CHAPTER 4
The International Flow of Funds and Exchange Rates
Chapter Outline
• Introduction
• The Balance of International Payments
• The Current Account
o Trade Balance
o Services Balance
o Income Balance
o Balance of Transfers
o Current Account Balance
• The Financial Account
o Foreign Direct Investment
o Security Investments
o Statistical Discrepancy
• World Trade and the Balance of Payments
• The Foreign Exchange Market
• The Exchange Rate
• Components of the Foreign Exchange Market
• International Monetary Systems
• Money and Inflation
• The Bretton Woods System
• The Flexible Exchange Rate System
• The European Euro
• Hard and Soft Currencies
• International Flows of Goods and Capital
• Purchasing Power Parity
o The Big Mac Index
o Inflation and PPP
o Problems with PPP
• Interest Rate Parity
o Problems with IRP
• Forecasting Exchange Rates
Teaching Objectives
After covering this chapter, the student should be able to:
• Explain the balance of payments for a country.
• Describe the foreign exchange market and its components.
• Discuss the development of international monetary systems.
• Explain exchange rate changes over time.
• Forecast exchange rates using different methodologies.
COMPREHENSIVE LECTURE OUTLINE
I. Introduction. World economic and financial markets have become increasingly
integrated. Balance of payments accounts document trade and finance interactions between
countries. This chapter discusses international trade patterns, examines the foreign exchange
market, and discusses the behavior of international currencies.
CLASS ACTIVITY: Use the Cultural Perspective case as an opportunity to allow students to
explore the impact of the financial crisis of 2008–2009 on the value of the dollar. Exhibit 4.1 •
The Dollar to Euro Exchange Rate
II. The Balance of International Payments. Balance of Payments (BOP) refers to a
statement of account that summarizes all transactions between the residents of one country and
the rest of the world for a given period of time.
• A country’s BOP is an objective standard that shows how well the country’s
economy and government policies are performing.
• BOP is generally split into two major components: the current account and the
financial account.
• Analyzing the BOP statistics is based upon the “flow of funds” analysis,
where money moving into a country is a credit, while money leaving the
country is a debit. Exhibit 4.2 • U.S. Balance of Payments.
• The Current Account of the BOP is largely driven by activities of consumers
and business. It consists of four subaccounts, which add up to give the current
account balance:
• Trade Balance is the net of merchandize exports and merchandize
imports. When a country imports more than it exports, it has a
merchandize trade deficit. Exhibit 4.3 • Top Ten Countries Trading
with the U.S.
• Services Balance is the net of exports of services and imports of services.
A surplus in the services balance will indicate that a country is competitive
in its services industry. The U.S. is primarily a service economy, with
services provided for customers in other countries comprising more of its
exports.
• Income Balance is the net of investment income from abroad and
investment income paid to foreigners.
• Balance of Transfers is the net transfer payments between countries
based on outflows and inflows.
• Current Account Balance. The sum of these subaccounts equals the
current account balance, which is more important than the trade balance.
• The Financial Account shows how the country’s current account balance is
financed. Exhibit 4.4 • U.S. Financial Account. The financial account of the
BOP consists of three subaccounts: U.S.-owned assets abroad, foreign-owned
assets in the U.S., and financial derivatives.
• Foreign Direct Investment encompasses the purchases of fixed assets
abroad used in the manufacture and sales of goods and services for local
consumption or exports. The flow of FDI is dictated by opportunities to
earn profit overseas.
• Security Investments also have a significant impact on the BOP’s
financial account. Financial capital flows between countries in search of
higher rates of return on foreign stocks and bonds. Capital flows generally
represent investments for the long term. Central banks hold foreign
exchange of major countries as part of their reserves in addition to their
local currency. In addition, large financial institutions finance international
trade. These security investment inflows and outflows of funds affect a
country’s BOP.
• The Statistical Discrepancy line item in BOP statistics reconciles any
imbalance to ensure that all debit and credit entries in the BOP statement
sum to zero. This line captures statistical inconsistencies in the recording
of the credit and debit entries as well as illegal trade.
• World Trade and the BOP. Exhibit 4.5 • Growth in World Merchandize
Trade by Selected Region and Economy [missing this heading in actual
figure] shows world trade patterns. Asian countries’ exports are growing the
fastest. The U.S. has slowed its import growth from 4% to only 0.5% and has
increased its exports in recent years. Europe is a net exporter with exports and
imports growing at an average of 3.5% and 3%, respectively. Over the past 6
years, the growth of international trade has been driven by world economic
growth as well as the elimination of barriers to trade.
