Macro Chap 33 - Exchange Rates and the Balance of Payments

Flexible exchange rates

- Exchange rates that are allowed to fluctuate in the open market in response to changes in supply and demand - Sometimes called floating exchange rates

Bretton Woods and the International Monetary Fund:

- In 1944, representatives of capitalist countries met in Bretton Woods, New Hampshire. -- They created a new international payment system to replace the gold standard. - Members agreed to maintain the value of their currencies within 1 percent of declared par value. -- Members are allowed a one-time adjustment. -- Members can alter exchange rates only with IMF approval thereafter.

capital account

A category of balance of payments transactions that measures flows of financial assets.

Financial account

A category of balance of payments transactions that measures flows of real and financial assets

Balance of payments

A system of accounts that measures transactions of goods, services, income, and financial assets between domestic households, businesses, and governments and residents of the rest of the world during a specific time period

Under the gold​ standard, exchange rates between currencies were fixed.

True

All of the following items are current account transactions except A. net unilateral transfers. B. exports of merchandise goods. C. U.S. private capital going abroad. D. imports of services.

U.S. private capital going abroad.

The gold standard constitutes an exchange rate arrangement between the dollar and the pound because

pegging to gold​ (a unilateral​ action) effectively​ "locks" the currencies into a fixed relationship.

Depreciation

A decrease in the exchange value of one nation's currency in terms of the currency of another nation.

What is the difference between a deficit item and a surplus item in the balance of​ payments?

A deficit item is when a transaction leads to a payment by a country and a surplus item is when a transaction leads to a receipt by a country.

hedge

A financial strategy that reduces the chance of suffering losses arising from foreign exchange risk.

Foreign exchange market

A market in which households, firms, and governments buy and sell national currencies

On​ Wednesday, the exchange rate between the euro and the U.S. dollar was ​$1.17 per​ euro, and the exchange rate between the Canadian dollar and the U.S. dollar was U.S. ​$0.79 per Canadian dollar. From these two​ rates, the implied exchange rate between the Canadian dollar and the euro​ (C$ per euro​) is ​C

$1.48

Current account

A category of balance of payments transactions that measures the exchange of merchandise, the exchange of services, and unilateral transfers

current account

A category of balance of payments transactions that measures the exchange of merchandise, the exchange of services, and unilateral transfers.

Which of the following is a true​ statement? A. A flexible exchange rate system lets the exchange rate of a currency be determined freely whereas a fixed exchange rate system pegs the value of the currency. B. A flexible exchange rate system lets the exchange rate of a currency be determined by the government whereas a fixed exchange rate system has no government intervention. C. A flexible exchange rate system lets the exchange rate of a currency be determined by occasional government intervention whereas a fixed exchange rate system lets the value of the currency fluctuate. D. A fixed exchange rate system lets the exchange rate of a currency be determined freely whereas a flexible exchange rate system pegs the value of the currency.

A flexible exchange rate system lets the exchange rate of a currency be determined freely whereas a fixed exchange rate system pegs the value of the currency.

Chinese furniture manufacturers produce high quality early American furniture and successfully export large quantities of the furniture to the United States

Add

international monetary fund

An agency founded to administer an international foreign exchange system and to lend to member countries that had balance of payments problems. The IMF now functions as a lender of last resort for national governments.

Appreciation

An increase in the exchange value of one nation's currency in terms of the currency of another nation

Current account balance​ =

Balance on goods and services - Net outflow of unilateral transfers​

What is the difference between the balance of trade and the balance of​ payments?

Both the balance of trade and the balance of payments consider exports and​ imports, while the balance of payments also includes​ cross-border exchange of​ services, income and financial assets.

In the week of February 01 comma 2019​, the exchange rate between the euro and the U.S. dollar was ​$1.14 per​ euro, and the exchange rate between the Canadian dollar and the U.S. dollar was U.S. ​$0.76 per Canadian dollar. ​*Real-time data provided by Federal Reserve Economic Data​ (FRED), Federal Reserve Bank of Saint Louis. From these two​ rates, the implied exchange rate between the Canadian dollar and the euro​ (C$ per euro​) is

C$1.5 per euro

The exchange rate as a shock absorber:

Exchange rate variations can perform a valuable service for a nation's economy: - Outside demand for the nation's products falls. - A trade deficit leads to a drop in demand for the nation's currency; it depreciates. - The nation's goods are now less expensive to other countries; exports increase.

flexible exchange rates

Exchange rates that are allowed to fluctuate in the open market in response to changes in supply and demand. Sometimes called floating exchange rates.

