Introduction to Unit 12 — The Balance of Payments and Exchange Rates

In this section we focus on international trade We begin the section by looking at the current and capital accounts that make up a nation’s balance of payments and are the two primary measures of international trade:

• The current account deals with the trade of goods and services between two countries. An export is a good (or service) that is sent from the domestic country and purchased abroad. An import is a foreign produced good that is imported for domestic consumption. The monetary value of exports from a country and imports into a country are measured in the current account. If the value of a country’s exports exceeds the value of the goods and services it imports, then that country has a trade surplus. For the past several decades, the U.S. has been running trade deficit where the monetary value of its imports has exceeded the value of its exports to the rest of the world.

When you hear the latest international trade numbers on the news, this refers to the current account.

The sum of the current and capital accounts equals zero. This implies that a country that runs a current account trade deficit will have an offsetting capital account trade surplus.

Consider a country that has a current account deficit. This implies that domestic consumers are spending more money on foreign goods and services than foreign consumers are purchasing of theirs. The net surplus of domestic money flowing abroad eventually returns in the capital account.

We will examine how changes in several variables will impact the current account for a country.

• Changes in economic growth rates and national income.
• Changes in relative prices or inflation rates.

• Changes in domestic preferences.

It is important to isolate each of these from all other events. Remember to hold everything else constant when looking at any of these three changes listed here. For example, if we allow for an increase in domestic growth, we are holding economic growth rates constant everywhere else — with our trading partners. All other variables such as exchange rates are held constant allowing us to focus on the factor we are trying to isolate. For each variation, consider the implications on the current account. Higher domestic growth rates, increases our incomes and consumption of goods and services, including imports. A rise in the domestic inflation rate, holding foreign inflation rates constant, implies there are relatively higher prices for domestically made goods and makes imports cheaper in comparison since their prices have not changed — we are holding them constant.

For the capital account we will allow for interest rates — the return on savings — to vary and look at how changes affect monetary flows. Higher domestic interest rates increase the attractiveness of our nation’s financial assets to foreigners as they can earn a relatively higher return by sending their money abroad.

Exchange rates deal with the value of one currency in terms of another. If the Mexican peso/dollar exchange rate is 8 pesos to $1, then it takes eight pesos to purchase a dollar or a dollar’s worth of goods and services. From the opposite perspective, a dollar buys eight pesos, used to purchase Mexican goods and services.

A devaluation in the currency lowers one currency’s value in terms of the other. For example, a few years ago the peso dollar exchange rate was 4 pesos to the $1. Today it is somewhere around 7 pesos per $1. In this case the peso has depreciated. Previously, it only took Mexican consumers four pesos to buy a dollar (or the equivalent worth in U.S. goods and services), now it takes the same consumer seven pesos to buy the same dollar. If a coke costs a dollar, the price for the Mexican consumer has increased from four to seven pesos, while it still costs a dollar for the U.S. consumer. In this example the dollar has appreciated in relation to the peso. The dollar’s purchasing power in terms of pesos has risen from four pesos to seven pesos.

Earlier in the course we studied various markets. The product, labor and capital markets were all examined and the equilibrium price, wage or interest rate was determined in each. Equilibrium in each market was found when supply and demand in the market were equal.

The equilibrium for a floating exchange rate is found in the market for foreign exchange. Exchange rates are quoted in terms of one currency in exchange for another; the yen/dollar (Ґ/$) exchange rate for example. To determine the dollar’s value in terms of yen in the foreign exchange market we are looking at the supply and demand for dollars in the foreign exchange market .

The supply of dollars in foreign exchange markets represents the dollars leaving the U.S. in the current and capital accounts to purchase foreign goods, services and financial assists. This does not represent the total supply of dollars, only those used for foreign transactions. If you purchase a Korean-made VCR here in the U.S. then you are supplying dollars to the foreign exchange market. If you purchase a U.S.-made mountain bike, then your transaction has no impact on foreign exchange markets.

When foreign consumers purchase U.S. made goods, services or financial assets, they are changing the demand for dollars in financial markets. They are making these transactions in their own currency, and this currency is being converted to dollars in the foreign exchange market.

To determine the yen-dollar exchange rate graphically, we will study the demand and supply of dollars in foreign exchange markets. Movements in either the supply or the demand for dollars in this market will impact the exchange rate between the two currencies.

With an move in the exchange rate value of the dollar, relative prices of imports and exports will change as well. If the dollar appreciates against another currency, then the relative prices of U.S. exports increase to foreign consumers and in comparison foreign import prices fall for U.S. consumers (holding everything else constant such as inflation rates in the two countries). A depreciation of the dollar benefits U.S. producers as it raises import prices (unless foreign producers do something to compensate such as lower their profit margins) and U.S.-made goods and services become relatively cheaper to foreign consumers. In this last case, a rise in exports and fall in imports will reduce the current account deficit.