Balance of Accounts and Foreign Exchange Markets

Modules 41-44

The Rest of the World

• US is not a closed economy

• 2013 Trade in Goods & Services–Exports = $2.28 Trillion–Imports = $2.74 Trillion

Figure 41.1 The Balance of PaymentsRay and Anderson: Krugman’s Macroeconomics for AP, First EditionCopyright © 2011 by Worth Publishers

The Rest of World

• When foreigners buy our goods or invest in the US, they need to use U.S. dollars

• We need to account for the dollars that are used to trade with the rest of the world

• In theory, the total dollars out must equal total dollars in

The Rest of the World

• Reconciling these flows is what is called the “Balance of Payments”

• There are two component accounts1. Current account 2. Capital account (aka Financial Account)

Current Account

• Value of trade in goods and services that do not produce liabilities– Transactions are concluded with no future

implications

1. Net Exports2. Factor (investment) income3. Transfers

Current Account1. Net Exports

– Trade Balance– Surplus or deficit

2. Factor Income– Wages paid/earned overseas– Dividends; Interest

3. Transfers– Foreign aid– Remittances

Capital Account

• Value of net change in ownership of assets– Things that have implications beyond current year

1. Government sales and purchases of assets2. Private sales and purchases of assets3. Financial reserves (currency held)

Capital Account

1. Government sales and purchases of assets– e.g., Central banks buy/sell US Treasury Bonds

2. Private sales and purchases of assets– e.g., Chinese citizens buy New York real estate

3. Financial reserves– Holdings of US dollars abroad

Balance of Payments

Because money out + money in must equal 0:

Current Account + Capital Account = 0

Current Account = - Capital Account

Table 41.2 The U.S. Balance of Payments in 2008 (billions of dollars)Ray and Anderson: Krugman’s Macroeconomics for AP, First EditionCopyright © 2011 by Worth Publishers

Balance of Payments

Figure 41.2 The Loanable Funds Model RevisitedRay and Anderson: Krugman’s Macroeconomics for AP, First EditionCopyright © 2011 by Worth Publishers

Loanable Funds MarketReal

Trade and the Loanable Funds Market

• All things being equal, higher real interest rates will attract foreign investment

• So countries with higher interest rates will increase supply of loanable funds from foreign investors

• The source country for those funds will experience a decline in supply

Figure 41.3 Loanable Funds Markets in Two CountriesRay and Anderson: Krugman’s Macroeconomics for AP, First EditionCopyright © 2011 by Worth Publishers

Real Real

Figure 41.4 International Capital FlowsRay and Anderson: Krugman’s Macroeconomics for AP, First EditionCopyright © 2011 by Worth Publishers

RealReal

The Foreign Exchange Market

• The market that results when currencies are sought by and offered up to those in other countries

• The “price” of one currency in terms of another is the exchange rate.– Expressed as a ratio– e.g., euros per dollar (€/$)

• Currently 0.86 €/$

Exchange rates

• At 0.86 €/$, each $1 would buy €0.86

• To find the number of dollars per euro, just take the inverse:

1/.86 = $1.16 $/€

• If the exchange rate increases, we can say that currency in the denominator appreciates, while the currency in the numerator depreciates.

Exchange Rates

• Since the exchange rate is the price of a currency, it can be used to calculate the prices of goods in one country relative to the other.

• Suppose 14 pesos/$– What would be the price in pesos of a $2000

computer?• 14 pesos/$ x $2,000 = 28,000 pesos

– What if it were 16 pesos/$?• 16 pesos/$ x $2,000 = 32,000 pesos

Exchange Rates

• In the previous example the dollar appreciated against the peso.– As a result the computer became more expensive

for the peso-holder

• If a country’s currency appreciates, its products become relatively more expensive

Figure 42.1 The Foreign Exchange MarketRay and Anderson: Krugman’s Macroeconomics for AP, First EditionCopyright © 2011 by Worth Publishers

Bottom-Bottom Rule

Changes in Curves

These changes will affect the supply of one currency and the demand for the other

1. Changes in the demand for a country’s goods and services

2. Changes in the desire to invest in a country3. Expectations of speculators

Examples: $US v. ¥ Japanese

1. US consumers demand more Japanese cars– Demand for ¥ increases– Supply of $ increases

2. US real GDP increases– Demand for ¥ increases– Supply of $ increases

3. US interest rates increase relative to Japan– Demand for $ increases– Supply of ¥ increases

Figure 42.2 An Increase in the Demand for U.S. DollarsRay and Anderson: Krugman’s Macroeconomics for AP, First EditionCopyright © 2011 by Worth Publishers

Real v. Nominal Exchange Rates

The real exchange rate takes into account the difference in price levels of the two countries

Real Exchange Rate = Nominal Exchange Rate (A/B) x PB/PA

A= currency in country AB= currency in country B

PA= price level in country A

PB= price level in country B

Real Exchange Rate

So, at 14 pesos per dollar, if the price level in the US was 100 and in Mexico was 125…

Real Exchange Rate = 14 pesos/$ x (100/125) = 14 x .8 = 11.2 pesos/$

Purchasing Power Parity

• Related to real exchange rate

• What nominal exchange rate would result in an identical basket of goods costing the same in each country?

• So if something costs $100 in the US and 1,000 pesos in Mexico, the rate would be 10