International Finance

and the Foreign

Exchange Market
Full Length Text — Part: 4 Chapter: 19
Macro Only Text — Part: 4 Chapter: 19

To Accompany “Economics: Private and Public Choice 13th ed.”

James Gwartney, Richard Stroup, Russell Sobel, & David Macpherson
Slides authored and animated by:
Joseph Connors, James Gwartney, & Charles Skipton

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Foreign Exchange Market

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Foreign Exchange Market
• Market where different currencies are
traded, one for another.
• The exchange rate enables people in one
country to translate the prices of foreign
goods into units of their own currency.
• An appreciation of a nation’s currency will
make foreign goods cheaper.
• A depreciation of a nation’s currency will
make foreign goods more expensive.

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Determinants
of the Exchange Rate

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Determinants of the Exchange Rate
• Under a flexible rate system, the exchange
rate is determined by supply and demand.
• The dollar demand for foreign exchange
originates from U.S. purchases for foreign
goods, services, and assets (real and financial).
• The supply of foreign exchange originates
from sales of goods, services, and assets from
Americans to foreigners.
• The foreign exchange market brings the
quantity demanded and quantity supplied
into balance.
• This also brings the purchases of Americans
from foreigners into equality with the sales
of Americans to foreigners.
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 Foreign Exchange Market Equilibrium
• The dollar price of the English
Dollar price of
pound is measured on the vertical foreign exchange
axis. The horizontal axis indicates (for pounds)
the flow of pounds in exchange S(sales to
foreigners)
for dollars.
• The demand and supply of pounds
are in equilibrium at the exchange Excess supply
rate of $1.80 = 1 English pound. of pounds
$2.00
• At this price, quantity demanded
equals quantity supplied.
$1.80 e
• A higher price of pounds (like Excess demand
$2.00 = 1 pound), would lead to for pounds
$1.60
an excess supply of pounds ...
causing the dollar price of the D(purchases from
pound to fall (depreciate). foreigners)

• A lower price of pounds (like Quantity of

$1.60 = 1 pound), would lead to Q foreign exchange
(pounds)
an excess demand for pounds …
causing the dollar price of the
pound to rise (appreciate). Jump to first page
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Changes in the Exchange Rate
• Factors that cause a currency to depreciate:
• a rapid growth of income (relative to trading
partners) that stimulates imports relative to
exports
• a higher rate of inflation than one's trading
partners
• a reduction in domestic real interest rates
(relative to rates abroad)
• a reduction in the attractiveness of the
domestic investment environment that leads
to an outflow of capital

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 Foreign Exchange
Market Equilibrium
Dollar price of
• Other things constant, if incomes foreign exchange
(for pounds)
increase in the United States, U.S. S(sales to
imports of foreign goods and foreigners)
services will grow.
• The increase in imports will
increase the demand for pounds
(in the foreign exchange market) $2.00 b
causing the dollar price of the
pound to rise from $1.80 to $2.00. $1.80 a

D2
D1
Quantity of
Q1 Q2 foreign exchange
(pounds)
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 Inflation with
Flexible Exchange Rates S2
Dollar price of
• If prices were stable in England foreign exchange
(for pounds)
while the price level in the U.S. S1
increased by 50 percent …the
U.S. demand for British goods
(and pounds) would increase … $2.70 b
as U.S. exports to Britain would
be relatively more expensive they
would decline and thereby cause
the supply of pounds to fall. $1.80 a
• These forces would cause the
dollar to depreciate relative to D2
the pound.
D1
Quantity of
Q1 foreign exchange
(pounds)
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Changes in the Exchange Rate
• Factors that cause a currency to appreciate:
• a slower growth rate relative to one’s trading
partners
• a lower inflation rate than one's trading
partners
• an increase in domestic real interest rates
(relative to rates abroad)
• an improvement in the attractiveness of the
domestic investment environment that leads
to an inflow of capital

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Questions for Thought:
1. Other things constant, which of the following
would cause the U.S. dollar to depreciate?
a. less rapid growth of income than our trading
partners
b. a lower rate of inflation than our trading
partners
c. an outflow of capital because of fear that the
U.S. stock market will perform poorly in the
future
d. an increase in the quantity of drilling
equipment purchased in the United States by
Pemex, the Mexican oil company, as a result
of a Mexican oil discovery

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Questions for Thought:
1. Other things constant, which of the following
would cause the U.S. dollar to depreciate?
e. an increase in the U.S. purchase of crude oil
from Mexico as a result of the development
of Mexican oil fields
f. higher real interest rates in Europe, inducing
many Americans to move their financial
investments from U.S. to European banks
g. an economic boom in Mexico, inducing
Mexicans to buy more U.S. made automobiles,
trucks, electric appliances, and personal
computers

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Questions for Thought:
2. “The number of euros that a U.S. dollar would
purchase fell from 1.00 in August of 2002 to
0.85 in August of 2004. This indicates that
the euro appreciated relative to the dollar
during this period.”
-- Is this statement true?
3. “Under a flexible exchange rate system, the
equilibrium exchange rate will tend to bring
the value of goods imported into balance
with the value of goods exported.”
-- Is this statement true?

