Economics Chapter 19 Homework Us Economy Recent Years 10 Important Note

Chapter 19 (17 Micro)

International Finance and the Foreign Exchange Market

OUTLINE

I. Foreign Exchange Market

A. Market where one currency is trade for another.

B. The exchange rate enables people one country to translate the prices of foreign goods

into units of their own currency.

C.

will make foreign goods more expensive.

II. Determinants of the Exchange Rate

A. Under a flexible rate system, exchange rate is determined by supply and demand.

2. The supply of foreign exchange originates from sales of goods, services, and assets

from Americans to foreigners.

3. The foreign exchange market will bring the quantity demanded and quantity

III. Why Do Exchange Rates Change?

A. The following factors will cause a currency to depreciate:

2.

4. A shift toward sound policies that attract an inflow of capital

B. The following factors will cause a currency to appreciate:

2. Lower inflation than

4. A shift toward unsound policies that cause an outflow of capital.

IV. International Finance and Alternative Exchange Rate Regimes

A. There are three major types of exchange rate regimes: (1) flexible rates, (2) fixed- rate,

unified currency, and (3) pegged exchange rates.

B. Examples of Fixed Rate, Unified System. Eleven nations of the European Union have

C. Pegged Rate Systems

1. A nation can either (a) follow an independent monetary policy and allow its

exchange rate to fluctuate or (b) tie its monetary policy to the maintenance of the

172 Chapter 19 (17 Micro)/International Finance and the Foreign Exchange Market

V. Balance of Payments

A. Any transaction that creates a demand for foreign currency (and a supply of the

domestic currency) in the foreign exchange market is recorded as a debit, or minus,

item. Imports are an example of a debit item.

B. Transactions that create a supply of foreign currency (and demand for the domestic

D. Current Account Transactions

1. Current Account: All payments (and gifts) related to the purchase or sale of goods

and services and income flows during the current period.

2. The four categories of current account transactions are:

E. Capital Account Transactions

1. Capital Account: transactions that involve changes in the ownership of real and

F. Under a pure flexible-rate system, official reserve transactions are zero; therefore, a

current-account deficit implies a capital-account surplus. Similarly, a current-account

surplus implies a capital-account deficit.

VI. Exchange Rates, Current Account Balance, and Capital Inflow

A. Are Trade Deficits Good or Bad?

1. With flexible exchange rates, an inflow of capital implies a trade (current account)

deficit.

2. is likely to result in a net

inflow of capital and trade deficit.

3. However, if the inflow of capital is used to finance current consumption or for the

finance of unproductive projects, it will exert an adverse impact on future income.

Chapter 19 (17 Micro)/International Finance and the Foreign Exchange Market 173

E. Should Trade Between Countries Balance?

1. Political leaders often imply that U.S. exports to a country, China or Japan for

example, should be approximately equal to our imports from that country.

2. Under a flexible exchange rate system, overall purchases from foreigners will

balance with overall sales to foreigners, but there is no reason why bilateral trade

between any two countries will balance.

3.

a. trade surpluses with trading partners that buy a lot of goods that it supplies at a

low cost, and,

OBJECTIVES

Trade between nations involves the exchange of currencies as well as the exchange of goods. This

exchange of currencies gives rise to a special market the foreign exchange market. In this chapter,

to other

currencies (the exchange rate) on the foreign exchange market.

This chapter analyzes the operation of a flexible exchange rate system. The impact of changes

in the growth of income, inflation rates, and interest rate on the foreign exchange market are

considered. The effects of monetary and fiscal policy under a flexible exchange rate system are

discussed.

The chapter also provides a discussion of the other two types of exchange-rate regimes: (1)

fixed-rate, unified currency, and (2) pegged exchange rates.

The chapter also includes an exploration of balance of payments accounts the classification

of debit and credit items in the balance of payments accounts. The major purpose of this chapter is

to promote student understanding of the special problems that arise when goods are exchanged by

trading partners who use different currencies.

IMPORTANT POINTS AND TEACHING SUGGESTIONS

2. When you explain the determination of exchange rates, frequent examples will promote student

understanding. Use them freely. When U.S. customers purchase cars, steel, ownership shares

3. Depreciation (and appreciation) are easily confused. When the dollar price of a foreign

currency increases, more dollars will be needed to buy units of the foreign currency (and

4. Students sometimes confuse a currency depreciation with inflation. A 10 percent depreciation

5. In order to avoid confusion, it is easiest to visualize investment abroad not as the export of

6. The Thumbnail Sketch summarizes the major factors that will cause either an appreciation or

7. With the shift from fixed to flexible exchange rates, the balance of trade and balance on current

account assumes greater significance. Explain why the balance on current account helps to

8.

