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Balance of Payments
A country’s balance of payments summarizes all economic transactions that occur during a given period between residents (people, firms, and governments) of that country and residents of other countries
Balance of payments measures a flow, or the balance of economic transactions
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Balance of Payments
Balance-of-payments accounts are maintained according to the principles of double-entry bookkeeping, in which entries on one side of the ledger are called credits, and entries on the other side are called debits.
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Merchandise Trade Balance
Equals the value of merchandise exports minus the value of merchandise imports
Reflects trade in goods, or tangible products, and is often referred to as the trade balanceIf the value of merchandise exports exceeds
the value of merchandise imports, there is a trade surplus
If the value of merchandise imports exceeds the value of merchandise exports, there is a trade deficit
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Exhibit 1: Relative to GDP, U.S. Imports Have Topped Exports Since 1976, and the Trade Deficit Has Widened
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Balance on Goods and Services
Balance on goods and services: the portion of a country’s balance-of-payments account that measures the value of a country’s exports of goods and services minus the value of its imports of goods and services (net exports)
Merchandise trade balance focuses on the flow of goods, but services (intangibles) are also traded internationally
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Unilateral Transfers
Unilateral transfers consist of government transfers to foreign residents: foreign aid, personal gifts to individuals abroad, etc.
Net unilateral transfers equal the unilateral transfers received from abroad by U.S. residents minus unilateral transfers sent to foreign residents by U.S. residents
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Balance on Current Account
The portion of a country’s balance-of-payments account that measures that country’s balance on goods and services plus its net unilateral transfers
Can be negative = current account deficit
Can be positive = current account surplus
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Capital Account
The record of a country’s international transactions involving purchases or sales of financial and real assets
Between 1917 and 1982, the United States ran a deficit in the capital accountU.S. residents purchased more foreign assets
than foreigners purchased assets in the U.S.This reversed itself in 1983, and since then
foreigners have purchased more U.S. assets than the other way around
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U.S. Balance of Payments 2003(billions of dollars)
All transactions requiring payments from foreigners to U.S. residents are entered as credits, indicated by a plus sign (+), because they result in an inflow of funds from foreign residents to U.S. residents.All transactions requiring payments to foreigners from U.S. residents are entered as debits, indicated by a minus sign (), because they result in an outflow of funds from U.S. residents to foreign residents. As you can see, a surplus in the capital account of $579.0 billion more than offsets a current account deficit of $541.8 billion.
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U.S. Balance of Payments
The statistical discrepancy that balances payments is a negative $37.2 billion
Statistical discrepancy: the official “fudge factor” that:measures the error in the balance-of-
paymentssatisfies the double-entry bookkeeping
requirement that total debits equal total credits
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Foreign Exchange and Exchange Rates
Foreign exchange: foreign money needed to carry out international transactions
Exchange rate: the price measured in the currency of one country that is needed to purchase one unit of another country’s currency
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The Euro and Exchange Rates
The euro is now the common currency of the euro area
The price, or exchange rate, of the euro in terms of the dollar is the number of dollars required to purchase one euro
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Foreign Exchange
Currency depreciation: with respect to the dollar, an increase in the number of dollars needed to purchase 1 unit of foreign exchange in a flexible rate system
Currency appreciation: With respect to the dollar, a decrease in the number of dollars needed to purchase 1 unit of foreign exchange in a flexible rate system
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Demand for Foreign Exchange
U.S. residents need euros to pay for goods and services produced in the euro area
The demand curve for euros the inverse relationship between the dollar price of the euro and the quantity of euros demanded, other things constant Incomes and preferences of U.S. consumers The expected inflation rates in the U.S. and the euro
area The euro price of goods in the euro area Interest rates in the U.S. and the euro area
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Demand for Foreign Exchange
In the aggregate, the lower the dollar price of foreign exchange, other things constant, the greater the quantity demanded
A drop in the dollar price of foreign exchange, in this case the euro, means that fewer dollars are required to purchase each euro: prices of euro goods become cheaper
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Supply of Foreign Exchange
The supply of foreign exchange is generated by the desire of foreign residents to acquire dollars
The positive relationship between the dollar-per-euro exchange rate and the quantity of euros supplied in the foreign exchange market implies an upward-sloping supply curve
Assumed constant are: euro area incomes and preferences expectations about the rates of inflation in the euro
area and the United States interest rates in the euro area and the United States
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Exhibit 4: The Foreign Exchange Market
1.10
0
D
S
Foreign exchange(millions of euros)800 820
Exc
han
ge
rate
(d
olla
rs p
er e
uro
)Initial equilibrium exchange rate is $1.10If the exchange rate is allowed to adjust freely, or to float in response to market forces, the market will clear continually
1.20
1.00
