Chapter 9

Exchange Rate and

Balance of payment
page 211 to 220
parkin
Ch. 9: The Exchange Rate and the
Balance of Payments.
 Exchange rates
• Definition
• Determinants
• Short run
• Long run
• Purchasing power parity
• Interest rate parity
 Balance of payments accounts
 Causes of an international deficit
 Alternative exchange rate policies and their long-run
effects
Currencies and Exchange Rates

U.S. Citizens sell dollars in the foreign exchange

market in order to purchase foreign currency to
• purchase imports
• purchase foreign assets (stocks, bonds, real estate, etc.)
• this is the supply of $
Foreign citizens buy dollars in the foreign exchange
market with foreign currency in order to
• purchase U.S. exports
• purchase U.S. assets.
• this is the demand for $
Currencies and Exchange Rates
Foreign Exchange Rates
•The price at which one currency exchanges for another.
Currency depreciation
• A fall
in the value of one currency in terms of another
currency
– Makes imports more expensive
– Makes exports more affordable
Currency appreciation
•A rise in value of one currency in terms of another
currency.
–Opposite effect of depreciation on
imports/exports.
The Foreign Exchange Market
The Demand for One Currency Is the Supply of
Another Currency
Foreign citizens demanding U.S. dollars supply
their own country’s money.
Factors that influence the demand for U.S. dollars
also influence the supply of foreign currencies.
Factors that influence the demand for another
country’s currency also influence the supply of U.S.
dollars.
The Law of Demand for Foreign Exchange

The demand for dollars is a derived demand.

• People buy U.S. dollars so that they can buy
U.S.-produced goods and services or U.S.
assets.
• ceteris paribus, the higher the exchange rate,
the smaller is the quantity of U.S. dollars
demanded in the foreign exchange market.
The Law of Demand for Foreign Exchange

Ceteris paribus, as the P of $ drops, quantity of $

demanded rises
 Exports effect
 As P of $ drops
foreign citizens wish to purchase more U.S.
exports
quantity of $ demanded rises.
 Expected profit effect
As P of $ drops,
the larger the expected profit from buying
U.S. assets
quantity of $ demanded rises
Supply of $ in the Foreign Exchange Market

The quantity of $ supplied in the foreign exchange market

is the amount that traders plan to sell during a given time
period at a given exchange rate.
The Law of Supply of Foreign Exchange

Ceteris paribus, as P of $ rises, the greater is the

quantity of $ supplied in the foreign exchange market.
Imports effect
• AsP of $ rises, U.S. citizens increase imports and sell
more $ to purchase more imports.
 Expected profit effect
• As P of $ rises, U.S. citizens see greater potential for
profits in foreign assets and sell more $ to purchase
more foreign assets.
The Foreign Exchange Market

Market Equilibrium
If $ is “too strong”,
surplus of $

If $ is “too weak”,
shortage of $
Exchange Rate Fluctuations

Changes in exchange rate cause movement along the

demand curve, NOT a change in demand.
Changes in Demand for $ caused by:
• World demand for U.S. exports
• U.S. interest rate relative to the foreign interest rate
• Expected profits on U.S. assets relative to profits on
foreign assets
• The expected future exchange rate
Exchange Rate Fluctuations

Changes in the exchange rate cause a movement along

the supply curve, NOT a change in supply
Changes in the supply of dollar are caused by:
 U.S. demand for imports
 U.S. interest rates relative to the foreign interest rate
 Expected profits on U.S. assets relative to profits on
foreign assets
 The expected future exchange rate
Exchange Rate Fluctuations

Exchange Rate Expectations

The exchange rate changes when it is expected to
change.
But expectations about the exchange rate are driven by
deeper forces. Two such forces are
 Interest rate parity
 Purchasing power parity
Financing International Trade

Balance of Payments Accounts

Record a country’s international trading, borrowing, and
lending.
Transactions leading to an inflow of currency into the
U.S. create a + (credit) in a balance of payments account
Transactions leading to an outflow of currency from the
U.S. create a – (debit) in a balance of payments account.
 Financing International Trade

