the U.S. abandoned its pledge to convert dollars into gold in 1971. This led to a
flexible exchange rate for the dollar and, therefore, flexible rates for every other major
currency that was related to the dollar.
QUIZ
1. U.S. exports:
A. Increase the foreign demand for dollars
B. Increase the domestic demand for dollars
C. Increase the foreign supply of dollars
21-9
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
Chapter 21 - The Balance of Payments, Exchange Rates, and Trade Deficits
D. Decrease the domestic supply of foreign currency
2. If an American can purchase 40,000 British pounds for $90,000, the dollar rate of exchange for
the pound is:
A. $1.40
B. $2.00
C. $2.25
D. $6.00
3. Other things being equal, an increase in the U.S. rate of inflation is likely to cause an increase in
the:
A. Quantity of exports
B. Quantity of imports
C. Demand for U.S. dollars
D. International value of the U.S. dollar
4. One reason for the persistent trade deficits in the United States during the late 1990s and early
2000s was:
A. Action taken to raise tariffs in the United States
B. A declining U.S. saving rate
C. Slower economic growth in the United States
D. Increased direct foreign investment in the United States
5. The current account in a nation's balance of payments includes:
A. its goods exports and imports, and its services exports and imports.
B. foreign purchases of domestic assets.
C. purchases of foreign assets.
D. all of these.
6. In the balance of payments of the United States, U.S. goods imports are recorded as a:
A. positive entry.
B. capital account entry.
C. current account entry.
D. official reserves entry.
7. If the rate of exchange for a pound is $4, the rate of exchange for the dollar is:
21-10
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
Chapter 21 - The Balance of Payments, Exchange Rates, and Trade Deficits
A. 1/4 pound.
B. 4 pounds.
C. $.25.
D. $1.00.
8. If the dollar depreciates relative to the Russian ruble, the ruble:
A. will be less expensive to Americans.
B. may either appreciate or depreciate relative to the dollar.
C. will appreciate relative to the dollar.
D. will depreciate relative to the dollar.
9. Under a system of fixed exchange rates, a nation that has chronic balance of payments deficits
may:
A. initiate protectionist trade policies.
B. run short of international monetary reserves.
C. be forced to invoke contractionary monetary and fiscal policies.
D. do all of these.
10. Present consumption supported by large trade deficits may come at the expense of:
A. permanent debt to foreign interests.
B. permanent foreign ownership of formerly U.S. owned assets.
C. large sacrifices of future consumption.
D. all of these.
21-11
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