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International Finance
and Alternative Exchange
Rate Regimes

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Three Major Types of
Exchange Rate Regimes
• There are three major types of exchange
rate regimes:
• flexible rates;
• fixed-rate, unified currency; and,
• pegged exchange rates.
• We have discussed flexible exchange rate
regimes extensively.
• We will now explain the nature and
operation of the other two major regimes.

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Fixed Rate, Unified Currency Regime
• Fixed rate, unified currency regime:
a system where currencies are linked to each
other at a fixed rate.
• A single central bank conducts the monetary
policy that influences the value of the unified
currency relative to other world currencies.
• The linkage may be either through the use of
the same currency or through a currency
board that agrees to trade the currencies, one
for another, at a fixed rate.

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Fixed Rate, Unified Currency Regime
• Some examples of fixed rate, unified
currency systems --
• The U.S., Panama, Ecuador, El Salvador,
and Hong Kong all of which use currencies
that are unified with the U.S. dollar.
• The 16 countries of the European Monetary
Union all use the euro, which is managed by
the European Central Bank. Several other
countries, including Estonia, Bulgaria, Latvia,
Lithuania, Bosnia, and Herzegovina use a
currency board to link their domestic
currencies to the euro. Thus, the euro is a
unified currency in all of these countries.

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Fixed Rate, Unified Currency Regime
• Countries such as El Salvador & Hong
Kong, that link their currency to the dollar
at a fixed rate, are no longer in a position
to conduct monetary policy. They merely
accept the monetary policy of the Federal
Reserve.
• The same can be said for the 16 countries
of the European Monetary Union and the
other countries that link their currency to
the Euro, all of whom accept the monetary
policy of the European Central Bank.

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Pegged Exchange Rate Regimes
• Pegged exchange rate system:
a system where the country commits to using
monetary and fiscal policy to maintain the
exchange-rate value of the domestic currency
at a fixed rate or within a narrow band relative
to another currency (or bundle of currencies).
• Unlike the case of a currency board, however,
countries with a pegged exchange rate
continue to conduct monetary policy.

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When Pegged Regimes
Lead to Problems
• A nation can either:
• follow an independent monetary policy,
allowing its exchange rate to fluctuate, or,
• tie its monetary policy to the maintenance
of the fixed exchange rate.
• It cannot, however:
• maintain currency convertibility at a fixed
exchange rate while following a monetary
policy more expansionary than that of the
country to which its currency is tied.

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When Pegged Regimes
Lead to Problems
• Attempts to peg rates and follow a monetary
policy that is too expansionary have led to
several financial crises—a situation where
falling foreign reserves eventually force the
country to forego the pegged rate.
• The experiences of Mexico in 1989-1994
and of Brazil, Thailand, South Korea,
Indonesia, and Malaysia in 1997-1998
illustrate this point very clearly.

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Questions for Thought:
1. Can a nation fix its exchange rate to another
currency such as the dollar and at the same
time follow an independent monetary policy?
Why or why not?
2. If a country operates under a currency board
regime, the country commits itself to …
a. an expansionary monetary policy in order
to maintain the convertibility of its currency.
b. issuing its currency at a fixed rate in exchange
for an equivalent amount of another designated
currency and investing the funds in bonds and
liquid assets which provide 100% backing for
the currency units issued.
c. raising taxes in order to maintain the
convertibility of its currency.
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Balance of Payments

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Balance of Payments
• Balance of payments:
accounts that summarize the transactions
of a country’s citizens, businesses, and
governments with foreigners
• Any transaction that creates a demand for
foreign currency (and a supply of the domestic
currency) in the foreign exchange market is
recorded as a debit item. Example: Imports
• Transactions that create a supply of foreign
currency (and demand for the domestic
currency) on the foreign exchange market are
recorded as a credit item. Example: Exports

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Balance of Payments
• Under a pure flexible rate system, the foreign
exchange market will bring the quantity
demanded and the quantity supplied into
balance, and as a result, it will also bring the
total debits into balance with the total credits.

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Balance of Payments
• Current account transactions:
all payments (and gifts) related to the purchase
or sale of goods and services and income flows
during the current period
• Four categories of current account
transactions:
• Merchandise trade
(import and export of goods)
• Service trade
(import and export of services)
• Income from investments
• Unilateral transfers
(gifts to and from foreigners)

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Balance of Payments
• Capital account transactions:
transactions that involve changes in the
ownership of real and financial assets
• The capital account includes both
• direct investments by foreigners in
the U.S. and by Americans abroad, and,
• loans to and from foreigners.
• Under a pure flexible-rate system, official
reserve transactions are zero; therefore:
• a current-account deficit implies
a capital-account surplus.
• a current-account surplus implies
a capital-account deficit.

