CHAPTER 20
INTERNATIONAL FINANCE
In this chapter, you will find:
Learning Outcomes
Chapter Outline with PowerPoint Script
Chapter Summary
Teaching Points (as on Prep Card)
Solutions to Problems Appendix
Experiential Assignments
INTRODUCTION
This chapter examines the workings of the foreign exchange market, starting with a discussion of the
balance of payments mechanism. After covering the various trade balance concepts on current and
financial account flows as well as their implications for measurement of trade surpluses or deficits, the
chapter moves to the determination of foreign exchange rates in a flexible rate system. The concept of
LEARNING OUTCOMES
20-1 Summarize the major accounts in the balance of trade, and explain how they balance out.
The balance of payments reflects all economic transactions between one country and the rest of the
20-2 Describe how the foreign exchange rate is determined using supply and demand curves and ex-
plain the shapes of the curves.
Because the exchange rate is usually a market price, it is determined by demand and supply. The
equilibrium exchange rate is one that equates quantity demanded with quantity supplied (see the dia-
grams below).
20-3 Describe the purchasing power parity theory.
According to the theory of purchasing power parity (PPP), the exchange rate between two countries
20-4 Trace the evolution of exchange rate regimes from the gold standard to the current system.
From 1879 to 1914, the international financial system operated under a gold standard, whereby the
major currencies of the world were convertible into gold at a fixed rate. During World War I, many
Chapter 20 International Finance 270
CHAPTER OUTLINE WITH POWERPOINT SCRIPT
USE POWERPOINT SLIDES 2-18 FOR THE FOLLOWING SECTION
Balance of Payments
International Economic Transactions: The balance of payments measures economic transactions
between a country and the rest of the world, whether these transactions involve goods and services, real
and financial assets, or transfer payments.
The Merchandise Trade Balance: The value of merchandise exports minus the value of merchandise
imports.
• Net unilateral transfers abroad: Unilateral transfers received from abroad by U.S. residents minus
unilateral transfers sent to foreign residents by U.S. residents.
• Balance on current account: The sum of the country’s net unilateral transfers and net exports of
goods and services and net income from assets owned abroad.
The Financial Account: Records a country’s international purchases of assets, including financial
assets—such as stocks, bonds, and bank balances—and real assets such as land, housing, factories, and
other physical assets.
USE POWERPOINT SLIDES 19-20 FOR THE FOLLOWING SECTION
Foreign Exchange Rates and Markets
• Foreign Exchange: Foreign money needed to carry out international transactions.
• Exchange Rate: The price measured in one country’s currency of buying one unit of another
country’s currency.
USE POWERPOINT SLIDE 21 FOR THE FOLLOWING SECTION
The Demand for Foreign Exchange: The inverse relationship between the dollar price of foreign
exchange and the quantity of foreign exchange demanded, other things constant.
USE POWERPOINT SLIDES 22-25 FOR THE FOLLOWING SECTION
The Supply of Foreign Exchange: The positive relationship between the dollar price of foreign exchange
USE POWERPOINT SLIDE 26 FOR THE FOLLOWING SECTION
Chapter 20 International Finance 271
Arbitrageurs and Speculators
• Arbitrageur: A dealer who takes advantage of any difference in exchange rates between markets by
USE POWERPOINT SLIDES 27-28 FOR THE FOLLOWING SECTION
Purchasing Power Parity: The theory that the exchange rate between two countries will adjust in the long
USE POWERPOINT SLIDE 29 FOR THE FOLLOWING SECTION
Flexible Exchange Rates: Exchange rates determined by demand and supply.
USE POWERPOINT SLIDES 30-32 FOR THE FOLLOWING SECTION
Fixed Exchange Rates: Exchange rates are fixed, or pegged, within a narrow band around the particular
USE POWERPOINT SLIDES 33-35 FOR THE FOLLOWING SECTION
Development of the International Monetary System
• Gold standard: An arrangement by which major currencies were convertible into gold at a fixed rate.
CHAPTER SUMMARY
The balance of payments reflects all economic transactions between one country and the rest of the world.
