Ch. 20
What is statistical discrepancy? What is it required to do?
"Fudge factor" Measure the error in the balance of payments Satisfies the double-entry bookkeeping requirement that total debits must equal total credits
When did the gold standard end?
1920s-1930s collapsed
What is the exchange rate usually?
A market price determined by demand and supply
Where must the necessary foreign exchange come from if the current account is in deficit?
A net inflow in the financial account Could borrow from foreigners, sell domestic stocks and bonds to foreigners, sell a steel plant in Pittsburgh or a ski lodge in Aspen to foreigners, etc
What does the foreign exchange result in when the current account is in surplus?
A net outflow in the financial account through lending abroad, buying foreign stocks and bonds, buying a shoe plant in Italy or a vila on the French Riviera, and so forth.
What should a given basket of internationally traded goods sell for?
About the same around the world
How are balance-of-payments accounts maintained?
According to the principles of double-entry bookkeeping Some entries are called credits, and others are called debits Total debits must equal total credits
What does the current asset account include?
All international transactions in currently produced goods and services, net income from foreign assets, and net unilateral transfers Negative: reflects a current asset deficit Positive: reflects a current account surplus, or zero
What is the foreign exchange market like?
An all-night diner The trading center is always open somewhere in the world
What happened after the dollar was allowed to float against the mark (German system)?
Bretton Woods system collapsed
Speculators
Buy or sell foreign exchange in hopes of profiting by trading the currency at a more favorable exchange rate later Aim to profit from market fluctuations (they try to buy low and sell high)
What is the managed float system?
Combines features of a freely floating exchanged rate with sporadic intervention by central banks as a way of moderating exchange rate fluctuations among the world's major currencies
What do flexible, or floating, exchange rates adjust?
Continually to the myriad forces that buffet foreign exchange markets
What is the International Monetary Fund (IMF)?
Created by the Bretton Woods Agreement -Set rules for maintaining the international monetary system, to standardize financial reporting for international trade, and to make loans to countries with temporary balance-of-payments problems
What does the current account (one of the major categories in the balance of payments) record?
Current flows of funds into and out of country, including imports and exports of goods and services, and net transfer payments from abroad.
Current transactions vs. financial transactions
Current- exports, imports, asset income, and unilateral transfers Financial- net purchases of foreign real and financial assets
Arbitrageurs
Dealers who take advantage of tiny differences in exchange rates across markets by buying low and selling higher-ensure this equality Little risk because they buy and sell simultaneously Take little risks because they simultaneously buy currency in one market and sell it in another Short lived (most are available for less than a second)
Revaluation
Decrease in the pegged exchange rate
What happened when there was a balance-of-payments deficit or surplus?
Deficit- loss of gold, supply of money shrunk Surplus- influx of gold, supply of money expanded
Debit entries in the current or financial accounts increase the?
Demand for foreign exchange, resulting in a depreciation of the dollar.
Flexible exchange rates
Determined by demand and supply
If the euro threatens to drop below the minimum acceptable exchange rate, monetary authorities must sell?
Dollars and buy euros
What is net unilateral transfers abroad?
Equal the unilateral transfers received from abroad by U.S. residents minus unilateral transfers sent abroad by U.S. residents
What is the merchandise trade balance?
Equals the value of merchandise exports minus the value of merchandise imports Reflects trade in goods, or tangible products Referred to as the trade balance
If the euro threatens to climb above the maximum acceptable exchange rate, monetary authorities must sell?
Euros and buy dollars, thereby keeping the dollar price of the euro down.
What are the government options for eliminating the exchange rate disequalibirum?
First, the pegged exchange rate can be increased, meaning that foreign currency costs more dollars. This is a devaluation of the dollar. (A decrease in the pegged exchange rate is called a revaluation.) Second, the government can reduce the domestic demand for foreign exchange directly by imposing restrictions on imports or on financial outflows. Many developing countries do this. Third, the government can adopt policies to slow the domestic economy, increase interest rates, or reduce inflation relative to that of the country's trading partners, thereby indirectly decreasing the demand for foreign exchange and increasing the supply of foreign exchange. Finally, the government can allow the disequilibrium to persist and ration the available foreign reserves through some form of foreign exchange control.
If governments try to set exchange rates, active and ongoing central bank intervention is often necessary to establish and maintain these?
Fixed exchange rates
A country's currency generally appreciates when its real interest rates are higher than in other countries, because?
Foreigners are more willing to buy and hold investments denominated in that high-interest currency.
What do unilateral transfers consist of?
Government transfers to foreign residents, foreign aid, money workers send to families abroad, personal gifts to friends and relative abroad, contributions of foreign charities . . .
What happens when exchange rates are flexible?
Governments usually have little direct role in foreign exchange markets
What does the demand and supply of foreign exchange arise from?
Importers and exporters, investors in foreign assets, central banks, tourists, arbitrageurs, and speculators
What does the statistical discrepancy ensure?
In the aggregate, accounts sum to zero
A country's currency generally appreciates when inflation is lower than that of other countries and depreciates when?
Inflation is higher compared to other countries
The increase in the dollar-per-eruo exchange rate . . .