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 U.S. Balance of Payments, 2008*
Balance
Debits Credits deficit (-) / surplus (+)

Current account:
1. U.S. merchandise exports + 1277.0
2. U.S. merchandise imports - 2117.2
3. Balance of merchandise trade (1 + 2) - 840.2
4. U.S. service exports + 549.6
5. U.S. service imports - 405.3
6. Balance on service trade (4 + 5) + 144.3
7. Balance on goods and services (3 + 6) - 695.9
8. Income receipts of Americans from abroad + 764.6
9. Income receipts of foreigners in the U.S. - 646.4
10. Net income receipts (8 + 9) 118.2
11. Net unilateral transfers - 128.4

12. Balance on current account (7 + 10 + 11) - 706.1

Source: http://www.economagic.com/. * Figures are in Billions of Dollars

Continued on next slide …

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 U.S. Balance of Payments, 2008*
Balance
Debits Credits deficit (-) / surplus (+)

Current account:
12. Balance on current account (7 + 10 + 11) - 706.1

Capital account:
13. Foreign investment in the U.S. (capital inflow) + 389.6
14. U.S. investment abroad (capital outflow) -271.3
15. Net other currency transactions + 105.6
16. Balance on capital account (13 + 14 + 15) + 223.9
Official Reserve Transactions:
17. U.S. official reserve assets -4.8
18. Foreign official assets in the U.S. + 487.0
19. Balance, Official Reserve Account (16 + 17) + 482.2

20. Total (12 + 16 + 19) 0.0

Source: http://www.economagic.com/. * Figures are in Billions of Dollars

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Capital Flows and
the Current Account

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Current Acct & Net Foreign Investment
Current Account as % of GDP
+2 surplus (+) or deficit (-)

0
-2
-4
-6
1978 1983 1988 1993 1998 2003 2008

Net Foreign Investment as % of GDP

surplus (+) or deficit (-)
+4

+2

-2
1978 1983 1988 1993 1998 2003 2008

• As the above figures for the U.S. indicate, under a flexible

exchange rate system the inflow and outflow of capital
exert a major impact on current account balances.
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Are Trade Deficits Bad?
• With flexible exchange rates, an inflow
of capital implies a trade (current account)
deficit; an outflow of capital implies a trade
(current account) surplus.
• While the term “deficit” generally has
negative connotations, this is not necessarily
true for a trade deficit.
• If a nation’s investment environment is
attractive, it is likely to result in a net inflow
of capital, which will tend to cause a trade
deficit.
• Similarly, rapid economic growth will tend
to stimulate imports, which is likely to result
in a trade deficit.

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Trade Deficits: Points to Ponder
• Although they often cause trade (and current
account) deficits, both rapid growth and a
healthy investment environment are signs of
a strong economy, not a weak one.
• A trade deficit (or surplus) is an aggregate
that reflects the voluntary choices of
individuals and businesses. In contrast
with a budget deficit, no legal entity is
responsible for the trade deficit.
• The trade deficits of the U.S. during the
1980s and 90s were largely the result of rapid
growth and a favorable investment climate.

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Should Trade Between
Countries Balance?
• Political leaders often imply that U.S.
exports to a country, China or Japan for
example, should be approximately equal
to our imports from that country.
• This is a fallacious view.
• Under a flexible exchange rate system,
overall purchases from foreigners will
balance with overall sales to foreigners,
but there is no reason why bilateral trade
between any two countries will balance.

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Should Trade Between
Countries Balance?
• Rather than balance, economics indicates
that a country will tend to experience …
• trade surpluses with trading partners that
buy a lot of goods that it supplies at a low
cost, and,
• trade deficits with trading partners that are
economical suppliers of goods that can be
produced domestically only at a high cost.

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Questions for Thought:
1. Since the early 1980s, the United States has
persistently run
a. a current account deficit and a capital account
surplus.
b. both a current account deficit and a capital
account deficit.
2. “Under a pure flexible exchange rate system, a
nation that has a current account deficit will
also have a capital account surplus.”
-- Is this statement true? Explain.

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Questions for Thought:
3. “Countries that offer attractive investment
opportunities relative to those available
elsewhere will often experience an inflow
of capital and a trade deficit.”
-- Is this statement true?
a. No; if a country’s investment environment
is attractive, this will generally lead to an
outflow of capital.
b. No; if the investment environment of a
country is attractive, it will generally run
a trade surplus.
c. Yes; the statement is true.

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Questions for Thought:
4. “If other countries did not impose trade
barriers that limit our exports, the flexible
exchange rate system of the United States
would bring U.S. exports to a specific
country (Japan, for example) into balance
with U.S. imports from that country.”
-- Is this statement true?
5. Will a healthy economy run a balance of trade
surplus? Does a balance of trade deficit
indicate that a nation is in financial trouble?
Can a country continue to run a trade deficit?
Why or why not?

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Questions for Thought:
6. In recent years, U.S. imports from China have
been substantially greater than U.S. exports to
China. This bi-lateral trade deficit is:
a. proof that the Chinese treat U.S. produced
goods unfairly.
b. surprising, because the flexible exchange rates
of the U.S. should bring its bilateral trade with
another country into balance.
c. not surprising, because there is no reason why
bi-lateral trade between two countries should
be in balance.

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 End
Chapter 19

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