Chapter 21 – The Balance of Payments, Exchange Rates, and Trade Deficits
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Chapter 21 The Balance of Payments, Exchange Rates, and Trade Deficits
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 barter
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
imports. Hence, the foreign-currency assets earned through exports can be used to
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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. 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
International Monetary Fund, and stocks of gold. These reserves are owned by
governments or their central banks.
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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
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
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Answer: If the dollar depreciated relative to the franc, this means that it took more
dollars to get the francs necessary to buy a watch. In other words, the watch becomes
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
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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.
Answer:
(a) This statement is true. If high rates of economic growth mean that the real incomes
of a country’s citizens are rising more rapidly than in other countries, its imports will
rise more than its exports. The demand for foreign currency by its citizens will
9. “Exports pay for imports. Yet in 2009 the nations of the world exported about $379 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 sale of
10. 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. How would the U.S. balance-of-payments surplus that is caused by the decline in demand be
resolved under a system of flexible exchange rates?
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Answer: See the graph illustrating the market for zees.
11. 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. Does it also
necessarily have a balance-of -payments deficit? 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? Would that outcome indicate
a balance-of-payments deficit or a balance-of- payments surplus? LO4
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Answer: No, if the exchange rate is floating freely this market is adjusting to bring the
balance of payments into balance-no need for intervention (the current account deficit is
12. 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”? LO5
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 in U.S. imports. (2)
Large trade deficits with China have contributed, with incomes in China too low to result
13. 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?
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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
PROBLEMS
1. Alpha’s balance-of-payments data for 2010 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
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Feedback: Consider the following example. Alpha’s balance-of-payments data for 2010
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?
2. China had a $372 billion overall current account surplus in 2007. Assuming that China’s net
debt forgiveness was zero in 2007 (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
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Answer: -$372
Feedback: Consider the following example. China had a $372 billion overall current
account surplus in 2007. Assuming that China’s net debt forgiveness was zero in 2007
(its capital account balance was zero), by how much did Chinese purchases of financial
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.
Feedback: Consider the following example. 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.
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(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?
Since the price of the Yen increased (more dollars must now be given up to purchase one
(d) Did the dollar appreciate or did it depreciate relative to the yen between years 1 and
more Yen), the dollar depreciated.
(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
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
Feedback: Consider the following example. 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?
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5. Return to Problem 3 and assume the exchange rate is fixed against the dollar at the equilibrium
exchange rate that occurs in year 1. Also suppose that Japan and the United States are the only
two countries in the world. In year 2, what quantity of yen would the Japanese government have
to buy or sell to balance its capital and financial account with its current account? In what specific
account would this purchase or sale show up in Japan’s balance of payments statement: Foreign
purchases of assets in Japan or Japanese purchase of assets abroad? Would this transaction
increase Japan’s stock of official reserves or decrease its stock? LO5
Feedback: Consider the following example. Return to Problem 3 and assume the
exchange rate is fixed against the dollar at the equilibrium exchange rate that occurs in
year 1. Also suppose that Japan and the United States are the only two countries in the
world. In year 2, what quantity of yen would the Japanese government have to buy or sell
to balance its capital and financial account with its current account? In what specific
account would this purchase or sale show up in Japan’s balance of payments statement:
Foreign purchases of assets in Japan or Japanese purchase of assets abroad? Would this
transaction increase Japan’s stock of official reserves or decrease its stock?
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