It makes the U.S. products cheaper for eurozone residents because fewer euros are needed to get the same number of dollars
What does a country's balance of payments do? (Balance-of-economic transactions)
It summarizes all economic transactions during a given period between residents of that country and residents of other countries Measures a flow of transactions during a particular period Some transactions do not involve actual payments
What would an ideal exchange rate system be like?
It would foster international trade, lower inflation, and promote a more stable world economy
How is the merchandise trade balance reported?
Monthly It influences foreign exchange markets, the stock market, and other financial markets
The inflow of receipts from the rest of the world, which are entered as credits, must equal?
Must equal the outflow of payments of the rest of the world, which are entered as debits
Because deficits in the merchandise trade account dominated surpluses in the services account________________
Net exports of goods and services have been in deficit for decades
Any surplus or deficit in one account must be what?
Offset by deficits or surpluses in other balance-of-payments accounts
Who are residents?
People, firms, organizations, and governments
Credit entries in these accounts increase the supply of foreign exchange?
Resulting in an appreciation of the dollar.
What did the Bretton Woods Agreement do?
Said that the rate that dollars could be exchanged for gold was fixed Other countries could adjust their exchange rates relative to U.S. dollar if a country faced a large and persistent deficit or surplus
What does a decrease in the number of dollars needed to purchase a euro indicate?
Strengthening, or appreciation of the dollar
What occurred in 1971?
The U.S. merchandise imports exceeded merchandise exports for the first time since WWII
What is the exchange rate?
The cost measured in one country's currency of one unit of another country's currency
What is foreign exchange?
The currency of another country needed to carry out international transactions
What is a country's gross domestic product, or GDP?
The economy's income and output during a given period, usually quarterly and yearly
What is the balance on goods and services?
The export value of goods and services, or net exports, a component of GDP
What does it mean is a country runs a current account surplus?
The foreign exchange received from exports, from foreign assets, and from unilateral transfers from abroad exceeds the amount needed to pay for imports, to pay foreign holders of domestic assets, and to make unilateral transfers abroad
The lower the dollar price of foreign exchange . . .
The greater the quantity of foreign exchange demanded
What are exchange rates determined by?
The interaction of the households, firms, private financial institutions, governments, and central banks that buy and sell foreign exchange
The cheaper it is to buy euros, .....
The lower the dollar price of eurozone products to U.S. residents, so the greater the quantity of euros demanded by U.S. residents
What does it mean to operate under a gold standard?
The major currencies were convertible into gold at a fixed rate (1879-1914)
What has the Bretton Woods system been replaced by?
The managed float system
What happens if the exchange rate is allowed to adjust freely, or to float, in response to market forces?
The market will clear continually, as the quantities of foreign exchange demanded and supplied are equated
Any increase in the demand for foreign exchange or any decrease in its supply, other things constant, increases?
The number of dollars required to purchase one unit of foreign exchange, which is a depreciation of the dollar.
Any decrease in the demand for foreign exchange or any increase in its supply, other things constant, reduces?
The number of dollars required to purchase one unit of foreign exchange, which is an appreciation of the dollar.
What is the equilibrium price?
The one that equates quantity demanded with quantity supplied
What is the balance on the current account?
When we add net unilateral transfers to net exports of goods and services and net income from assets owned abroad Reported quarterly
As long as trade across borders is unrestricted and as long as exchange rates are allowed to adjust freely?
The purchasing power parity (PPP) theory predicts that the exchange rate between 2 currencies will adjust in the long run to equalize the cost across countries of an internationally traded basket of goods
What was each country's monetary policy influenced by?
The supply of gold
What happens if merchandise imports exceed merchandise exports?
The trade balance is in deficit
What happens if merchandise exports exceed merchandise imports?
The trade balance is in surplus
The positive relationship between the dollar-per-euro exchange rate and the quantity of euros supplied on the foreign exchange market is expressed in by?
The upward-sloping supply curve for foreign exchange
Why are services often called "invisibles"?
They are not tangible
If monetary officials must keep selling foreign exchange to keep the value of their domestic currency from falling?
They risk running out of foreign exchange reserves. Faced with this threat, the government has several options for eliminating the exchange rate disequilibrium.
What was the United States' response to the stem of the gold outflow?
They stopped exchanging gold for dollars, but then the dollar became less attractive
What is net investment income from abroad?
U.S. investment earnings from foreign assets minus foreigners' earnings from their U.S. assets
What does the trade balance depend on?
Variety of factors, including the relative strength and competitiveness of the domestic economic compared with other economies and the relative value of the domestic currency compared with other currencies
What does an increase in the number of dollars needed to purchase a euro indicate?
Weakening or Depreciation of the dollar
When does money flow out?
When American buy foreign assets or build factories overseas
When does money flow in?
When foreigners buy U.S. assets or build factories here
When does a company run a deficit in its current account?
When the amount of foreign exchange received from exports, from foreign assets, and from unilateral transfers falls short of the amount needed to pay for imports, pay foreign holders of domestic assets, and make unilateral transfers
Devaluation
When the pegged exchange rate can be increased, meaning the foreign currency costs more dollars