Download - Ch. 18: International Finance
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Ch. 18: International Finance
–Financing international trade–Balance of payments accounts–International borrowing and lending–Explanations for U.S. change from lender to
borrower. –Exchange rate determination. – Interest rate differentials
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Financing International Trade
• Balance of Payments Accounts– Records international trading, borrowing and
lending. – Three accounts:
• Current account• Capital account• Official settlements account• + in balance of payments = inflows of currency• - In balance of payments = outflows of currency
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Financing International Trade
Current account: net exports + net investment income + net transfers
Capital account (financial account):
Foreign investment in U.S. - U.S. investment in foreign co.’s
Official settlements: – net change in U.S. official holdings of foreign currency
Current + Capital + official settlements = 0 (approx.)
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Financing International Trade– The balance of payments (as a % of GDP)
over the period 1983 to 2003.
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Borrowers and Lenders, Debtors and Creditors
• A country that is borrowing more from the rest of the world than it is lending to it – is a net borrower.– has a current account deficit and a capital account
surplus (assume official settlements acc=0)• A country that is lending more to the rest of
the world than it is borrowing from it – is a net lender.– has a current account surplus, and capital account
deficit (assume official settlements=0)• The U.S. is currently a net borrower (but as late
as the 1970s it was a net lender.)
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Borrowers and Lenders, Debtors and Creditors
• Debtor nation– during its entire history has borrowed more
from the rest of the world than it has lent to it.
• Creditor nation– invested more in the rest of the world than
other countries have invested in it over its entire history
• Difference between borrower/lender nation & creditor/ debtor – difference between stocks and flows of financial capital.
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– Being a net borrower is not a problem provided the borrowed funds are used to finance capital accumulation that increases income.
– Being a net borrower is a problem if the borrowed funds are used to finance consumption.
Borrowers and Lenders, Debtors and Creditors
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Borrowers and Lenders, Debtors and Creditors
• Current Account Balance• NX + Net int. income + Net transfers• NX is largest item in current account.• The other two items are much smaller and
don’t fluctuate much.
• NX = (T – G) + (S – I )• (T-G): govt surplus/deficit.• (S-I): private sector saving
(surplus/deficit).
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Financing International Trade
• Net exports for the U.S. for 2003
–$506 billion = +$42 b (priv sector surplus)
- 548 b (govt sector deficit)
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Borrowers and Lenders, Debtors and Creditors
• S-I has moved in the opposite direction of (T-G)
• No strong relationship between NX and the other two balances individually.
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Borrowers and Lenders, Debtors and Creditors
• Is U.S. Borrowing for Consumption or Investment?– U.S. borrowing from abroad finances
investment. – It is much less than private investment and
almost equal to government investment in public infrastructure capital.
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The Exchange Rate
Foreign exchange market– currency of one country is exchanged for the
currency of another.• Foreign exchange rate
• The price at which one currency exchanges for another
• Currency depreciation/appreciation– fall/rise in the value of the currency in terms
of another currency.
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The Exchange Rate
More recent currency trends at http://finance.yahoo.com/currency
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The Exchange Rate
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The Exchange Rate
• Demand for $ in the Foreign Exchange Market– Quantity of dollars that traders plan to buy in
the foreign exchange market during a given period:
– Depends on • The exchange rate• Interest rates in the U.S. and other countries• Expected future exchange rate
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The Exchange Rate
• Law of Demand for Foreign Exchange– The demand for dollars is a derived demand.– People in foreign countries buy $ so that they
can buy U.S.-made goods and services or U.S. assets.
– As the exchange rate rises (f.c. per $), U.S. exports become more expensive for foreigners and the quantity of $ demanded falls.
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The Exchange Rate
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The Exchange Rate
• Changes in the Demand for Dollars – Interest rates in the U.S. and in other countries – Changes in the expected future exchange rate– U.S. prices relative to foreign prices– Changes in expected relative profitability of
investments in U.S.– Changes in income in foreign countries
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The Exchange Rate
• Supply in the Foreign Exchange Market– Ceteris paribus, the higher the exchange rate
(f.c. per $), the greater is the quantity of dollars supplied in the foreign exchange market.
– As f.c. per $ increases, imports from foreign countries become cheaper to U.S., and U.S. wants to sell more $ to purchase imports.
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The Exchange Rate
• Changes in the Supply of Dollars– Shift in the supply curve.– Interest rates in the U.S. and in other countries – Changes in the expected future exchange rate– U.S. prices relative to foreign prices– Changes in expected relative profitability of
investments in U.S.
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The Equilibrium
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The Exchange Rate
• Changes in the Exchange Rate– Changes in demand and supply in the foreign
exchange market change the exchange rate (just like they change the price in any market).
– interest rates. – inflation rates– investment opportunities– expected future exchange rates
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Movements in exchange rates
• Increase in U.S. interest rates relative to rest of world.
• Increase in expected investment returns relative to rest of world.
• Increase in U.S. inflation relative to rest of world.
• Expected increase in value of $ in future.
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Other Exchange Rate Considerations.– Purchasing power parity:
• A currency should buy the same amount of goods and services in every country.
• If PPP does not hold, there may be an opportunity for profit-making through arbitrage.
• Example– Gold costs $300 per ounce in U.S.; 200 Euros
in Europe. PPP exchange rate should be $300=200 Euros (i.e. .67 Euros per dollar).
– If exchange rate is 1 Euro per dollar, » how can profits be made?» how will this affect exchange rate?
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The Exchange Rate
• If PPP holds, e = P in f.c./ P in $% ch in e = inflation in f.c. – inflation in U.S.
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The Exchange Rate
• Interest rate parity – The return on a currency is the interest rate
on that currency plus the expected rate of appreciation over a given period.
– When the returns on two currencies are equal, interest rate parity prevails.
– Market forces achieve interest rate parity very quickly.
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The Exchange Rate• Return in $ = return in f.c. - % change in P of $
– If a German bond pays 10% over next year and value of $ increases 10%, what’s return in $?
– If a German bond pays 10% over next year and value of $ decreases 10%, what’s return in $?
• Interest differentials across countries reflect expected movements in exchange rates.
• If German bonds pay 10% and U.S. bonds pay 4%, what is
– expected movement in exchange rate? – Expected difference in inflation rate?
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The Exchange Rate
• The Fed in the Foreign Exchange Market– Through its influence on the interest rate, the
Fed can influence the exchange rate. – The Fed can also intervene directly
• By buying $ in foreign exch. market (selling f.c.) – Fed can increase demand for $– Strengthen $– Incur net loss of official reserves.
• By selling $ in foreign exch. Market (buying f.c.) – Fed can increase supply of $– Weaken $– Incur net gain of official reserves.