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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 NEWs

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.

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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.

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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.

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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).

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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)

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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.

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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.

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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.

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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

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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:

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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.

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