DISCUSSION STARTER: REALITY CHECK 1.
Have you ever thought you had some money left over but did not? You started with $20 in
cash that was gradually spent on coffee and a few everyday items you picked up at the store.
When you went to see a movie at a local theatre, you unexpectedly did not have enough cash
left to buy a ticket and had to borrow some cash from a friend. How was your current account
and financial account affected by these transactions, specifically balance of payments? How
can you explain the shortage of cash?
III. The Foreign Exchange Market. The exchange of currencies takes place in foreign
exchange markets which consist of a network of international banks and currency traders. The
three largest foreign exchange markets are in London, New York, and Tokyo, each of them
catering to the foreign exchange needs of certain regions of the world. The foreign exchange
market is a 24-hour market with international financial institutions connected by means of
sophisticated telecommunications systems that enable instant, real time exchange rate quotations.
The function of the foreign exchange market is to facilitate international trade and investment.
Hence, there is a close relationship between the balance of payments and foreign exchange rates.
• The Exchange Rate. An exchange rate is a price at which one currency can be
converted to another currency. In a free-market-oriented foreign exchange market,
major currency values are determined by the demand for and supply of currencies,
known as an independent floating exchange rate system. The values of some
currencies are determined by the managed floating exchange rate system, when a
currency’s value depends partly upon demand and supply in the foreign exchange
market and partly on active government intervention in the foreign exchange market.
A fixed exchange rate system is one in which the country pegs its currency at a fixed
rate to a major currency or basket of currencies and the exchange rate fluctuates
within a narrow margin around a central rate.
ETHICAL PERSPECTIVES: Is the Chinese Renminbi Undervalued? Use the Ethical
Perspectives case as an opportunity to discuss the impact of undervalued Chinese currency—
yuan or renminbi—on the balance of payments of China, the U.S., and Europe.
Questions:
1. Why is an undervalued Chinese yuan an ethical issue? Who benefits? Who suffers?
Explain. Answer: It is an ethical issue, because the valuation of the yuan affects the
2. What would be a workable solution to the yuan valuation debate? Is there a solution that
would allow all parties to benefit? Answer: The most favorable outcome would be a
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gradual revaluation of the yuan with an eventual goal of a managed floating exchange
rate system. Revaluation of the yuan would reduce the overly rapid growth of the Chinese
economy. In the U.S., reining in government deficit spending and increasing saving
would help to reduce the risk of inflation that could trigger further current account
deficits due to high domestic prices.
• Components of the Foreign Exchange Market. The forex market consists of spot,
forward, and future markets. The spot market trades currencies on a real time basis
for immediate delivery. The forward market enables purchases and sales of
currencies in the future with prices established at a previous time. Firms use the
forward market to lock in future exchange rates and ensure against uncertain future
currency movements.
DISCUSSION STARTER: REALITY CHECK 2.
Browse the Internet and find the spot rate for EUR/USD. If the one-month forward rate was
1.40 EUR/USD, would the dollar be selling at a discount or premium relative to the spot rate?
IV. International Monetary Systems. Over time, various international monetary systems
have developed to facilitate international trade. Governments around the world have worked
together to promote stable exchange rates and world trade.
• Money and Inflation. Many governments have used money to meet the political goals of
stimulating economic growth and providing employment for citizens. Printing more
money could increase economic activity. Excess supplies of money could cause inflation:
When the supply of money exceeds the demand for goods and services, the prices of
goods and services can rise.
• The Bretton Woods System. In 1944, the Bretton Woods Agreement established a
global currency system based on a gold standard with the U.S. dollar pegged at a fixed
rate of exchange to gold in an effort to control inflation. After World War II, the U.S.
dollar became a standard of value for all world currencies, and the currencies of 43 other
countries were fixed to the dollar. The International Monetary Fund (IMF) was
established under the Bretton Woods Agreement to help ensure the stability of the
international monetary and financial system. It seeks to foster the smooth functioning of
the international monetary system, provide emergency funds as a lender of last resort to
countries with BOP problems, and offer financing to countries conditional on
recommended economic changes. Member countries contribute to the fund in return for
temporary access to pooled resources. Over time, the U.S. dollar became overvalued.
