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Finance Flashcards

Chapter 19- International Finance

Balance of Payment Accounts Record a country’s international trading, borrowing, and lending1) Current account2) Capital and finance account3) Official settlements account*The sum of these three accounts will always equal zero
Current Account Records receipts from the sale of goods and services to other countries (exports), minus payments for goods an services bought from other countries (imports), plus the net amount of interest and transfers (such as foreign aid payments) received from and paid to other countries*Net exports + Net interest + Net transfers
Capital and Financial Account Records foreign investment in the United States minus U.S. investment abroad*Net investment + [Other] net investment + Statistical Discrepancy
Official Settlements Account Records the changes in the U.S. official reserves*Official settlements account balance
U.S. Official Reserves The government’s holdings of foreign currency*If reserves increase, the official settlements account balance is negative; if reserves decrease, the official settlements account balance is positive(holding foreign money is like investing abroad)
Components of the Balance of Payments Accounts Current Account:Exports = ( + ) > like income from workImports = ( – ) > like expenditures on goods and servicesNet interest = ( +/- )Net transfers = ( +/- )Capital and Financial Account:Foreign Investment in the U.S. = ( + ) > like income from investmentU.S. Investment Abroad = ( – )Other net Foreign Investment in the U.S. = ( +/- ) > like taking out a mortgageStatistical Discrepancy = ( +/- )Official Settlements Account:Official Settlements Account Balance = ( +/- ) > like a change in one’s bank account
U.S. Balance of Payments Historically 1) Current account deficit during the 1980s (capital and financial account surplus)2) Near-zero balance in the recession of the early 1990s3) Current account deficit growing larger until 2006 (capital and financial account surplus growing larger)4) Current account deficit shrinking since 2006 (capital and financial account surplus shrinking)5) Official settlements balance changes very slightly, and is always at a near-zero deficit/surplus
U.S. Balance of Payments in 2012 Current Account:Exports of goods and services = +$2,211 billionImports of goods and services = -$2,745 billionNet interest = +$224 billionNet transfers = -$130 billionCurrent account balance = -$440 billionCapital and Financial Account:Foreign investment in the United States = +$544 billionU.S. investment abroad = -$98 billionOther net foreign investment in the United States = +$4 billionStatistical discrepancy = -$6 billionCapital and financial account balance = +$444 billionOfficial Settlements Account:Official settlements account balance = -$4 billion
Net Borrower A country that is borrowing more from the rest of the world than it is lending to the rest of the world*Starting in 1983 and continuing through 1987; borrowing was zero in 1991; increased through 2006 then started decreasing- Average net foreign borrowing by the U.S. between 1983 and 2012 was $306 billion a year
Net Lender A country that is lending more to the rest of the world than it is borrowing from the rest of the world *U.S. throughout the 1960’s and 1970’s-Oil rich countries such as Saudi Arabia
Debtor Nation A country that during its entire history has borrowed more from the rest of the world than it has lent to the rest of the world (national stock of foreign investment is low)-Based on interest payments
Creditor Nation A country that during its entire history has invested more in the rest of the world than other countries have investment in that country-Based on investment(investing ≠ lending)
Flows and Stocks Flows = borrowing and lending (per unit of time)Stocks = debts (owed at a point of time)Following a string of current account deficits, the U.S. became a debtor nation again in 1989 (only other time was the 1800s)*Common in developing nations (“Third World Debt Crisis”)Borrowing is bad if is financing consumption because higher interest rates are being incurred, and consumption eventually has to be reduced; borrowing is good if it is financing investment because that generates more money
Current Account Balance CAB = NX + Net interest and transfers from abroad*Fluctuations in net exports are the main source of fluctuations in the current account balance
Net Exports Determined by the government budget and private saving and investment
Private Sector Balance Saving – Investment (S – I)1) If Saving > Investment, private sector surplus is lent to other sectors2) If Investment > Saving, borrowing from other sectors finances private sector deficit
Government Sector Balance Net Taxes – Government Expenditure on Goods and Services (NT – G)1) If NT > G, government sector surplus is lent to other nations2) If G > NT, borrowing from other sectors is used to finance government sector deficit*Sum of federal, state, and local governments