The current account measures flows from (a) goods; (b) services, including consulting and tourism;
income from holdings of foreign assets; and (c) unilateral transfers, or public and private transfer
payments to and from foreign residents. The financial account measures international transactions in real
and financial assets.
Chapter 20 International Finance 272
Under a system of fixed exchange rates, monetary authorities try to stabilize the exchange rate, keeping it
between a specified ceiling and floor value. A country may try to hold down the value of its currency, so
TEACHING POINTS
1. Students typically have preconceptions about international finance. Some believe that the laws of
supply and demand are somehow mysteriously suspended and that a handful of people control the
2. By distinguishing between current and financial account balances within the overall balance-of-
payments mechanism, you can easily discuss the reasoning underlying the so-called twin deficits
SOLUTIONS TO PROBLEMS APPENDIX
1. (Balance of Payments) The following are hypothetical data for the U.S. balance of payments.
Use the data to calculate each of the following:
a. Merchandise trade balance
b. Balance on goods and services
c. Balance on current account
d. Capital account balance
e. Statistical discrepancy
Billions of Dollars
Merchandise exports 350.0
Merchandise imports 2,425.0
Service exports 170.0
Service imports 2,145.0
Net income and net transfers 221.5
Outflow of U.S. capital 245.0
Inflow of foreign capital 100.0
Chapter 20 International Finance 273
a. –$2,075.0 billion
2. (Balance of Payments) Explain where in the U.S. balance of payments an entry would be
recorded for each of the following:
a. A Hong Kong financier buys some U.S. corporate stock.
b. A U.S. tourist in Paris buys some perfume to take home.
c. A Japanese company sells machinery to a pineapple company in Hawaii.
d. U.S. farmers make a gift of food to starving children in Ethiopia.
e. The U.S. Treasury sells a bond to a Saudi Arabian prince.
f. A U.S. tourist flies to France on Air France.
g. A U.S. company sells insurance to a foreign firm.
a. Capital inflows
3. (Determining the Exchange Rate) Use these data to answer the following questions about the
market for British pounds:
Quantity Quantity
Demanded Supplied
Price of pounds (in $) (of pounds) (of pounds)
$4.00 50 100
3.00 75 75
2.00 100 50
a. Draw the demand and supply curves for pounds, and determine the equilibrium exchange
rate (dollars per pound).
b. Suppose that the supply of pounds doubles. Draw the new supply curve.
c. What is the new equilibrium exchange rate?
d. Has the dollar appreciated or depreciated?
e. What happens to U.S. imports of British goods?
Chapter 20 International Finance 274
a. The following graph illustrates supply and demand curves for British pounds.
4. (Purchasing Power Parity Theory) What is the purchasing power parity theory. Is it a short-
run or a long-run theory? Why may it not always work?
According to the theory of purchasing power parity (PPP), the exchange rate between two
5. (Exchange Rate Regimes) Briefly trace the exchange rate regimes beginning with the gold
standard up to our current system.
From 1879 to 1914, the international financial system operated under a gold standard,
whereby the major currencies of the world were convertible into gold at a fixed rate. During
6. (Exchange Rates) Discuss the differences between a flexible exchange rate and a fixed ex-
change rate. What measures can the government take to maintain fixed exchange rates?
Flexible exchange rates are determined by demand and supply and continually adjust based on
the forces at work in foreign exchange markets. At the same time, so long as exchange rates
remain flexible, federal governments have little direct influence in foreign exchange markets.
Chapter 20 International Finance 275
Under these circumstances, debits in the financial accounts result in depreciation of the local
currency, while credits in the financial accounts result in appreciation of the local currency.
7. (The Current System: Managed Float) What is a managed float? What are the disadvantages of
freely floating exchange rates that led countries to the managed float system?
Under the managed float system, exchange rates generally fluctuate with changes in supply and
demand for foreign exchange. However, sporadic intervention by the central banks is used to
Experiential Assignments
1. Trade among European nations has been bolstered by the introduction of the euro in 2002. Have
2. The latest data on exchange rates appear in the “Currency Trading” column in the Money and In-
vesting section of the daily Wall Street Journal. Have students try tracking a particular foreign
currency over the course of several weeks. Has the dollar been appreciating or depreciating relative to
that currency? Try to explain why it has been appreciating or depreciating.