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Chapter 21 - The Balance of Payments, Exchange Rates, and Trade Deficits
Chapter 21 - The Balance of Payments, Exchange Rates, and Trade Deficits
McConnell Brue Flynn 20e
DISCUSSION QUESTIONS
1. Do all international financial transactions necessarily involve exchanging one nation’s distinct
currency for another? Explain. Could a nation that neither imports goods and services nor exports
goods and services still engage in international financial transactions? LO1
Answer: The answer is almost certainly a yes. Only in rare cases would you find
2. Explain: “U.S. exports earn supplies of foreign currencies that Americans can use to finance
imports.” Indicate whether each of the following creates a demand for or a supply of European
euros in foreign exchange markets: LO1
a. A U.S. airline firm purchases several Airbus planes assembled in France.
b. A German automobile firm decides to build an assembly plant in South Carolina.
c. A U.S. college student decides to spend a year studying at the Sorbonne in Paris.
d. An Italian manufacturer ships machinery from one Italian port to another on a Liberian
freighter.
e. The U.S. economy grows faster than the French economy.
f. A U.S. government bond held by a Spanish citizen matures, and the loan amount is paid back to
that person.
g. It is widely expected that the euro will depreciate in the near future.
Answer: American exports lead to an increase in the foreign-currency bank
b. A supply of euros: The German automobile firm must purchase U.S. dollars, or
c. A demand for euros: The U.S. college student must purchase euros before
d. A supply of euros: The Italian manufacturer must purchase U.S. dollars, or
e. A demand for euros: Since the U.S. economy grows faster than the French
f. A demand for euros: The U.S. pays the Spanish citizen in U.S. dollars. The
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Chapter 21 - The Balance of Payments, Exchange Rates, and Trade Deficits
g. A supply of euros: Since individuals holding euros expect the currency to
3. What do the plus signs and negative signs signify in the U.S. balance of payments statement?
Which of the following items appear in the current account and which appear in the capital and
financial account? U.S. purchases of assets abroad; U.S. services imports; foreign purchases of
assets in the United States; U.S. good exports, U.S. net investment income. Why must the current
account and the capital and financial account sum to zero? LO2
Answer: The plus sign (+) indicates a credit to the U.S. balance of payments. The
negative sign (-) indicates a debit the U.S balance of payments.
U.S. purchases of assets abroad: current account
4. What are official reserves? How do net sales of official reserves to foreigners and net purchases
of official reserves from foreigners relate to U.S. balance-of-payment deficits and surpluses?
Explain why these deficits and surpluses are not actual deficits and surpluses in the overall
balance of payments statement. LO2
Answer: Official reserves consist of foreign currencies, certain reserves held with the
Although the balance of payments must always sum to zero, in some years a net sale of
In other years, the capital and financial account balances the current account because of
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Chapter 21 - The Balance of Payments, Exchange Rates, and Trade Deficits
either net purchases of official reserves in the balance of payments or, alternatively, as the
resulting increase in the stock of official reserves held by the government.
5. Generally speaking, how is the dollar price of euros determined? Cite a factor that might
increase the dollar price of euros. Cite a different factor that might decrease the dollar price of
euros. Explain: “A rise in the dollar price of euros necessarily means a fall in the euro price of
dollars.” Illustrate and elaborate: “The dollar-euro exchange rate provides a direct link between
the prices of goods and services produced in the Euro Zone and in the United States.” Explain the
purchasing-power-parity theory of exchange rates, using the euro-dollar exchange rate as an
illustration. LO3
Answer: The dollar price of the euro is determined in a currency exchange market that
equates the supply of euros with the demand for euros.
A factor that might increase the dollar price of the euro could be the result of an increase
A factor that might decrease the dollar price of the euro could be the result of a decrease
If the euro appreciates relative to the dollar, it takes more dollars to purchase one euro. At
Through exchange rates, residents of all trading nations can express the prices of goods
and services in other trading nations in terms of their domestic currencies. A change in
The purchasing power parity theory of exchange rates holds that exchange rates change
6. Suppose that a Swiss watchmaker imports watch components from Sweden and exports
watches to the United States. Also suppose the dollar depreciates, and the Swedish krona
appreciates, relative to the Swiss franc. Speculate as to how each would hurt the Swiss
watchmaker. LO3
Answer: If the dollar depreciated relative to the franc, this means that it took
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Chapter 21 - The Balance of Payments, Exchange Rates, and Trade Deficits
7. Explain why the U.S. demand for Mexican pesos is downsloping and the supply of pesos to
Americans is upsloping. Assuming a system of flexible exchange rates between Mexico and the
United States, indicate whether each of the following would cause the Mexican peso to appreciate
or depreciate, other things equal: LO3
a. The United States unilaterally reduces tariffs on Mexican products.
b. Mexico encounters severe inflation.
c. Deteriorating political relations reduce American tourism in Mexico.
d. The U.S. economy moves into a severe recession.
e. The United States engages in a high-interest-rate monetary policy.
f. Mexican products become more fashionable to U.S. consumers.
g. The Mexican government encourages U.S. firms to invest in Mexican oil fields.
h. The rate of productivity growth in the United States diminishes sharply.
