074 - Chapter 74 - Foreign Exchange & Trade Balance

World Bank Group

World Bank International Finance Corporation Multinational Investment Guarantee Agency International Centre for Settlement of Investment Disputes

foreign exchange market

a market in which currencies of different countries are bought and sold

What is the best explanation of monetary policy?

A government's decisions on money supply and interest rates {Explanation - Monetary policy is a government's decision, through its central bank, regarding money supply and interest rates.}

If a country had $1 million in exports and $1.5 million in imports, what would the trade balance be?

$500,000 deficit {Explanation - $1 million in exports minus $1.5 million in imports = negative $500,000 or a $500,000 deficit.}

Given the following, what is the balance of payments? Foreign Investment in Domestic sector = $1,000,000 Domestic Investment in Foreign sector = $500,000 Exports = $1,000,000 Imports = $2,000,000

$500,000 deficit {Explanation - Balance of payments = Money Inflows ($1,000,000 Exports + $1,000,000 in foreign investment in domestic sector) - Money Outflows ($2,000,000 Imports + $500,000 domestic investment in foreign sector) = (500,000)}

Latervia is a very small country that has exports of $100,000, imports of $20,000, net income from abroad $250,000, and net current transfers $200,000. What is Latervia's current account?

$530,000 {Explanation - The correct answer is: Current Account = (Exports-Imports) + Net Income from Abroad + Net Current Transfers.}

Which of the following statements regarding an exchange rate is not true?

Fixed exchange rates are determined by supply and demand forces. {Explanation - An exchange rate is the rate at which one country's currency can be traded for another country's currency. They exist so that countries and firms can do business with each other and pay in the appropriate currency. They are also necessary when individuals travel to other countries and have to exchange their money for the local foreign currency. The can be quoted at the current rate which is known as the spot rate. However, a flexible exchange rate is determined by the forces of supply and demand, not a fixed exchange rate.}

Which of the following does NOT impact the trade balance of a country?

GDP {Explanation - GDP is known as gross domestic product and is a measurement that includes several things, including exports and imports. It doesn't influence the trade balance; instead the trade balance (or exports and imports) influences GDP.}

What is most likely to happen with a strong dollar?

Higher demand for imports. {Explanation - When the U.S. dollar is strong compared to many other country's currencies, imports are less expensive. A strong dollar means you can purchase more foreign currencies and this makes foreign goods relatively cheaper. A strong dollar makes exports more expensive, which would lead to fewer exports.}

currency depreciates

currency becomes less valuable in terms of other currencies, exports rise & imports fall; it weakened or fell in value relative to another currency

currency appreciates

currency becomes more valuable in terms of other currencies, exports fall & imports rise; it increased in value relative to another currency

When expansionary monetary policy leads to a decrease in interest rates, the exchange rate _____.

decreases {Explanation - When interest rates are lowered through monetary policy to help boost the economy, this lowers the amount of capital that flows into the United States. Foreign investors can't earn a very good return. This decreases the demand for dollars and decreases the U.S. exchange rate.}

current account

in the balance of payments, records transactions involving the export or import of goods and services; used to measure the short-term inflows and outflows of money into a country. This includes exports and imports of services and merchandise, which are commonly referred to when speaking about trade deficits and trade surpluses. More exports helps to create a trade or account surplus; more imports, a deficit.

balance of payments surplus

more money flows in than out

Components of the Financial-Capital Account

1. Domestic investment in the foreign sector This is the net flow of payments used by people or organizations in the domestic economy to purchase financial and physical assets in other nations. 2. Foreign investment in the domestic sector This is the flow of payments from foreign countries to purchase financial and physical assets in the American (or domestic) economy.

If the exchange rate between the U.S. dollar and Mexican Peso is 13 Pesos to 1 U.S. dollar, how many dollars would a gallon of ice cream costing 52 pesos be?

4 {Explanation - The gallon of ice cream would cost approximately 4 dollars. 52 pesos/13 (conversion ratio) = $4}

Assume the following exchange rates: 1 Dollar = 102 Japanese Yen 1 Dollar = 0.6 British Pound 1 Dollar = 0.91 Swiss Franc 1 Dollar = 13 Pesos Which of the following is the least amount of money?

507 Pesos {Explanation - Yen = 5100/102 exchange rate = $50 American dollars Pound = 27/.6 exchange rate = $45 American dollars Franc = 38/.91 exchange rate = $41.76 American dollars Pesos = 507/13 exchange rate = $39 American dollars $39 American dollars or 507 Pesos is the least amount of money.}

When are exchange rates determined by demand and supply forces?