Equilibrium:

Households, businesses, and governments must eventually reach equilibrium

Disequilibrium:

If family expenditures exceed family income and this situation is financed by borrowing, the household may be considered to be in disequilibrium because such a situation cannot continue indefinitely.

Merchandise trade deficit​ =

Merchandise imports - Merchandise exports​

What affects the balance of payments?

Relative rate of inflation Political stability: - Capital flight

special drawing rights (SDRS)

Reserve assets created by the International Monetary Fund for countries to use in settling international payment obligations.

Balance of services​ =

Service exports - Service imports​

U.S. interest rates rise relative to interest rates in​ China, so Chinese residents seek to purchase additional U.S. financial assets.

Subtract

U.S. parents begin buying fewer​ Chinese-made toys for their children.

Subtract

Current account deficit

The current account of the balance of payments is in deficit when a country imports more goods and services than it exports.

Current account surplus

The current account of the balance of payments is in surplus when a country exports more goods and services than it imports.

In February 2019​, the exchange rate between the Japanese yen and the U.S. dollar was ​$0.0091 per yen. In March 2019​, it was ​$0.0090 per yen. ​*Real-time data provided by Federal Reserve Economic Data​ (FRED), Federal Reserve Bank of Saint Louis. Did the dollar appreciate or depreciate against the​ yen? By how​ much, expressed as a percentage​ change? ​

The dollar appreciated against the yen by 1.10​%

All of the following would be listed as surplus items on the U.S. balance of payments international accounts except A. exports of merchandise. B. U.S.​ tourists' expenditures in foreign countries. C. foreign military spending in the United States. D. sales of U.S. dollars to foreign residents.

U.S.​ tourists' expenditures in foreign countries.

On​ Wednesday, the exchange rate between the Japanese yen and the U.S. dollar was ​$0.0100 per yen. On​ Thursday, it was ​$0.0099 per yen. It can be concluded that the U.S. dollar has ________ relative to the yen.

appreciated

If the central​ bank, the Bank of​ Japan, wants to keep the value of the yen​ unchanged, then it should

buy foreign currencies in exchange for the​ yen, thereby increasing its supply and value of the yen will fall to its original level.

Freely floating foreign exchange rates fluctuate based​ on:

changes in supply and demand.

The inclusion of services and net unilateral transfers along with merchandise trade produces a​ nation's

current account.

A Central European company sells products to a U.S.​ hobby-store chain.

deficit

A U.S. microprocessor manufacturer purchases raw materials from a Canadian firm.

deficit

U.S. churches and mosques send relief aid to Pakistan following a major earthquake in that nation.

deficit

When a currency falls in value relative to another currency it is said to​ have:

depreciated.

An exchange system which has occasional government intervention is a

dirty float

The larger the current account​ surplus, the

larger the financial account deficit.

Unlike the balance of​ payments, the balance of trade is a narrowly defined concept. This balance is limited to a​ nation's trade in

merchandise

U.S. demand for Japanese products creates a​ ________ U.S. dollars and a​ ________ Japanese yen in the foreign exchange market.

supply​ of; demand for

A Mexican company pays a U.S. accounting firm to audit its income statements.

surplus

Japanese residents pay a U.S. travel company to arrange hotel​ stays, ground​ transportation, and tours of various U.S.​ cities, including New​ York, Chicago, and Orlando.

surplus

An exchange system where the exchange value fluctuates within a given range of values is a

target zone

The fall in the real interest rate in Britain relative to the U.S. real interest rate causes international investors to seek the higher returns available from obtaining financial assets in ____ and the equilibrium exchange rate to ____. ​Consequently, _____ dollars must be exchanged for pounds and the dollar _____ relative to the pound.

the U.S.; fall; fewer; appreciates

On​ Wednesday, the exchange rate between the euro and the U.S. dollar was ​$1.52 per​ euro, and the exchange rate between the Canadian dollar and the U.S. dollar was U.S. ​$0.96 per Canadian dollar. From these two​ rates, the implied exchange rate between the Canadian dollar and the euro​ (C$ per euro​) is ​C

$1.58

In 2012​, for the United​ States, the current account balance was negative $ 461 ​billion, the flow of U.S. private holdings of assets abroad was negative $ 129 ​billion, and the flow of foreign private assets held in the United States was $ 559 billion. ​*Real-time data provided by Federal Reserve Economic Data​ (FRED), Federal Reserve Bank of Saint Louis. Using the information provided​ above, fill in the blank below. The balance on the financial account during the year was

$461 billion

Balance on goods and services​ =

(Service exports - Service ​imports) - Merchandise trade deficit.

