MACRO Chpt 20: International Finance

Why PPP does not hold perfectly:

1. For the law of one price and PPP to hold, the goods or services sold in different locations must be identical. 2. Some goods and services are not tradable, i.e. a haircut. 3. Trade barriers inhibit the trade of goods across some international borders. If goods cannot be traded or if tariffs and quotas add to the costs of trade, then the prices will not equalize and PPP will not hold. 4. Shipping costs keep prices from completely equalizing. 5. Since PPP comes into play in the long-run, it may not hold in the short-run because prices will not have fully adjusted.

Increases in aggregate-demand in Japan arising from yen depreciation:

A depreciation of the yen increases aggregate-demand for Japanese goods and services. In the short-run, real GDP increases and unemployment decreases due to some sticky prices. In the long-run, when prices adjust fully, there are no real effects, just inflation, because the price level rises.

Is a trade deficit a sign of economic weakness? Why or why not?

A trade deficit means that more goods and services are coming in than are going out. We are not worse off when more goods or services flow in. In fact, historical data reveal that the U.S. trade deficit often increases during periods of economic growth, because people in the U.S. are wealthier and they are able to buy more imports.

How supply shifts affect the exchange rate:

All else being equal, an increase in the quantity of a foreign currency shifts the supply of that currency to the right. This shift causes the exchange rate to decrease. Thus, the foreign currency depreciates and the U.S. dollar appreciates.

How demand shifts affect the exchange rate:

An increase in the demand for foreign currency leads to an increase in the exchange rate for that currency. This signals a depreciation of the U.S. dollar relative to the other country's currency. A decrease in the demand for foreign currency leads to a decrease in the exchange rate for that currency. This signals an appreciation for the U.S. dollar relative to the other country's currency.

Why do exchange rates rise and fall?

An increase in the exchange rate indicates a depreciation of the domestic currency. the exchange rate increases when there is an increase in demand for foreign goods, services, and financial assets relative to the demand for domestic goods, services, and financial assets. The exchange rate also increases when there is a decline in the supply of foreign currency relative to the domestic currency. A decrease in the exchange rate indicates an appreciation of the domestic currency. The exchange rate decreases when there is a decrease in demand for foreign goods, services, and financial assets relative to the demand for domestic goods, services, and financial assets. The exchange rate also falls when there is an increase in the supply of foreign currency relative to the supply of domestic currency.

What are three factors that might make capital account surplus grow?

Having a high amount of real and financial assets: U.S.-owned assets abroad, foreign-owned assets in the U.S., net financial derivatives, and statistical discrepancy.

Shifts in the demand for foreign currency:

Increases in the demand for foreign currency derive from an increased demand for foreign goods and services and/or foreign financial assets. Decreases in the demand for foreign currency derive from a decreased demand for foreign goods and services and/or foreign currency.

Why are current account balances generally mirror images of capital account balances?

Key identity of the balance of payments: while either account can be in deficit or surplus, together they sum zero. A positive account balance in the current account means that there must be a negative balance in the capital account, and vise versa. current account balance + capital account balance = 0 Thus, if the current account balance is in deficit, the capital account balance is in surplus by the same amount.

Sometimes, official government reserves are singled out in the balance of payments accounts. For example, when China buys U.S. financial assets (currency and Treasury securities), this purchase is classified as "Official Government Reserves." On which side of the balance of payments should such purchases be reflected - the current account of the capital account? Explain.

On the capital account side because this side includes financial assets and real assets.

What is purchasing power parity?

Purchasing power parity (PPP) is a theory about the determinants of long-run exchange rates. PPP implies that the exchange rate between two nations is determined by a ratio of relative price levels in the two nations. If a nation experiences more inflation than its trading partners do, its exchange rate will rise, indicating a depreciation of its currency. PPP is based on the law of one price.

Three primary causes of current account deficits:

Strong economic growth, lower personal savings rates, and fiscal policy.

What are the three factors that affect the demand side of the market for foreign currency?

The price of currency (exchange rate): the law of demand holds, when the price in a foreign country falls, goods and services produced there are less expensive relative to goods and services produced in the U.S., so the quantity demanded of those cheaper goods increases. The demand for foreign goods: when a demand for a nation's exports rises, the demand for its currency rises as well. The demand for foreign financial assets: to buy stocks and bonds in a foreign country, you have to convert to the local currency of that country.

Shifts in the supply of foreign currency:

The supply for any foreign nation's currency is determined by that nation's government. If the Bank of Japan increases the supply of yen relative to the supply of dollars, the supply curve shifts to the right. If the supply of yen decreases relative to the supply of dollars, the curve shifts to the left.

What causes trade deficits?

Trade deficits are essentially synonymous with current account deficits. As such, they increase when the current account deficit or the capital account surplus increases. Economic growth increases the current account deficit as wealthier residents demand more imports. It also works through the capital account as higher rates of return attract foreign funds. A second cause of trade deficits is lower person savings rates. A third cause of trade deficits is larger government budget deficits.

Exchange rates and its affects on imports and exports:

When exchange rates rise, foreign countries become more expensive relative to the dollar. This means that imports become more expensive. But it also means that U.S. exports become less expensive, so foreigners around the globe can afford to buy more goods and services from the United States.

Flexible (floating) exchange rates

are exchange rates that are determined by the market forces of supply and demand for currency.

Pegged (fixed) exchange rates

are exchange rates that are fixed at a certain level through the actions of a government.

Account surplus

exists when more payments are flowing into an account than out of the account. Because goods and services constitute most of the current account, a surplus of the current account would be driven by trade surplus.

Account deficit

exists when more payments are flowing out of an account than into the account. Generally, this means that we are importing more goods and services than we are exporting.

Balance of payments

is a record of all of a Nation's payments between that country and the rest of the world. Anytime a payment is made across borders, the payment is tracked in the BOP. The BOP is divided into two major accounts: the current account and the capital account.

Derived demand

is demand for a good or service that derives from the demand for another good or service.

Purchasing power parity (PPP)

is the idea that a unit of currency should be able to buy the same quantity of goods and services in any country. PPP is the extension of the law of one price. If, after converting currencies, the price of oranges is higher in Japan than Florida, then supply to Japan increases and supply in Florida decreases until the prices are equal. Pa = exchange rate x Pb

Exchange rate

is the price of foreign currency. This price tells how much a unit of foreign currency costs in terms of another currency. Exchange rates matter because they affect the relative prices of goods and services. Any good that crosses a border has to pass though a foreign exchange market on its way to sale. Exchange rates affect the prices of all imports and exports - and therefore GDP.

Currency depreciation

occurs when a currency decreases in value relative to other currencies. If the dollar depreciates, it is less valuable in world markets.

Currency appreciation

occurs when a currency increases in value relative to other currencies.

Exchange rate manipulation

occurs when a national government internationally adjusts its money supply to affect the exchange rate of its currency.

Law of one price

says that after accounting for transportation costs and trade barriers, identical goods sold in different locations must sell for the same price. Pa = Pb Initially, the price of a pound of oranges in Florida is $1.80, while the same oranges sell for $2.20 per pound in Michigan. Thus, orange supplies reduce supply in Florida and increase supply in Michigan. If transportation costs are zero, these supply changes will take place until the price is the same in both locations.

Current account

tracks payments for goods and services, gifts, and current income for investments.

Capital account

tracks payments for real and financial assets between nations.