Always {Explanation - The laws of supply and demand are the guiding forces that determine exchange rates and the value of currencies. These natural forces are not set by the Federal Reserve.}

Why can the currency exchange rate have a large impact on the trade balance?

Because an overvalued currency can make exports less competitive. {Explanation - Currency exchange rates have a big influence on the trade balance, and as a result, indirectly affect the current account. An overvalued currency or strong dollar makes imports cheaper and exports less competitive. This widens the current account deficit.}

_____ are payments made by those in the domestic economy to purchase financial and physical assets in other countries.

Domestic investments in the foreign sector. {Explanation - Domestic investments in the foreign sector are payments used by those in the domestic economy to purchase financial and physical assets in other nations.}

Why does Saudi Arabia have a large trade surplus?

Due to the fact that they have over 20% of the world's petroleum reserves {Explanation - Nearly 90% of all of Saudi export earnings come from the oil industry. With nearly 20% of the world's petroleum reserves, Saudi Arabia is able to sell and export huge quantities of oil to many of the industrialized nations that rely heavily on it for their way of life.}

All of the following are types of exchange rates that countries can use, EXCEPT:

EXCEPT: Infinite {Explanation - These are all types or ways to define an exchange rate, with the exception of infinite. Flexible exchange rates can also be referred to as free floating exchange rates.}

Which exchange rate would most likely be used for a good or service that will be delivered at a future date?

Forward {Explanation - The spot exchange rate is the current exchange rate. A forward exchange rate refers to an exchange rate that is quoted and traded today but for delivery and payment on a specific date in the future.}

How do loans for infrastructure, health, and education help further economic development?

Once basic needs such as health, education, and proper infrastructure are met, a country can work on improving its economy. {Explanation - Economic development cannot occur unless there is a healthy, educated population with proper infrastructure.}

If U.S. exports to Japan increased, what most likely happened?

The U.S. dollar decreased in value compared to the Japanese Yen. {Explanation - When the value of the U.S. dollar depreciates or falls, foreign trading partners can now buy more U.S. dollars with their currency, and the price of U.S. goods is relatively cheaper. This will increase exports and overall sales for U.S. businesses!}

World Bank

The general mission of the World Bank is to provide long-term financing for economic development

How can a fiscal policy affect exchange rates?

Through interest rate, income, and price level effect {Explanation - Fiscal policy can affect the exchange rates through three different paths via income changes, price changes, and through interest rates.}

trade balance

also called balance of trade, is the calculation of its exports minus imports. The balance can also be understood as how many goods and services are being sold to foreign countries minus how many goods and services our domestic citizens are buying from foreign countries

forward exchange rate

an exchange rate that is quoted and traded today but for delivery and payment on a specific future date

Flexible exchange rate

an exchange rate that is set by market forces of supply and demand between different countries for each other's currencies

fixed exchange rate

an exchange rate that is set by officials, and the government commits to buying and selling currencies at that fixed rate. The purpose is to keep the currency trading in a very narrow band, and it can also be referred to as a pegged rate

International Bank for Reconstruction and Development (IBRD)

provides low-interest and no-interest loans to developing countries that cannot get financing elsewhere. The IBRD also provides technical and research assistance to developing countries. Examples of projects funded by these loans include infrastructure projects, such as power plants, roads, railroads, ports, telecommunication, and water systems IBRD has about 188 member nations

When the American dollar buys more than its equivalent in another currency, it is considered to be _____ the other currency.

strong compared to {Explanation - When a dollar buys more than its equivalent in another currency, it's often labeled strong.}

Bank for International Settlements (BIS)

the central bankers' bank. Today, it is primarily a forum for central bank cooperation to help create and maintain a stable international financial system.

law of demand

the demand for a good falls as the price rises and goes up as the price falls

spot exchange rate

the exchange rate at which a foreign exchange dealer will convert one currency into another that particular day

law of supply

the quantity of a good supplied rises as the market price rises and falls as the price falls

exchange rate

the rate at which one country's currency can be traded for another country's currency

An increase in the value of a domestic currency will mainly affect _____.

trade deficit {Explanation - Strong domestic currencies lead to cheaper imports, and a country tends to import more than they export. This causes a trade deficit, which can exert a contractionary effect on the economy. The export appears expensive to other countries so that there is less buying.}

balance of trade surplus

when the value of all exports exceeds the value of all imports

balance of trade deficit

when the value of all imports exceeds the value of all exports

How is domestic currency related to exports?

A strong domestic currency decreases exports. {Explanation - A strong U.S. dollar decreases exports because U.S. products are more expensive for foreign consumers. A weak U.S. dollar increases exports because U.S. products are cheaper for foreign consumers.}

Identify the situation where a weak currency, or lower exchange rate, can be beneficial.