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Exhibit 5: Effect on the Foreign Exchange Market of an Increased Demand for Euros
1.10
0
D
S
Foreign exchange(millions of euros)
800
$1.12
820
Suppose an increase in U.S. incomes causes Americans to increase their demand for all normal goods, including those from the euro area: demand curve shifts from D to D'The shift of the demand curve leads to an increase in the exchange rate from $1.10 to $1.12 per euroThe euro appreciates and the dollar depreciates: euro area people purchase more American products
Exc
han
ge
rate
(d
olla
rs p
er e
uro
)
D'
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Arbitrageurs
Dealers who take advantage of temporary geographic differences in exchange rates by simultaneously buying a currency in one market and selling it in another If one euro costs $0.89 in New York and $0.90 in
Frankfurt, the arbitrageur would buy euros in New York and at the same time sell them in Frankfurt
Demand for euros in New York would increase Supply of euros in Frankfurt would increase Price differential would be eliminated
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Speculators
Speculators buy or sell foreign exchange in hopes of profiting from fluctuations in the exchange rate over time trading the currency at a more favorable exchange
rate later
By taking risks, speculators aim to profit from market fluctuations by trying to buy low now and sell high later
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Purchasing Power Parity
Purchasing power parity theory (PPP): predicts the exchange rate between two currencies will adjust in the long run to reflect price-level differences between the two currency regions
This is true as long as trade across borders is unrestricted and exchange rates are allowed to adjust freely
PPP is generally a long-run indicator
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Purchasing Power Parity
A given basket of internationally traded goods should therefore sell for about the same around the world after adjusting for transportation costs and the like
Big Mac Index
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Flexible Exchange Rates
Exchange rate determined by the forces of demand and supply without government intervention
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Fixed Exchange Rates
Fixed exchange rates: rate of exchange between currencies pegged within a narrow range and maintained by the central bank’s ongoing purchases and sales of currencies
Suppose the European Central Bank selects what it thinks is an appropriate rate of exchange between the dollar and the euro: it attempts to fix, or peg, the exchange rate within a narrow band around the particular value selected
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Fixed Exchange Rates
If the value of the euro threatens to climb above the maximum acceptable exchange rate, monetary authorities Sell euros and buy dollars keeping the dollar
price of the euro downIf the value of the euro threatens to drop
below the minimum acceptable exchange rate, monetary authorities Sell dollars and buy euros in foreign
exchange markets
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Fixed Exchange Rates
If monetary officials must keep selling foreign exchange to maintain the pegged rate, they risk running out of foreign exchange reserves
The government has several options The pegged exchange rate can be increased:
devaluation of the domestic currency The pegged exchange rate can be decreased:
revaluation of the domestic currency The government can attempt to reduce the domestic
demand for foreign exchange directly by imposing restrictions on imports or capital flows
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Fixed Exchange Rates
The government can adopt contractionary fiscal or monetary policies to reduce the country’s income level, increase interest rates, or reduce inflation relative to that of the country’s trading partners
Finally, the government can allow the disequilibrium to persist and ration the available foreign reserves through some form of foreign exchange control
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Development of the International Monetary System
From 1879 to 1914, the international financial system operated under a gold standard
The gold standard provided a fixed, predictable exchange rate that did not vary as long as currencies could be redeemed for gold at the announced rate
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Bretton Woods Agreement
Because the U.S. had a strong economy, the dollar was selected as the key reserve currency
Created the International Monetary Fund (IMF) to Set rules for maintaining the international monetary
system Standardize financial reporting for international
trade Make loans to countries with temporary balance of
payments problems Establish a revolving fund to lend money to troubled
economies
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Demise of the Bretton Woods System
During the latter part of the 1960s, inflation in the U.S. caused the dollar to become overvalued at the official exchange rate The gold value of the dollar exceeded the exchange
value of the dollar
The result was that in August 1971, the U.S. stopped exchanging gold for dollars
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Demise of the Bretton Woods System
The dollar was devalued with the hope that this would put the dollar on firmer footing and would save the dollar standard
With prices rising at different rates, an international monetary system based on fixed exchanged rates was doomed and the Bretton Woods system collapsed
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Current System: Managed Float
Managed float system: combines features of a freely floating exchange rate with sporadic intervention by central banks as a way of moderating exchange rate fluctuations among the world’s major currencies
Most smaller countries still peg their currencies to one of the major currencies or to a basket of major currencies
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Managed Float
Major criticisms of flexible exchange rates: They are inflationary because they free monetary
authorities to pursue expansionary policies They have often been volatile, especially since the
late 1970s This volatility creates uncertainty and risks for
importers and exporters and can lead to wrenching changes in the competitiveness of a country’s export sector
Policymakers’ ideal is a system that will foster international trade, lower inflation, and promote a more stable world economy