Breakdown of U.S. Account Balance in 2012 Exports (X) = $2,196 billionImports (M) = $2,743 billionInvestment (I) = $2,475 billionSaving (S) = $3,167 billionNet Taxes (NT) = $1,660 billionNet Exports (X – M) = $-547 billionPrivate Sector Balance (S – I) = $960 billionGovernment Sector Balance (NT – G) = $-1507 billionEquation: Y = C + I + G + X – M = C + S + NTRearrange: (X – M) = (S – I) + (NT – G)(Net Exports = Private Sector Balance + Government Sector Balance)*U.S. borrowing finances investment ($2,475 billion on new buildings, plant, and equipment; $619 billion on defense equipment and public structures)
Current Account Balances Around the World 1) U.S. has the largest international payment deficit2) For every deficit there is a corresponding surplus3) China, Japan, and other advanced economies have a surplus that in total equals the U.S. deficitU.S. ≈ $450 billion deficitLatin American & the Caribbean ≈ $100 billion deficitAfrica ≈ $25 billion deficitJapan ≈ $50 billion surplusDeveloping Asia ≈ $125 billion surplusChina ≈ $225 billion surplusEuro Area ≈ $225 billion surplusOther Advanced Economies ≈ $300 billion surplusMiddle East ≈ $375 billion surplus
Foreign Exchange Market The market in which the currency of one country is exchanges for the currency of another *Made up of importers, exporters, banks, traders, brokers, etc.Opens on Monday morning in Hong Kong (while west coast markets are closing on Sunday); the market is open all day in different parts of the world- in 2013, typically $4 trillion changed hands each day
Foreign Exchange Rate The price at which one currency is traded for another (i.e. one dollar per 0.75 Euros in August 2013)
Currency Appreciation (e.g. Dollar v. Euro) The rise in the value of one currency in terms of another currency (e.g. the dollar rose from 86 Euro cents in 1999 to 1.17 Euros in 2000; 36% appreciation)*Dollar fell to 0.63 Euros per dollar in 2008; has since fluctuated between 0.70 and 0.80 euros per dollar
Currency Depreciation The fall in the value of one currency in terms of another currency (e.g. the dollar fell from 1.17 Euros in 2000 to 0.63 Euros in 2008; 46% depreciation)*Always calculate based on the previous value
Demand in the Foreign Exchange Market The quantity of U.S. dollars that traders plan to buy in the foreign exchange market during a given time period depends on mainly:1) The exchange rate2) Interest rate in the United States and other countries3) The expected future exchange rate
The Law of Demand for Foreign Exchange 1) Derived demand – people want dollars to buy other things in the U.S. (goods, stocks, etc.)2) Other things remaining the same, the higher the exchange rate, the smaller is the quantity of dollars demanded (like the opposite of inflation)-Increase in exchange rate = movement down along the demand curve; decrease in exchange rate = movement up along the demand curve3) Influences – Exports Effect, Expected Profit Effect
Exports Effect (for foreigners) The larger the value of U.S. exports, the larger is the quantity of dollars demanded to pay for these exports1) Exchange rate falls2) Price of U.S. goods/services falls3) U.S. increases exports (other countries increase imports)4) The quantity of dollars demanded increases to pay for increased exports (imports)
Expected Profit Effect (for foreigners) The larger the expected profit from holding dollars, the greater is the quantity of dollars demanded in the foreign exchange market*For a given expected future exchange rate, the lower the exchange rate today, the larger is the expected profit from holding dollars and the greater is the quantity of dollars demanded in the foreign exchange market- The lower the exchange rate today, the more people think that they can profit when the exchange rate eventually rises
Changes in Demand for Dollars Influences that change demand/buying plans (shift curve):1) Interest rates in the United States and other countries2) The expected future exchange rate
Interest Rates in the United States and Other Countries Borrowing at a higher interest rate in a different country brings higher profits (gap determines demand)1) The U.S. interest rate minus the foreign interest rate is called the U.S. interest rate differential2) The larger the U.S. interest rate differential, the greater is the demand for U.S. assets and the greater is the demand for dollars*Direct Relationship with Demand for Money
The Expected Future Exchange Rate (for Demand) Other things remaining the same, the higher the expected future exchange rate, the greater is the demand for dollars(i.e. if the exchange rate is 0.70 dollars/euro now, and is expected to be 0.80 next month, you will spend 700,000 euros now to get 1,000,000 dollars, and trade it in to get 800,000 euros- shifts the demand curve to the right)*Direct Relationship with Demand for Money
Supply in the Foreign Exchange Market The quantity of U.S. dollars that traders plan to sell in the foreign exchange market during a given time period depends mainly on:1) The exchange rate2) Interest rates in the United States and other countries3) The expected future exchange rate*Same as factors affecting the quantity demanded
