Chapter 41 – The Balance of Payments, Exchange Rates, and Trade Deficits
41-1
Chapter 41 – The Balance of Payments, Exchange Rates, and Trade Deficits
McConnell Brue Flynn 21e
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
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 deposit
holdings of Americans. These holdings will be decreased through American purchases of
Chapter 41 – The Balance of Payments, Exchange Rates, and Trade Deficits
41-2
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.
4. “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
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
Chapter 41 – The Balance of Payments, Exchange Rates, and Trade Deficits
41-3
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
in the demand for the euro or an increase in the supply of the euro. (Examples) Decrease
in Demand: Less Airbus aircraft purchased by U.S. airlines. Increase in supply: More
Boeing aircraft purchased by European airlines.
If the euro appreciates relative to the dollar, it takes more dollars to purchase one euro. At
the same time, it takes fewer euros to buy a dollar, meaning that the euro price of dollars
has fallen.
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 exchange rate between any two countries will automatically lead to an adjustment in
the prices of all goods and services in both countries in terms of the other’s currency. The
determination of these price conversions represents the most basic and visible function of
exchange rates.
The purchasing power parity theory of exchange rates holds that exchange rates change
to equal the ratios of the nations’ price levels. If a certain item costs $100 in the U.S. and
50 euros in Germany, then the exchange rate should be $1 = 0.5 euros. It should take the
same amount of dollars to buy the item anywhere in the world if exchange rates adjust to
maintain purchasing power parity.
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
Chapter 41 – The Balance of Payments, Exchange Rates, and Trade Deficits
41-4
Answer: If the dollar depreciated relative to the franc, this means that it took more
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 goods and services are
less expensive in dollar terms and purchases more of them, demanding a greater quantity
Chapter 41 – The Balance of Payments, Exchange Rates, and Trade Deficits
41-5
8. Explain why you agree or disagree with the following statements: LO3
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.
9. Would it be accurate to think of a fixed exchange rate as a simultaneous price ceiling and price
floor? LO4
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
Chapter 41 – The Balance of Payments, Exchange Rates, and Trade Deficits
41-6
nation is receiving more goods and services from abroad than it is sending abroad.” How can that
considered to be “unfavorable”? LO6
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
Chapter 41 – The Balance of Payments, Exchange Rates, and Trade Deficits
41-7
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.
d. $100.
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.
Chapter 41 – The Balance of Payments, Exchange Rates, and Trade Deficits
41-8
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.
4. A meal at a McDonald’s restaurant in New York costs $8. The identical meal at a McDonald’s
restaurant in London costs £4. According to the purchasing-power-parity theory of exchange
rates, the exchange rate between U.S. dollars and British pounds should tend to move toward:
LO3
a. $2 = £1.
b. $1 = £2.
c. $4 = £1.
d. $1 = £4.
Chapter 41 – The Balance of Payments, Exchange Rates, and Trade Deficits
41-9
5. Suppose that the Fed is fixing the dollar-pound exchange rate at $2.50 = £1. If the Fed’s reserve
of pounds falls by £500 million, by how much would the supply of dollars increase, all other
things equal? LO4
6. Diagram a market in which the equilibrium dollar price of 1 unit of fictitious currency zee (Z)
is $5 (the exchange rate is $5 =Z1). Then show on your diagram a decline in the demand for zee.
LO4
a. Referring to your diagram, discuss the adjustment options the United States would have in
maintaining the exchange rate at $5 = Z1 under a fixed-exchange-rate system.
b. Suppose that the Fed’s FX reserves increase by 40 million zees as a result of the decline in
demand. How many millions of dollars worth of bonds will the Fed have to sell in order to
sterilize the accompanying increase in the domestic money supply?
Chapter 41 – The Balance of Payments, Exchange Rates, and Trade Deficits
41–10
7. Suppose that the government of China is currently fixing the exchange rate between the U.S.
dollar and the Chinese yuan at a rate of $1 = 6 yuan. Also suppose that at this exchange rate, the
people who want to convert dollars to yuan are asking to convert $10 billion per day of dollars
into yuan, while the people who are wanting to convert yuan into dollars are asking to convert 36
billion yuan into dollars. What will happen to the size of China’s official reserves of dollars?