9. Be sure to emphasize that the balance of payments must balance. Under a flexible exchange

system (official reserve balance equals zero), this means that a nation running a capital account

10. It is important to note that exchange rates are always moving in the wrong direction for

11. One interesting classroom illustration involves the impact of a change in oil prices on exchange

rates. Oil is priced internationally in dollars. In the early 1980s, as oil prices in dollars went

12. Be sure to review the non-flexible exchange rate regimes. It is worth mentioning that eleven

nations of the European Union have recently adopted a unified currency system. An alternative

13. Games 1 to 3 will help reinforce the material in chapter 18.

14. Critical Analysis Question 5 provides material that should help students understand the

determinants of exchange rates. Questions 2, 7, 9, 13, and 15 provide material suitable for a

176 Chapter 19 (17 Micro)/International Finance and the Foreign Exchange Market

GAMES

1. International Beer Consumption

Type: In-Class demonstration

Topics: exchange rates

Textbook: Chapter 18 International Finance and the Foreign Exchange Market

Materials Needed: three imported beers, foreign currency

Time: 3 minutes

Class limitations: works in any size class

Purpose

This demonstration introduces exchange rates.

Instructions

Put the beers on the podium.

Points for discussion

The answer is obviously: pay in U.S. dollars, but the markets behind that are interesting.

2. A Profitable Opportunity

Type: In-Class Assignment

Topics: exchange rates, arbitrage

Textbook: Chapter 18 International Finance and the Foreign Exchange Market

Materials Needed: none

Time: 20 minutes

Class limitations: works in any size class

Purpose

This assignment requires students to practice calculating prices with exchange rates and looking

for profit opportunities. The numbers used in this example are actual transaction prices from 1990.

Instructions

is produced in Canada, and sold in many

countries. In the province of Ontario, a six-

the border in Michigan, a six pack of the same beer was on sale for $2.75 U.S. At the time, the

exchange rate was $0.75 U.S. = $1.00 Canadian.

Ask the class to make the following calculations.

1) How much would it cost in U.S. currency to buy the beer in Ontario?

2) How much would it cost in Canadian currency to buy the beer in Michigan?

3) Is there an arbitrage opportunity?

4) If there is an arbitrage opportunity where would you buy and where would you sell? How

much profit could you expect on a six-pack?

5) Why might the price differential exist?

Common answers and points for discussion

1) How much would it cost in U.S. currency to buy the beer in Ontario?

2) How much would it cost in Canadian currency to buy the beer in Michigan?

3) Is there an arbitrage opportunity?

4) If there is an arbitrage opportunity where would you buy and where would you sell? How

much profit could you expect on a six-pack?

178 Chapter 19 (17 Micro)/International Finance and the Foreign Exchange Market

5) Why might the price differential exist?

This is a substantial price difference. Neither transportation costs, nor duties and tariffs can

3. Comparing International Prices

Type: Take-home Assignment

Topics: exchange rates, arbitrage, purchasing power parity

Textbook: Chapter 18 International Finance and the Foreign Exchange Market

Class limitations: works in any size class

Purpose

This assignment has students practicing working with exchange rates and comparing prices in two

countries. The numbers used in this example are actual prices from 1997.

Instructions

Chapter 19 (17 Micro)/International Finance and the Foreign Exchange Market 179

Name ___________________________________ Principles of Economics

International Price Comparisons

1. Go to a local store and find prices for ten (or more) of the goods shown below.

2. Use the exchange rate of $1.00 US = 14 Dominican Pesos to compare the prices in each

country.

3. Circle the three items with the largest price differences.

4. Why might prices differ?

Price in Santo Calculate local price

Domingo, DR (U.S. dollars) for price

Product (Dominican Pesos) comparison

avocado 5.45 ___________

rice, 1 pound 5.45 ___________

beer, 6-pack 59.95 ___________

rum, 700 cc 42.75 ___________

Tanquery Gin, 750 ml 189.00 ___________

15.95 ___________

29.95 ___________

Pepperidge Farm Cookies, 6 oz 36.95 ___________

corn oil, 96 oz 75.95 ___________

butter, 1/4 pound 7.95 ___________

hot dog rolls, 8 rolls 14.00 ___________

180 Chapter 19 (17 Micro)/International Finance and the Foreign Exchange Market

Common Answers and points for discussion

Price in Santo Calculate local price

Domingo, DR (U.S. dollars) for price

Product (Dominican Pesos) comparison

avocado 5.45 $0.39

rice, 1 pound 5.45 0.39

beer, 6-pack 59.95 4.28

rum, 700 cc 42.75 3.05

Tanquery Gin, 750 ml 189.00 13.50

29.95 2.13

Pepperidge Farm Cookies, 6 oz 36.95 2.63

Corn oil, 96 oz 75.95 5.45

butter, 1/4 pound 7.95 0.56

HINTS FOR ANSWERING CRITICAL ANALYSIS QUESTIONS

1. The Japanese cameras will become more expensive, and the quantity purchased by Americans

will decline.

6. Under a flexible exchange rate system, a deficit on current account implies a surplus on capital

account. Is it a dangerous thing if the United States runs a surplus on its capital account

transactions (and therefore a deficit on current account) because foreigners find investment

opportunities in the United States attractive?

11. The current-account balance will move toward a larger deficit (or smaller surplus), and the

12. Not necessarily. It depends on the source of the trade surplus. When a country has a high rate

of saving, a strong export sector will be required for the profitable investment of the saving. In