Transcript Slide 1

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
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
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.)
Financing International Trade
– The balance of payments (as a % of GDP)
over the period 1983 to 2003.
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.)
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.
Borrowers and Lenders, Debtors and Creditors
– 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
• 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).
Financing International Trade
• Net exports for the U.S. for 2003
• –$506 billion = +$42 b (priv sector surplus)
•
- 548 b (govt sector
deficit)
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.
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.
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.
The Exchange Rate
More recent currency trends at http://finance.yahoo.com/currency
The Exchange Rate
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
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.
The Exchange Rate
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
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.
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.
The Equilibrium
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
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.
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?
The Exchange Rate
• If PPP holds,
–  e = P in f.c./ P in $
% ch in e = inflation in f.c. – inflation in U.S.
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.
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?
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.