An economy coming out of recession {Explanation - A weak currency, or lower exchange rate, can be better for an economy and for firms that export goods to other countries. This can help during times of slow growth or when an economy is coming out of a recession. The weak dollar means foreign countries and individuals can now purchase more American currency with less of their currency. This encourages exports by American firms and can lead to more profits and higher job growth over time. On the flip side, a weak currency makes imports more expensive, so an import business would not benefit. It would also make someone's trip to another country more expensive, as they may have to use more dollars to buy the foreign currency.}

Which of the following statements is true?

An increase in the U.S. demand for foreign goods and services will cause an increase in the supply of dollars in currency markets. {Explanation - As a country demands more foreign goods, they must first exchange their currency for the foreign currency to purchase it. This increases the supply of the domestic country's currency in the currency markets. On the other side, an increase in foreign demand for US goods will increase the supply of those foreign currencies but not US dollars, because they will have to exchange their currency to purchase US goods.}

Why did the U.S. trade deficit start to grow in the 1990s?

Because the economy grew much faster than that of their major trading partners {Explanation - In the 1990s, the U.S. economy was growing much faster than the economies of America's major trading partners. As a result, Americans were demanding and purchasing foreign goods, or imports, at a much faster pace than other countries were buying American goods, or exports.}

Deduce the effects of having a higher exchange rate for the U.S. dollar on foreign currencies and imports.

Both foreign currencies and imports become cheaper. {Explanation - A high exchange rate for the U.S. dollar makes foreign currencies cheaper, which lowers the price of imports. Your dollar buys more foreign currency, which means you have more money to spend on imports or foreign goods.}

Which two components make up the balance of payments account?

Capital/financial and current account. {Explanation - The capital/financial account and current account make up the balance of payments account and determine whether there is a money deficit or surplus for a country.}

If more Americans want to suddenly purchase goods in Mexico, what likely happens?

Demand for pesos increases, dollar falls in value compared to peso {Explanation - An increase in the US demand for products in Mexico would cause Americans to demand more pesos so they could purchase more products in Mexico. This would increase the supply of dollars on the currency markets as they exchanged them for pesos. The increase in supply of the dollar and the increase in demand for the peso would both help increase the value of the peso and decrease the value of the dollar.}

All of the following are true, EXCEPT that the current account _____.

EXCEPT: is also known as the capital account {Explanation - Balance of payments refers to a country's transactions with the rest of the world and is made up of two different categories. One area is known as the current account and the other as the capital account. Current account and capital account are composed of different economic variables and are not the same.}

Which of the following is one of the primary goals of the IMF?

Encourage exchange stability {Explanation - The IMF uses monetary policies to encourage trade and exchange stability. Sometimes it will offer short-term financing.}

What is the rate at which one currency is converted in another called?

Exchange rate {Explanation - The exchange rate is the rate at which one currency is exchanged for another. Supply and Demand forces help determine this.}

Which of the following is FALSE concerning trade?

FALSE: Trade surplus in the U.S. started in 1975 {Explanation - All of the following are true about trade balance except that the US has run a trade surplus since 1975. It has actually run a deficit since 1975.}

Consider a scenario where there has been a decrease in the exchange rate of the American dollar. How will the inflation and import prices vary?

Higher inflation and higher import prices {Explanation - A lower, or weak, currency value or exchange rate can lead to increased inflation. This results because the lower exchange rate causes higher import prices. You have to exchange more of your money to buy foreign currency. Relatively higher foreign good prices give domestic firms the ability to raise, or charge, higher prices at home. As a result, inflation can increase, which continues to erode the value of your cash holdings.}

What are goods that are produced in a foreign country but sold in a home country called?

Imports {Explanation - Imports are goods that are produced in a foreign country, but sold in a home country.}

Strong Exchange Rate Effects

Imports cheaper: When a currency appreciates or strengthens in relation to other currencies, imports get cheaper. Lower inflation: When the exchange rate for a currency strengthens, it makes imports cheaper. Balance of trade deficit: One of the biggest disadvantages of higher exchange rates or a strong dollar may be that it leads to trade deficits.

What would you expect if there is an increase in exchange rate?

Imports get cheaper {Explanation - When a currency appreciates, or strengthens, in relation to other currencies, imports get cheaper. This means your dollar will buy more of another foreign currency so that you can purchase foreign goods. This puts downward pressure on overall prices and decreases inflation.}

Weak Exchange Rate Effects

Imports more expensive: If the dollar or your own currency declines, this erodes the value of your personal finances. Increased inflation: Higher import prices by foreign firms also give domestic firms the ability to raise or charge higher prices at home. Balance of trade surplus: On the other hand, a weak dollar or currency can help exports.