LO4
a. Increase.
b. Decrease.
c. Stay the same.
8. Suppose that a country follows a managed-float policy but that its exchange rate is currently
floating freely. In addition, suppose that it has a massive current account deficit. Other things
equal, are its official reserves increasing, decreasing, or staying the same? If it decides to engage
in a currency intervention to reduce the size of its current account deficit, will it buy or sell its
own currency? As it does so, will its official reserves of foreign currencies get larger or smaller?
LO5
Chapter 41 – The Balance of Payments, Exchange Rates, and Trade Deficits
41–11
9. If the economy booms in the United States while going into recession in other countries, the
U.S. trade deficit will tend to ______. LO6
a. Increase.
b. Decrease.
c. Remain the same.
10. Other things equal, if the United States continually runs trade deficits, foreigners will own
________ U.S. assets. LO6
a. More and more.
b. Less and less.
c. The same amount of.
Chapter 41 – The Balance of Payments, Exchange Rates, and Trade Deficits
41–12
PROBLEMS
1. Alpha’s balance-of-payments data for 2016 are shown below. All figures are in billions of
dollars. What are the (a) balance on goods, (b) balance on goods and services, (c) balance on
current account, and (d) balance on capital and financial account? Suppose Alpha sold $10 billion
of official reserves abroad to balance the capital and financial account with the current account.
Does Alpha have a balance-of-payments deficit or does it have a surplus? LO2
Chapter 41 – The Balance of Payments, Exchange Rates, and Trade Deficits
41–13
2. China had a $214 billion overall current account surplus in 2012. Assuming that China’s net
debt forgiveness was zero in 2012 (its capital account balance was zero), by how much did
Chinese purchases of financial and real assets abroad exceed foreign purchases of Chinese
financial and real assets. LO2
3. Refer to following table, in which Qd is the quantity of yen demanded, P is the dollar price of
yen, Qs is the quantity of yen supplied in year 1, and Qs‘ is the quantity of yen supplied in year 2.
All quantities are in billions and the dollar-yen exchange rate is fully flexible. LO3
a. What is the equilibrium dollar price of yen in year 1?
b. What is the equilibrium dollar price of yen in year 2?
c. Did the yen appreciate or did it depreciate relative to the dollar between years 1 and 2?
d. Did the dollar appreciate or did it depreciate relative to the yen between years 1 and 2?
e. Which one of the following could have caused the change in relative values of the dollar and
yen between years 1 and 2: (1) More rapid inflation in the United States than in Japan; (2) an
increase in the real interest rate in the United States but not in Japan; or (3) faster growth of
income in the United States than in Japan.
Chapter 41 – The Balance of Payments, Exchange Rates, and Trade Deficits
41–14
Feedback: a. What is the equilibrium dollar price of yen in year 1?
c. Did the yen appreciate or did it depreciate relative to the dollar between years 1 and 2?
d. Did the dollar appreciate or did it depreciate relative to the yen between years 1 and 2?
e. Which one of the following could have caused the change in relative values of the
4. Suppose that the current Canadian dollar (CAD) to U.S. dollar exchange rate is $.85 CAD = $1
US and that the U.S. dollar price of an Apple iPhone is $300. What is the Canadian dollar price of
an iPhone? Next, suppose that the CAD to US dollar exchange rate moves to $.96 CAD = $1 US.
What is the new Canadian dollar price of an iPhone? Other things equal, would you expect
Canada to import more or fewer iPhones at the new exchange rate? LO3
Chapter 41 – The Balance of Payments, Exchange Rates, and Trade Deficits
41–15
5. Return to problem 3 and assume that the exchange rate is fixed at 110. In year 1, what would
be the minimum initial size of the U.S. reserve of loonies such that the United States could
maintain the peg throughout the year? What about the minimum initial size that would be
necessary at the start of year 2? Next, consider only the data for year 1. What peg should the U.S.
set if it wants the fixed exchange rate to increase the domestic money supply by $1.2 trillion?
LO6