Major nations met to consider abandoning the Bretton Woods agreement. Under the
resulting Smithsonian Agreement in December 1971, the U.S. devalued the dollar against
other countries’ currencies. In August 1974, the U.S. closed the gold window and
relinquished the dollar-gold exchange standard. In January 1976, IMF members adopted
the Jamaica Agreement. Its key principles were:
o Members could adopt their own exchange systems
o A system of global fixed exchange rates would only be implemented if approved
by a vote of 85% of the membership
o Gold would no longer be a common denominator of the monetary system
o The special drawing right (SDR) created by the IMF was recommended as the
primary reserve asset of the international monetary system. Today the SDR is a
basket of currencies consisting of dollars, euros, pounds, and yen, with relative
weights set by the IMF based on trade patterns.
• The Flexible Exchange Rate System. After 1971, a flexible exchange rate system began
to emerge with market forces of supply and demand determining the prices of different
currencies. A clean float currency has minimal government intervention, and with few
exceptions, is market determined. A dirty float currency has varying degrees of
government intervention to maintain a range of acceptable values against other
currencies. Some countries practice dollarization by using the dollar or some other
foreign currency together with or instead of a domestic currency. Dollarization can be
unofficially adopted by citizens in a country or officially approved by a country as legal
tender in transactions.
• The European Euro. The European community established the European Exchange
Rate Mechanism (ERM) in 1979. Under ERM, a weighted basket of European currencies
known as the ECU (European Currency Unit) was defined based on a managed-float
system with fixed exchange rates varying within 2.25% margins. European nations
formed the European Monetary Union (EMU) in 1999. The EMU introduced the euro as
a new currency to replace the currencies of the member countries in the Eurozone. In
2002, euro coins and notes were distributed. For countries using the euro, problems of
currency fluctuations, inflation, and related economic downturns were substantially
reduced. For individual European consumers and businesses, the euro put an end to the
expensive and time-consuming need to convert one currency to another. By 2009, 17
countries had joined the Eurozone. The European Central Bank (ECB) and Eurosystem of
central banks in Eurozone countries maintain responsibility for managing the euro. It is
expected that the Eurozone will continue to expand in the future.
• Hard and Soft Currencies. Hard currencies are used by emerging market countries to
peg the values of the soft currencies. Even though each hard currency is fairly stable
within its own region, its value can considerably fluctuate against its counterparts around
the world.
DISCUSSION STARTER: REALITY CHECK 3.
China’s currency, the “renminbi,” is denominated in yuan units. The yuan is pegged to a
basket of world currencies. What if China freely floated the yuan? How would the dollar to
yuan exchange rate be affected? In evaluating this possibility, take into account that the U.S.
imports large quantities of Chinese exports.
V. International Flows of Goods and Capital. World trade and foreign investment have
expanded over the past 100 years. According to the law of one price, identical goods should sell
for the same price in different countries according to the local currencies. If the law of one price
does not hold, one could make arbitrage profits by purchasing goods in one country and selling
them in the other country.
• Purchasing Power Parity. The law of one price is the underlying principle of
purchasing power parity (PPP) theory. By comparing the prices of identical goods in
different countries, assuming efficient markets that arbitrage away price differences, the
real or PPP exchange rate can be computed.
o The Big Mac Index. In 1986, The Economist began publishing the Big Mac
Index based upon the McDonalds’ restaurant sandwich and consisting of a
number of goods. The Economist computes the parity ratio of foreign cost to U.S.
cost. This ratio should be 1 under PPP. Differential costs of the Big Mac over
time and across nations should be related to changes in currency values as PPP
tends to push prices up or down to one price.
o Inflation and PPP. PPP posits that exchange rate changes are explained by
relative prices across countries. Empirical tests of PPP have found mixed results.
While PPP appears to hold for periods exceeding five years, it may not hold in
shorter periods. For countries with large price disparities due to inflation or other
reasons, PPP is predictive of exchange rate movements. For other countries with
little difference in inflation rates, PPP is less reliable. Some of the problems that
explain the failure of PPP include transportation costs and trade barriers,
government interventions, and MNCs with pricing power on a global basis. The
value of a country’s currency is attributable to more than the difference in price
levels between countries. Market expectations about economic growth, global
competitiveness, monetary and fiscal policy, and many other factors could affect
a country’s currency value.