Balance of Payments Accounts: A country’s

balance of payments accounts records its
international trading, borrowing, and lendinga in.
Financing International Trade
Three Accounts :
1. Current account
2. Capital and financial account
3. Official settlements account
 Financing International Trade
Current account
• The current account records receipts from
exports of goods and services sold abroad,
payments for imports of goods and services
from abroad, net interest income paid
abroad, and net transfers abroad (such as
foreign aid payments).
• The current account balance equals the
sum of exports minus imports, net interest
income, and net transfers.
 Financing International Trade
Capital and financial account:
• The capital and financial account records
foreign investment in the United States
minus U.S. investment abroad.
• This account also has a statistical
discrepancy that arises from errors and
omissions in measuring international capital
transactions.)
 Financing International Trade
Official settlements account
• The records the change in U.S. official
reserves, which are the government’s
holdings of foreign currency.
• If U.S. official reserves increase, the official
settlements account balance is negative.
Financing International Trade
Financing International Trade

Borrowers and Lenders

A net borrower has a current account deficit
A net lender has a current account surplus
The U.S. is currently a net borrower but during the
1960s and 1970s, the U.S. was a net lender.
Financing International Trade
Debtors and Creditors
•A debtor nation
–country that owes more than other countries
owe to it.
•A creditor nation
–a country that owes less than other coutnries
owe to it.
•Since 1986, the United States has been a debtor nation.

•Borrower/lender status based upon one year

•Debtor/creditor status based upon entire history of
borrowing/lending.
Financing International Trade

Is being a net borrower “bad”?

•Borrowing does not reduce long term economic growth
provided the borrowed funds are used to finance capital
accumulation that increases income.
•can reduce economic growth if the borrowed funds are
used to finance consumption.
•difficult to determine whether U.S. is borrowing for
consumption or capital accumulation.
–Low savings rates in U.S. may be a concern.
Financing International Trade
Determinants of U.S. Borrowing/lending from rest of world
C+S+T=C+I+G+NX
NX=(S-I) + (T-G)
• (S-I) = private sector balance
• (T-G) = public sector balance
if balance>0, surplus
if balance<0, deficit
Ceteris paribus, U.S. borrowing from rest of
world rises as public or private sector balance
decreases
Financing International Trade

For the United States in 2010,

 Net exports were -$536 billion.
 Government sector balance was -$1,295 billion
 Private sector balance was $759 billion
Financing International Trade
The Three Sector Balances
The private sector
balance and the
government sector balance
tend to move in opposite
directions.
Net exports is the sum of
the private sector and
government sector
balances.
Exchange Rate Policy

Three possible exchange rate policies are

 Flexible exchange rate
 Fixed exchange rate
 Crawling peg

Flexible Exchange Rate

A flexible exchange rate policy is one that permits the
exchange rate to be determined by demand and supply
with no direct intervention in the foreign exchange market
by the central bank.
Exchange Rate Policy

Fixed Exchange Rate

pegs the exchange rate at a value decided by the

government or central bank and that blocks the
unregulated forces of demand and supply by direct
intervention in the foreign exchange market.

A fixed exchange rate requires active intervention in the

foreign exchange market.
Exchange Rate Policy

Suppose that the target

is 100 yen per U.S. dollar.
If demand increases, the
central bank sells U.S.
dollars to increase supply.
Effect of “undervalued
dollar” and subsequent
intervention on
1. U.S. money supply?
2. U.S. Inflation?
Exchange Rate Policy

If demand decreases,

the central bank buys
U.S. dollars (with foreign
reserves) to decrease
supply.
Effect of “over-valued”
dollar and subsequent
intervention on:
1. U.S. money supply
and reserves of
foreign currency
2. U.S. inflation
Exchange Rate Policy

Crawling Peg
• selects a target path for the exchange rate with
intervention in the foreign exchange market to achieve that
path.
• China is a country that operates a crawling peg.
• Crawling peg works like a fixed exchange rate except that
the target value changes.
• Avoids wild swings in the exchange rate
Exchange Rate Policy
People’s Bank of China
in the Foreign exchange
Market

China’s official foreign

currency reserves
are piling up.

China will buy $ to drive

up price of $; sell $ to
drive down price of $.
Exchange Rate Policy

The People’s bank buys

U.S. dollars to maintain the
target exchange rate.
China’s official foreign
reserves increase.

Based on diagram, is $
over- or under-valued
relative to Chinese Yuan?