The Law of Supply in the Foreign Exchange Market 1) Traders supply U.S. dollars when people buy other currencies and traders buy other currencies so that they can buy foreign-made goods and services2) Other things remaining the same, the higher the exchange rate, the greater is the quantity of dollars supplied in the foreign exchange market (like price)-Increase in exchange rate = movement up along the supply curve; decrease in exchange rate = movement down along the supply curve3) Influences – Imports Effect, Expected Profit Effect
Imports Effect (for Americans) The larger the value of U.S. imports, the larger is the quantity of foreign currency demanded to pay for these imports1) Exchange rate rises2) Price of foreign-made goods/services falls3) U.S. increases imports (other countries increase exports)4) The quantity of U.S. dollars supplied increases to pay for these imports
Expected Profit Effect (for Americans) The larger the expected profit from holding a foreign currency, the greater is the quantity of that currency demanded in the foreign exchange market and the greater is the quantity of dollars supplied*For a given expected future exchange rate, the higher the exchange rate today, the larger is the expected profit from selling dollars and the greater is the quantity of dollars supplied in the foreign exchange market- The higher the exchange rate today, the more people think that they can profit when the exchange rate eventually falls (people are profiting on a currency other than dollars)
Changes in the Supply of Dollars Influences that change supply/selling plans (shift curve):1) Interest rates in the United States and other countries2) The expected future exchange rate
Interest Rates in the United States 1) The larger (more positive) the U.S. interest rate differential, the smaller is the demand for foreign assets and the smaller is the supply of dollars in the foreign exchange market2) The smaller (more negative) the U.S. interest rate differential, the larger is the demand for foreign assets and the larger is the supply of dollars in the foreign exchange market *Inverse relationship with the supply of money
The Expected Future Exchange Rate (for Supply) Other things remaining the same, the higher the expected future exchange rate, the smaller is the supply of dollars(i.e. if the exchange rate is at 0.70 euros per dollar and is expected to be 0.80 euros per dollar next month, you will hold onto your dollars, and instead of selling them now for 700,000 euros, you will sell them later for 800,000 euros)- Shifts the supply curve to the left*Inverse relationship with the supply of money
Market Equilibrium 1) If the exchange rate it too high, there is a surplus(the quantity supplied exceeds the quantity demanded)- the exchange rate will fall2) If the exchange rate is too low, there is a shortage(the quantity demanded exceeds the quantity supplied)- the exchange rate will rise*The foreign exchange market adjusts second-by-second because traders want the best prices possible, and they share information on buying and selling plans
Reasons for Fluctuations in the Dollar 1) 1999-2000: the dollar appreciated against the euro (from 0.86 to 1.17 euros per dollar) because the U.S. economy expanded faster than the European economy- interest rates in Europe were 2% lower (positive U.S. interest rate differential and expected dollar appreciation)- demand for dollars increased and supply of dollars decreased (graph shifts –> higher exchange rate)2001-2008: the dollar depreciated against the euro (from 1.17 to 0.63 euros per dollar) because U.S. growth rate slipped behind European growth rate- U.S. interest rate differential became negative and the U.S. current account deficit increased and expected exchange rate decreased- demand for dollars decreased and supply of dollars increased (graph shifts –> lower exchange rate)*Since 2008, the dollar has fluctuated and risen slightly
Reasons for Exchange Rate Volatility 1) The exchange rates of other countries are changing at the same time as the U.S. exchange rate2) Because everyone is a potential buyer or seller in the foreign exchange market, the exchange rate changes dramatically but the quantity traded remains the same (everyone has a price limit)3) Supply and Demand are not independent; changes in the market cause opposite effects in supply and demand which results in large price changes and small quantity changes (interest rate differential and expected future exchange rate)- A rise in the U.S. interest rate differential increases the demand for U.S. dollars in the foreign exchange market and decreases the supply- A rise in the expected future exchange rate increases the demand for U.S. dollars in the foreign exchange market and decreases the supply
Exchange Rate Expectations Changes in exchange rate occur because the exchange rate is expected to changeExpectations change because:1) Purchasing power parity2) Interest rate parity