Bretton Woods and the IMF:

- 1971: President Richard Nixon suspended the convertibility of the dollar into gold. -- The United States devalued the dollar (lowered its official value) relative to the currencies of 14 major industrial nations. - 1973: Members of the EEC, now the EU, allowed their currencies to float against the dollar.

Hedge

- A financial strategy that reduces the chance of suffering losses arising from foreign exchange risk - Currency swaps

Problems with the gold standard:

- A nation gives up control of its monetary policy. - New gold discoveries often cause inflation.

Accounting identities

- Accounting identities are values that are equivalent by definition. - Ultimately, net lending by households must equal net borrowing by businesses and governments.

An example of derived demand:

- Assume that the pharmaceuticals cost 100 pounds per package. - If 1 pound costs $1.20, then a package of pharmaceuticals would cost $120.

A foreign currency price of​ $1.75 per pound means it will cost you 1.75 pounds to buy​ $1.

False

If it costs you​ $1 to purchase 13 Mexican pesos​ today, and tomorrow it costs you​ $1 to purchase 14 Mexican​ pesos, there has been an appreciation in the value of the Mexican peso in the foreign exchange market.

False

In the absence of interventions by finance ministries or central​ banks, any nation experiencing a current account surplus must also be running a financial account surplus

False

In​ 2015, the United States had a current account surplus.

False

Suppose that the following two events take place in the market for​ China's currency, the​ yuan: U.S. parents are more willing than before to buy action figures and other Chinese toy​ exports, and​ China's government tightens restrictions on the amount of U.S.​ dollar-denominated financial assets that Chinese residents may legally purchase. Which of the following describes the outcome in the market for the​ yuan?

The demand for yuan​ increases, the supply​ decreases, and the yuan appreciates.

Balance of trade

The difference between exports and imports of goods

Exchange rate determination in the market for foreign exchange:

The equilibrium exchange rate is the exchange rate at which the quantity of a country's currency demanded is equal to the quantity supplied.

Par value

The officially determined value of a currency

Improvements in Mexican production technology yield superior​ guitars, and many musicians around the world desire these guitars.

The peso appreciates due to an increase in the demand for pesos.

Perceptions of political instability surrounding regular elections in Mexico make international investors nervous about future business prospects in Mexico.

The peso depreciates due to an increase in the supply of pesos.

foreign exchange risk

The possibility that changes in the value of a nation's currency will result in variations in the market value of assets.

Exchange rate

The price of one nation's currency in terms of another nation's currency

Accounting identities are definitions of equivalent values.

True

Floating exchange rates can be beneficial for a​ nation, especially if that​ nation's residents are relatively immobile.

True

In order to maintain a fixed exchange rate when confronted with an increase in the supply of domestic​ currency, a central bank can purchase domestic currency with foreign currency reserves in an effort to increase the demand for the domestic currency.

True

Appreciation and depreciation of euros:

We say your demand for British pounds is derived from your demand for pharmaceuticals in Britain.

Suppose that during a recent year for the United​ States, merchandise imports were ​$1.8 ​trillion, unilateral transfers were a net outflow of ​$0.2 ​trillion, service exports were ​$0.2 ​trillion, service imports were ​$0.1 ​trillion, and merchandise exports were ​$1.2 trillion. a. The merchandise trade deficit was b. The balance on goods and services was c. The current account balance was

a. 1.8 - 1.2 = $0.6 trillion b. (0.2 - 0.1) - 0.6 = $-0.5 trillion c. -0.5 - 0.2 = $-0.7 trillion

Suppose that signs of an improvement in the Japanese economy lead international investors to resume lending to the Japanese government and businesses.​ Policymakers, however, are worried about how this will influence the yen. This event would cause

an increase in the demand for the​ yen, and the yen would appreciate.

The rising​ dollar-price of the rand means the rand is

appreciating

All other things held​ constant, if the U.S. real interest rate decreases relative to the rest of the​ world, then in foreign exchange markets the demand for dollars will​ ________ and the dollar will​ ________.

decrease; depreciate

The Bank of​ China's attempt to peg the rate of exchange of its​ currency, the​ yuan, in terms of the U.S. dollar requires

dollar purchases when the yuan appreciates and dollar sales when the yuan depreciates.

The desire of British residents to purchase more streaming videos from U.S. firms causes the equilibrium dollar price of the pound to ____. ​Consequently, ___ dollars must be exchanged for pounds and the dollar ___ relative to the pound.

fall; fewer; appreciates

The appearance of relatively less economic and political stability in the U.S. causes ___ British residents to want to put their savings into U.S. assets and the equilibrium dollar price of the pound to ____. Consequently, ____ dollars must be exchanged for pounds and the dollar ___ relative to the pound.

fewer; rise; more; depreciates

The difference between financial inflows and financial outflows is the

financial account

the​ nation's financial account balance

financial inflows - financial outflows.