What is true about contractionary monetary or fiscal policy?

It decreases our income, decreases our demand for imports, and increases the exchange rate. {Explanation - When the government, or Federal Reserve, use contractionary monetary or fiscal policy to slow down the economy, this decreases our income, decreases our demand for imports, and ultimately increases the dollar exchange rate.}

Predict the effect on the exchange rate when the Federal Reserve uses monetary policy to increase income or available money.

It increases demand for foreign currencies and lowers exchange rate. {Explanation - When the Federal Reserve increases the money supply or makes credit easier (your ability to get a loan), the income in our pockets increases. As our pocketbooks get bigger, we spend more money on imports. As we sell dollars and demand more foreign currencies so we can pay for those imports, this decreases the dollar exchange rate.}

Why is a negative balance of payment bad for a country?

It means more money is going out to pay for imports than is coming in from the sale of exports. {Explanation - Balance of payment is the difference in value between a country's imports and exports. It is desirable to have a positive balance of payment where more money is coming in than going out. A negative balance of payments means more money is going out than coming in.}

Why is the balance of payments useful for understanding the state of the economy?

It shows all the inflows and outflows of the economy. {Explanation - The balance of payments is kind of like your checkbook register that shows all the inflows and outflows of your money! It measures how much money is going in and out of a country.}

The same pair of shoes can be imported from different countries. The prices of the shoes in Japan, Mexico, England, and India are 3330 Yen, 646 Pesos, 28 Pound Sterling, and 2535 Rupees respectively. The exchange rates are 111 Yen, 17 Pesos, 0.8 Pound Sterling and 65 Rupees to 1 U.S. dollar. The cheapest pair of shoes can be purchased from:

Japan {Explanation - The shoes will be imported from the country where they are the cheapest. 3330 Yen = 3330/111= 30 USD 646 Pesos = 646/17 = 38 USD 28 Pound Sterling = 35 USD 2535 Rupees = 39 USD So it would be wise to buy the shoes from Japan.}

If the American dollar rose in value in relation to the Japanese Yen, what would likely be the effect?

Japanese goods and services will be relatively cheaper for Americans {Explanation - If the American dollar rose in relation to the Yen, it would take less dollars to purchase the same amount of Yen as before. This would make Japanese products cheaper to Americans. Americans would most likely buy more Japanese goods over time as they now are cheaper.}

What is the primary mission of the World Bank?

Lend money for economic development {Explanation - The World Bank provides loans to developing countries to help finance projects aimed at economic development.}

Which of the following statements about the financial/capital account is NOT true?

NOT: Financial account surpluses to offset foreign trade deficits are always a good thing. {Explanation - If the financial/capital account runs a large enough surplus (money coming in from foreign countries to invest), it can help offset a trade deficit (exports greater than imports). However, that's not always a good thing. For example, it means that the country is selling off its assets to foreign investors (land, businesses, factories, stock ownership) to pay for its purchases of foreign goods and services.}

Which of the following is NOT associated with foreign trade?

NOT: Mutual funds {Explanation - Exports, imports, surplus, and current account are all economic concepts or terms that can be associated with typical foreign trade conversations. Mutual funds are not directly related to foreign trade. They are an individual financial investment option for people in the financial markets such as the US stock market.}

Which of the following is NOT a component of the current account?

NOT: Value of personal savings accounts {Explanation - The value of personal savings accounts is not a component of the current account.}

balance of payments ("BOP")

a measure of the total flow of money into or out of a country; a country's record of all transactions between its residents and the residents of all other foreign nations. It is kind of like your checkbook register that shows all the inflows and outflows of your money! It measures how much money is going in and out of a country.

financial account ("capital account")

in the balance of payments, transactions that involve the purchase or sale of assets; where long-term flows of payments are recorded between countries. This includes payments for physical capital, such as factories and equipment, as well as financial capital, such as stocks, bonds, and real estate. These payments or purchases can be made by individuals, businesses, and even governments.

International Development Association ("IDA")

makes loans to help developing countries; started in 1960. It works with the IBRD and focuses its efforts on the poorest countries in the world and offers assistance in turning their struggling economies around.

International Monetary Fund ("IMF")

mission is to promote international cooperation regarding monetary policy, encourage the expansion of international trade, and currency exchange stability. It also provides short-term financing to help countries meet their financial obligations Remember that the World Bank provides long-term project financing, and the IMF provides short-term help with balance of payment problems.

balance of payments deficit

more money flows out than in

Partially flexible exchange rate

primarily set by supply and demand forces but is sometimes influenced by the government strategically buying and selling currencies to influence the prices of their currency