Economics NINTH EDITION Chapter 19 The World of International Finance Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved Learning Objectives 19.1 Discuss how the price of foreign exchange is determined by demand and supply 19.2 Distinguish between the nominal exchange rate and the real exchange rate 19.3 Explain how the current account, financial account, and capital account are all related to one another 19.4 List the benefits and costs of a system of fixed exchange rates compared to a system of flexible exchange rates 19.5 Discuss how international financial crisis can emerge Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved 19.1 HOW EXCHANGE RATES ARE DETERMINED (1 of 5) What Are Exchange Rates? • Exchange rate The price at which currencies trade for one another in the market • Euro The common currency in Europe An increase in the value of a currency relative to the currency of another nation is called an appreciation of a currency A decrease in the value of a currency relative to the currency of another nation is called a depreciation of a currency Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved 19.1 HOW EXCHANGE RATES ARE DETERMINED (2 of 5) How Demand and Supply Determine Exchange Rates • Market equilibrium occurs where the demand for U.S dollars equals the supply Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved 19.1 HOW EXCHANGE RATES ARE DETERMINED (3 of 5) Changes in Demand or Supply An increase in the demand for dollars will increase (appreciate) the dollar’s exchange rate Higher U.S interest rates or lower U.S prices will increase the demand for dollars Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved 19.1 HOW EXCHANGE RATES ARE DETERMINED (4 of 5) Changes in Demand or Supply An increase in the supply of dollars will decrease (depreciate) the dollar exchange rate Higher European interest rates or lower European prices will increase the supply of dollars Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved 19.1 HOW EXCHANGE RATES ARE DETERMINED (5 of 5) Changes in Demand or Supply Let’s summarize the key facts about the foreign exchange market, using euros as our example: • The demand curve for dollars represents the demand for dollars in exchange for euros The curve slopes downward As the dollar depreciates, there will be an increase in the quantity of dollars demanded in exchange for euros • The supply curve for dollars is the supply of dollars in exchange for euros The curve slopes upward As the dollar appreciates, there will be an increase in the quantity of dollars supplied in exchange for euros • Increases in U.S interest rates and decreases in U.S prices will increase the demand for dollars, leading to an appreciation of the dollar • Increases in European interest rates and decreases in European prices will increase the supply of dollars in exchange for euros, leading to a depreciation of the dollar Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved 19.2 REAL EXCHANGE RATES AND PURCHASING POWER PARITY (1 of 3) REAL-NOMINAL PRINCIPLE What matters to people is the real value of money or income—its purchasing power—not the face value of money or income • Real exchange rate The price of U.S goods and services relative to foreign goods and services, expressed in a common currency Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved 19.2 REAL EXCHANGE RATES AND PURCHASING POWER PARITY (2 of 3) The figure shows the real exchange rate for the United States compared to its net exports as a share of GDP Notice that, in general, when the real (multilateral) exchange rate increased, U.S net exports fell Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved Insert Figure 19.4 19.2 REAL EXCHANGE RATES AND PURCHASING POWER PARITY (3 of 3) • Law of one price The theory that goods easily tradable across countries should sell at the same price expressed in a common currency • Purchasing power parity A theory of exchange rates whereby a unit of any given currency should be able to buy the same quantity of goods in all countries Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved 19.3 THE CURRENT ACCOUNT, THE FINANCIAL ACCOUNT, AND THE CAPITAL ACCOUNT (1 of 5) • Balance of payments A system of accounts that measures transactions of goods, services, income, and financial assets between domestic households, businesses, and governments and residents of the rest of the world during a specific time period • Current account The sum of net exports (exports minus imports) plus net income received from abroad plus net transfers from abroad Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved 19.3 THE CURRENT ACCOUNT, THE FINANCIAL ACCOUNT, AND THE CAPITAL ACCOUNT (2 of 5) • Financial account The value of a country’s net sales (sales minus purchases) of assets • Capital account The value of capital transfer and transaction in nonproduced, nonfinancial assets in the international accounts Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved 19.3 THE CURRENT ACCOUNT, THE FINANCIAL ACCOUNT, AND THE CAPITAL ACCOUNT (3 of 5) Rules for Calculating the Current, Financial, and Capital Accounts • Here is a simple rule for understanding transactions on the current, financial, and capital accounts: Any action that gives rise to a demand for foreign currency is a deficit item Any action that gives rise to a supply of foreign currency is a surplus item • The current, financial, and capital accounts of a country are linked by a very important relationship: current account + financial account + capital account = Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved 19.3 THE CURRENT ACCOUNT, THE FINANCIAL ACCOUNT, AND THE CAPITAL ACCOUNT (4 of 5) Rules for Calculating the Current, Financial, and Capital Accounts Insert Table 19.2 SOURCE: Economic Report of the President (Washington, D.C.: U.S Government Pricing Office, 2015) Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved 19.3 THE CURRENT ACCOUNT, THE FINANCIAL ACCOUNT, AND THE CAPITAL ACCOUNT (5 of 5) Rules for Calculating the Current, Financial, and Capital Accounts • Net international investment position Domestic holding of foreign assets minus foreign holdings of domestic assets • Sovereign investment fund Assets accumulated by foreign governments that are invested abroad Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved APPLICATION TAX HAVENS AND GLOBAL IMPALANCES APPLYING THE CONCEPTS #2: How does accounting for investments made in tax havens help explain some puzzles in international finance? Two major puzzles arise in the international financial statistics • First, there appears to be more investment income paid than receive each year Since every dollar paid must go to someone, this shows as a gap in the statistics • Second, According to international statistics, developed countries are lending to developed countries Gabriel Zucman of the London School of Economics found that over percent of all global wealth is held through tax havens, such as the Cayman Islands and