Of the current foreign exchange arrangements of the member nations of the International Monetary​ Fund, a majority have

fixed exchange rates.

If a family unit is spending more than its current​ income, it must be engaged in one of four actions. Which of the following is not one of those four​ actions?

increasing its money holdings or buying assets

The rise in interest in​ British-published books by and about Jane Austen and travel to Britain to visit Jane​ Austen's former home causes the equilibrium exchange rate to ____​, so _____ dollars must be exchanged for pounds and the dollar ____ relative to the pound.

rise; more; depreciates

To prevent the exchange rate from _____​, ​Bahrain's central bank would intervene by buying ____ dinars at any exchange rate.

rising; fewer

The trade balance

sales (exports) - purchases (imports)

All other things held​ constant, when the U.S. rate of inflation is less than that of its trading​ partners, we would expect to see a​ ________ in the U.S. current account balance.

smaller deficit

the nation current account

the trade balance + net unilateral transfers + service balance

Suppose that during a recent year for the United​ States, the current account balance was negative $ 0.3 ​trillion, and the net acquisitions of financial assets by U.S. residents and government entities was ​+$0.3 trillion. a. The balance on the financial account during the year was b. The net incurrence of financial liabilities by U.S. residents and government entities during the year was ​

​$0.3 trillion $0 trillion

All other things held​ constant, if the supply curve for Swiss francs shifts to the​ left, the dollar price per Swiss franc will​ ________ and the equilibrium quantity of Swiss francs supplied and demanded will​ ________.

​increase; decrease

The equilibrium foreign exchange rate:

- Appreciation -- An increase in the exchange value of one nation's currency in terms of the currency of another nation - Depreciation -- A decrease in the exchange value of one nation's currency in terms of the currency of another nation

The balance of trade versus the balance of payments:

- Balance of trade: Exports of goods minus imports - Balance of payments: A system of account for all transactions between a nation's residents and the rest of the world

Factors that can induce changes in equilibrium exchange rates:

- Changes in real interest rates - Changes in consumer preferences - Perceptions of economic stability

Market determinants of exchange rates:

- Changes in real interest rates - Changes in consumer preferences - Perceptions of economic stability

The key accounts within the balance of payments:

- Current account - Financial account

Balancing the current account:

- Current account surplus -- Net exports plus unilateral transfers plus net investment income exceeds zero - Current account deficit -- Net exports plus unilateral transfers plus net investment income is negative

Three categories of balance of payments transactions:

- Current account transactions - Financial account transactions - Official reserve account transactions

Current account transactions:

- Merchandise trade exports and imports: - Tangible items—things you can feel, touch, and see - Service exports and imports: -- Intangible items that are bought and sold - Unilateral transfers: -- Gifts from citizens and from governments

When family expenditures exceed income, the family must be doing one of the following:

- Reducing its money holdings or selling stocks, bonds, or other assets - Borrowing - Receiving gifts from friends or relatives - Receiving public transfers from a government

The gold standard:

- The gold standard is an international monetary system in which nations fix their exchange rates in terms of gold. - All currencies are fixed in terms of all others, and any balance of payments deficits or surpluses can be made up by shipments of gold. - A balance of payments deficit: -- More gold flowed out than flowed in -- Equivalent to a restrictive monetary policy - A balance of payments surplus: -- More gold flowed in than out -- Equivalent to an expansionary monetary policy

Foreign exchange risk

- This risk is the possibility that changes in the value of a nation's currency will result in variations in the market value of assets. - Limiting foreign exchange risk is a classic rationale for adopting a fixed exchange rate.

An accounting identity among nations:

- When people from different nations trade or interact, certain identities or constraints must also hold. - Let's look at the three categories of the balance of payments transactions.

Suppose that under a gold​ standard, the U.S. dollar is pegged to gold at a rate of ​$35 per ounce and the pound sterling is pegged to gold at a rate of ​£17.5 per ounce. The exchange rate between the U.S. dollar and the pound sterling ​($/pound​) will be ______.

2;

Suppose that under the Bretton Woods​ system, the dollar is pegged to gold at a rate of ​$42 per ounce and the pound sterling is pegged to the dollar at a rate of ​$3 ​= £1. If the dollar is devalued against gold and the pegged rate is changed to ​$48 per​ ounce, the implied exchange value of the pound in terms of dollars is​ ($/£)

3.43