• Interest Rate Parity (IRP). Relative interest rates on financial securities are another
possible determinant of exchange rate changes. Under the law of one price, the rates of
return on different countries’ government bonds of similar maturity and risk should be
comparable. According to interest rate parity theory, the interest rate on such bonds
should be the same. Otherwise there would be arbitrage opportunities for investors to
purchase the higher interest rate bond and sell the lower interest rate bond to make
riskless profits. According to the uncovered interest rate parity theory, it is possible that
the expected future spot rate is not equal to the forward exchange rate. This difference is
possible if a risk premium exists in expected future spot rates due to risk-averse investor
behavior. IRP argues that the interest rate earned on assets in different countries will tend
toward equality after taking into account exchange rate changes. If IRP does not hold,
global capital flows will take place to arbitrage away excess profit opportunities in
international investments.
o Problems with IRP. Empirical evidence on IRP theories is mixed. Transaction
cost is one possible impediment to IRP. As the investment time horizon
increases, deviations from IRP may be more likely due to political risk, legal
restrictions, tax effects, managed-float exchange rate regimes, and other
unpredictable circumstances. Additionally, market psychology can play a role in
exchange rate movements. While IRP may not strictly hold at all times, market
efficiency due to traders seeking arbitrage profits would tend to cause relative
interest rates and exchange rates between countries to change in integrated
financial markets.
ECONOMIC PERSPECTIVES: The Asian Currency Crisis. Use the Economic Perspectives
case as an opportunity to discuss the causes of the Asian Currency Crisis of the 1990s.
Suggestion: You could ask students to do this case as individuals or in teams as a class activity.
Have the students read the case presented in the text and answer the questions at the end of the
case.
Questions:
1. What were the major causes of the economic bubble in Thailand? What lessons can be
learned from this bubble? Answer: The economy of Thailand was growing more rapidly
2. Why did problems in Thailand contagiously affect other Asian countries? Why does the
fall in a country’s currency affect its stock market? Answer: The panic in Thailand
DISCUSSION STARTER: REALITY CHECK 4.
Browse the Internet and find the latest Big Mac Index data. What does the data show in terms
of the value of the dollar relative to the euro, pound, and yen? Are these currencies over- or
undervalued relative to the dollar?
VI. Forecasting Exchange Rates. The PPP and IRP theories can be used to forecast future
exchange rates. The forecasts of relative inflation rates can be used to estimate the future
exchange rate of domestic currencies to foreign currencies. Inflation forecasts are readily
available from private and public sources.
DISCUSSION STARTER: REALITY CHECK 5.
Some observers believe that large U.S. government deficits will lead to higher inflation in the
future. If this did happen, how could the PPP theory be used to forecast the impact of this
higher inflation on the value of the dollar?
Assignments
End-of-Chapter Discussion Questions
1. In the BOP accounts, what are the four basic components of the current
account? How can information about the financing of a country’s current
account be obtained? Answer: Trade balance is the net of merchandize
2. What is the difference between independent floating, managed floating,
and fixed exchange rate systems? Provide an example of a direct quote of
an exchange rate. Answer: In a free-market-oriented foreign exchange
3. Briefly describe the international monetary systems implemented under
the Bretton Woods, Smithsonian, and Jamaica Agreements. Answer: The
4. How can the Big Mac Index be used to make PPP comparisons between
countries? Using such comparisons, what can be learned about the future
possible direction of exchange rates between countries? Answer: The
5. Assume that the one-year U.S. Treasury bond rate is 3% and the similar
European government bond rate is 5%. Comparing these inflation rates,
could it be expected that the dollar will appreciate or depreciate against
the euro over the next year? If the spot rate is 1.50 dollars per euro, what
would be the forward rate? Answer: Using the equation (iUS – iE) = (F –
Mini-Case Synopsis and Questions
Questions:
1. How did Greece get into trouble with its government debt? Did joining the
Eurozone help them pay rising government debts? Explain your answers.
2. Should Greece exit the euro? How would it benefit? What could go wrong?
Point/Counterpoint, Interpreting Global Business News, and Portfolio Projects
Students’ answers to these assignments will vary widely. Their writing should
reflect an understanding of the chapter’s basic concept, thorough research, and
logic and critical thinking skills.