Purchasing Power Parity Money is worth what it will buy; i.e. if a Big Mac costs $3 in the U.S. and 4 Canadian dollars in Canada and the exchange rate is 1.33 Canadian dollars per U.S. dollar, the Big Mac costs the same amount in either countryIf purchasing power parity is lost (i.e. the price changes in one place, but not the other, and the exchange rate remains the same, money will buy more in the place will the lower real price)Example: If most prices in the U.S. increase, but not in Canada, people will expect the U.S. dollar exchange rate to decreases; the demand for U.S. dollars decreases and the supply of U.S. dollars increases, so the exchange rate falls*If the price rise was in Canada, the exchange rate would rise- If the prices in the United States rise faster than those in other countries, the exchange rate falls (depreciation); if the prices in the United States rise more slowly than those in other countries, the exchange rate rises (appreciation)
Purchasing Power Parity Around the World August 2013:Overvalued currencies will depreciate at some point in the future, and undervalued currencies will appreciateTurkish Lira ≈ 49% undervaluedSouth African Rand ≈ 47% undervaluedRussian Ruble ≈ 44% undervaluedPolish Zloty ≈ 41% undervaluedMexican Peso ≈ 37% undervaluedCzech Koruna ≈ 28% undervaluedEuropean Euro ≈ 7% overvaluedJapanese Yen ≈ 8% overvaluedCanadian Dollar ≈ 9% overvaluedNew Zealand Dollar ≈ 14% overvaluedDanish Krone ≈ 39% overvaluedAustralian Dollar ≈ 40% overvaluedNorwegian Krone ≈ 44% overvalued (50%%*)Swiss Franc ≈ 58% overvalued (60%%*)
Interest Rate Parity While the nominal interest rate may be higher than one country in another, the net interest rate may be the same in both countries depending on the exchange rate(i.e. if the interest rate in Canada is 5%, and the interest rate in the U.S. is 3%, but the Canadian dollar is supposed to depreciate by 2% per year, then the net return on investment in either country is 3%)- Interest rate parity always prevails because funds move to the place where they will get the highest returns
Monetary Policy and the Exchange Rate 1) If the Fed increases the U.S. interest rate and other central banks keep the interest rates in other countries unchanged, the value of the U.S. dollar rises in the foreign exchange market2) If other central banks increase their interest rates and the Fed keeps the U.S. interest rate unchanged, the value of the U.S. dollar falls in the foreign exchange market
Pegging the Exchange Rate Some central banks try to avoid exchange rate fluctuations by pegging the value of their currency against another currency1) If the exchange rate rises, the central banks sells dollars2) If the exchange rate falls, the central bank buys dollars* Equilibrium exchange rate is the central bank’s target- If the demand for dollars increases, the Fed increases the supply of dollars (sells dollars) and prevents the exchange rate from rising- If the demand for dollars decreases, the Fed decreases the supply of dollars (buys dollars) and prevents the exchange rate from fallingWhen the Fed buys dollars, it uses its reserves of foreign currency, and when the Fed sells dollars, it takes foreign currency in exchange and its reserves increase – If the demand for dollars decreased permanently, the Fed would have to buy dollars and sell euros every day to maintain the exchange rate, and when they ran out of euros, the dollar would sink- If the demand for dollars decrease increased permanently, the Fed would have to buy dollars and sell euros every day; they would be piling up unwanted reserves, and eventually have to let the dollar risePersistent intervention on the side of the market cannot be sustained
The People’s Bank of China in the Foreign Exchange Market 1) Fed does not peg the value of the dollar2) People’s Bank of China pegs the value of the yuan at 6.10 yuan per dollar; China has massive reserves of U.S. dollars (2007-2009, reserves increased by more than $1 trillion); if the bank took no action, there would be a different equilibrium exchange rate
China’s Foreign Exchange Market Interventions 1) Piling up reserves since 20002) Buildup of reserves was especially large from 2007-20113) Yuan appreciates when the number of yuan per dollar decreases, and depreciates when the number of yuan per dollar increases4) The actual equilibrium was below the target exchange rate, so China had to continue buying U.S. dollars in exchange for yuan
Management of the Yuan 1) Pegged the value of the yuan for more than 10 years 2) Devalued the yuan in 1994; the yuan appreciated in 1994 and 1995, but was pegged then at 8.28 yuan per dollar for more than 10 years3) In July 2005, the yuan began a managed float (appreciation/decreased exchange rate)4) In July 2008, the yuan was pegged at 6.8 yuan per U.S. dollar5) Since 2010, the yuan has been floating again
Actions of the Fed 1) Open Market Sale:- quantity of money decreases- interest rates rise- U.S. interest rate differential increases- demand for U.S dollars increases- supply of U.S. dollars decreases- U.S. dollar exchange rate rises2) Open Market Purchase:- quantity of money increases- interest rates fall- U.S. interest rate differential decreases- demand for U.S. dollars decreases- supply of U.S. dollars increases- U.S. dollar exchange rate falls
Aggregate Demand 1) Increases if the exchange rate falls or the global economy expands2) Decreases if the exchange rate rises or the global economy contracts

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