Answer: The U.S. demand for pesos is downward-sloping: When the peso
depreciates in value (relative to the dollar) the United States finds that Mexican
a. The peso will appreciate. Mexican goods will become cheaper, so U.S. demand for
b. The peso will depreciate. The high rate of inflation in Mexico (relative the U.S.) will
c. The peso will depreciate. The reduction in U.S. tourism in Mexico reduces the demand
d. The peso will depreciate. The recession in the U.S. economy will reduce imports from
e. The peso will depreciate. The high interest rate in the U.S. will attract investors from
f. The peso will appreciate. U.S. consumers purchase more goods from Mexico. This
g. The peso appreciates. The U.S. firms must purchase pesos to invest in Mexico. This
h. The peso appreciates. The sharp decline in U.S. productivity reduces investment in the
8. Explain why you agree or disagree with the following statements: LO3
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Chapter 21 - The Balance of Payments, Exchange Rates, and Trade Deficits
a. A country that grows faster than its major trading partners can expect the international value of
its currency to depreciate.
b. A nation whose interest rate is rising more rapidly than interest rates in other nations can expect
the international value of its currency to appreciate.
c. A country’s currency will appreciate if its inflation rate is less than that of the rest of the world.
Answer:
a. This statement is true. If high rates of economic growth mean that the real
b. This statement is true. If domestic real interest rates are increasing more
c. This statement is true. If a country’s inflation rate is lower than rates in other
9. “Exports pay for imports. Yet in 2012 the nations of the world exported about $540 billion
more of goods and services to the United States than they imported from the United States.”
Resolve the apparent inconsistency of these two statements. LO2
Answer: Exports pay for imports in the long run. In the short term, a country can
import more goods and services than it exports through external borrowing or the
10. What have been the major causes of the large U.S. trade deficits in recent years? What are the
major benefits and costs associated with trade deficits? Explain: “A trade deficit means that a
nation is receiving more goods and services from abroad than it is sending abroad.” How can that
considered to be “unfavorable”? LO6
Answer: (1) The U.S. economy has grown more rapidly than the economies of
several major trading nations. Thus U.S. exports have not kept pace with the rise
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Chapter 21 - The Balance of Payments, Exchange Rates, and Trade Deficits
A trade deficit is considered “unfavorable” because it must be financed by
11. LAST WORD Suppose Super D’Hiver—a hypothetical French snowboard retailer—wants to
order 5000 snowboards made in the United States. The price per board is $200, the present
exchange rate is 1 euro = $1, and payment is due in dollars when the boards are delivered in 3
months. Use a numerical example to explain why exchange-rate risk might make the French
retailer hesitant to place the order. How might speculators absorb some of Super D’Hiver’s risk?
Answer: Because payment is due in three months in dollars, the French retailer
might worry that his anticipated price, which today is 1 million euros (5,000
boards at $200 when the exchange rate is 1 euro per dollar), might rise if the euro
loses value relative to the dollar. For example, at the end of three months the euro
Who would be willing to sign such a contract? It could be a speculator who is
betting that the value of the euro will rise against the dollar rather than fall.
REVIEW QUESTIONS
1. An American company wants to buy a television from a Chinese company. The Chinese
company sells its TVs for 1,200 yuan each. The current exchange rate between the U.S. dollar
and the Chinese yuan is $1 = 6 yuan. How many dollars will the American company have to
convert into yuan to pay for the television? LO1
a. $7,200.
b. $1,200.
c. $200.
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Chapter 21 - The Balance of Payments, Exchange Rates, and Trade Deficits
d. $100.
Feedback: The American company will have to convert $200 into yuan in order to pay
for the television. With the exchange rate at $1 = 6 yuan, it will take $200 (= 200 times
2. Suppose that a country has a trade surplus of $50 billion, a balance on the capital account of
$10 billion, and a balance on the current account of -$200 billion. The balance on the capital and
financial account will be: LO2
a. $7,200 billion.
b. $1,200 billion.
c. $200 billion.
d. $100 billion.
Feedback: The correct answer is that the balance on the capital and financial account
will be $200 billion. We know this must be true because the balance on the current
Note that the other information given in the problem (that the country has a trade
Finally, make sure to remember that the current account balance and the capital and
financial account balance always sum to zero because any current account imbalance
3. The exchange rate between the U.S. dollar and the British pound starts at $1 = £0.5. It then
changes to $1 = £0.75. Given this change, we would say that the U.S. dollar has _________ while
the British pound has _____________. LO3
a. Depreciated; appreciated.
b. Depreciated; depreciated.
c. Appreciated; depreciated.
d. Appreciated; appreciated.
Feedback: The correct answer is that the U.S. dollar has appreciated while the British
pound has depreciated.
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consent of McGraw-Hill Education.
Chapter 21 - The Balance of Payments, Exchange Rates, and Trade Deficits
The U.S. dollar has appreciated because it has gained in purchasing power. Whereas a
At the same time, this change in the exchange rate means that the British pound has lost
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