these assets go unrecorded Once accounted for, the puzzles are resolved Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved 19.4 FIXED AND FLEXIBLE EXCHANGE RATES (1 of 5) To set the stage for understanding exchange rate systems, let’s recall what happens when a country’s exchange rate appreciates— increases in value There are two distinct effects: • The increased value of the exchange rate makes imports less expensive for the residents of the country where the exchange rate appreciated • The increased value of the exchange rate makes U.S goods more expensive on world markets Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved 19.4 FIXED AND FLEXIBLE EXCHANGE RATES (2 of 5) Fixing the Exchange Rate • Foreign exchange market intervention The purchase or sale of currencies by government to influence the market exchange rate To increase the price of dollars, the U.S government sells Euros in exchange for dollars This shifts the demand curve for dollars to the right Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved 19.4 FIXED AND FLEXIBLE EXCHANGE RATES (3 of 5) Fixed versus Flexible Exchange Rates FLEXIBLE EXCHANGE RATE SYSTEM • Flexible exchange rate system A currency system in which exchange rates are determined by free markets FIXED EXCHANGE RATES • Fixed exchange rate system A system in which governments peg exchange rates to prevent their Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved currencies from fluctuating 19.4 FIXED AND FLEXIBLE EXCHANGE RATES (4 of 5) Fixed versus Flexible Exchange Rates BALANCE OF PAYMENTS DEFICITS AND SURPLUSES • Balance of payments deficit Under a fixed exchange rate system, a situation in which the supply of a country’s currency exceeds the demand for the currency at the current exchange rate • Balance of payments surplus Under a fixed exchange rate system, a situation in which the demand of a country’s currency exceeds the supply for the currency at the current exchange rate • Devaluation A decrease in the exchange rate to which a currency is pegged under a fixed exchange rate system • Revaluation An increase in the exchange rate to which a currency is pegged under a fixed exchange rate system Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved 19.4 FIXED AND FLEXIBLE EXCHANGE RATES (5 of 5) The U.S Experience with Fixed and Flexible Exchange Rates Fixed exchange rate systems provide benefits, but they require countries to maintain similar economic policies—especially to maintain similar inflation rates and interest rates Higher prices in the United States cause the U.S real exchange rate to rise This increase in the real exchange rate over time causes a trade deficit to emerge Exchange Rate Systems Today The flexible exchange rate system has worked well enough since the breakdown of Bretton Woods Some economists believe that the world will eventually settle into three large currency blocs: the euro, the dollar, and the yen Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved APPLICATION A TROUBLED EURO APPLYING THE CONCEPTS #3: What are the fundamental causes for the problems with the Euro? • When the euro was launched in 1999, the vision of its founders was to use the monetary union to further unify Europe economically and politically They envisioned a large economic market, comparable to the United States They believed that by moving to a single currency with agreements on a number of fiscal rules that they could achieve economic stability and growth • Unfortunately, this vision proved to be naïve Under the umbrella of the euro, financial investors throughout the world poured funds into Spain and Ireland fueling an unsustainable housing boom and also lending excessive amounts to the governments of Greece, Italy, and Portugal that faced severe budget challenges • When the housing boom collapsed and the worldwide recession of 2007 increased budgetary pressures, it became clear that the banks and governments of these countries could not easily pay their debts Moreover, with a single currency for the euro area, countries could not make adjustments through depreciation of their currency The options facing Europe were bleak: either large-scale financial transfers from Germany and other successful countries, or sharp cutbacks in budgets and prolonged unemployment to reduce wage levels • What became apparent was that the United States did not just have a single currency; it also had a unified fiscal system that provided transfers to states and regions in economic distress Monetary union without a corresponding fiscal system cannot be easily sustained Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved 19.5 MANAGING FINANCIAL CRISES • Hardly a year goes by without some international financial crisis • Even when a country takes strong, institutional steps to peg its currency, a collapse is still possible Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved APPLICATION THE ARGENTINE FINANCIAL CRISIS APPLYING THE CONCEPTS #4: What are the causes of financial collapses that occur throughout the globe? During the late 1980s, Argentina suffered from hyperinflation As part of its financial reforms, it pegged its currency to the U.S dollar, making pesos “convertible” into dollars To issue pesos, the central bank had to have an equal amount of dollars, or its equivalent in other hard currencies, on hand Some economists believed this reform would bring stability to the financial system Unfortunately, they were proved wrong Several problems developed: • • • As the dollar appreciated, Argentina began to suffer from a large trade deficit Wage increases also pushed up the real exchange rate Argentina had to borrow extensively in dollar-denominated loans Eventually, Argentina was forced to default on its international debt in 2002 and freeze bank accounts The hopes of the reforms in the early 1990s had become a bitter memory Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved KEY TERMS Balance of payments Flexible exchange rate system Balance of payments deficit Foreign exchange market intervention Balance of payments surplus Law of one price Capital account Net international investment position Current account Purchasing power parity Devaluation Real exchange rate Euro Revaluation Exchange rate Sovereign investment funds Financial account Fixed exchange rate system Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved ...Learning Objectives 19. 1 Discuss how the price of foreign exchange is determined by demand and supply 19. 2 Distinguish between the nominal exchange rate and the real exchange rate 19. 3 Explain how... financial account, and capital account are all related to one another 19. 4 List the benefits and costs of a system of fixed exchange rates compared to a system of flexible exchange rates 19. 5 Discuss... Education, Inc All Rights Reserved 19. 1 HOW EXCHANGE RATES ARE DETERMINED (2 of 5) How Demand and Supply Determine Exchange Rates • Market equilibrium occurs where the demand for U.S dollars equals the