Unit 7: Exchange Rates, the Balance of Payments, and Trade Deficits

Balance of Payments

• Measure of money inflows and outflows between the U.S. and the World (ROW).
• Inflows are referred to as credits
• Outflows are referred to as debits

• The Balance of Payments is divided into 3 accounts
• Current Account
• Capital/Financial Account
• Federal Reserves Account

Double Entry Book Keeping

• Every transaction in the balance of payments is recorded twice in accordance with standard accounting price
• Example - US manufacture, John Deere, exports $50 million worth of farm equipment to Ireland.
• A credit of $50 million to the capital / financial account (+ $50 million worth of Euros or financial assets)  
• A debit of $50 million to the capital / financial account (+ $50 million worth of Euros or financial assets)
• Notice that the two transactions offset each other. Theoretically, the balance payments should always equal zero

Current Account

• Balance of Trade or Net Exports
• Exports of goods / services - imports of goods/ services
• Exports create a credit to balance payments
• Imports create a debit to balance payments

Net Foreign Income

• Income earned by U.S. owned foreign assets, income paid to foreign held U.S. assets
• Example - Interest payments on U.S. owned Brazilian bonds - interest payments on German owned U.S. treasury bonds

Net Transfers 

• tend to be unilateral
• Foreign Aid -> a debit to the current account
• Example - Mexican migrant workers send money to family in Mexico

Capital/Financial Account

• The balance of capital ownership
• Includes the purchase of both real and financial assets
• Direct investment in U.S. is a credit to the capital account
• Example - Toyota Factory in San Antonio
• Direct investment by U.S. firms/individuals in a foreign country are debits to the capital account
• Example - The Intel factory in San Jose, Costa Rica
• Purchase of foreign financial assets represents a debit to the capital account
• Example - Warren Buffet buys stocks in PetroChina
• Purchase of domestic financial assets by foreigners represents a credit to the capital account
• Example - The UAE sovereign wealth fund purchases a large stake in the NASDAQ

What Causes Capital/Financial Accounts?

• Differences in rates of return on investment
• Ceteris Paribus : savings will flow toward higher returns

Relationships between Current and Capital Account

• The Current Account and Capital Account should zero each other out
• Current account negative balance = deficit
• Capital account positive balance = surplus

Official Reserves

• The foreign currency holdings of the United States Federal Reserve System
• When there is a balance of payments surplus, the Fed accumulates foreign currency and debits the balance of payments
• When there is a balance of payments deficit, the Fed depletes its reserves of foreign currency and credits the balance of payments
• The official reserves zero out the balance of payments

Credits vs. Debits

• Credits - additions to a nation's account
• Debit - subtractions to a nation's account

How to Calculate the following

• Balance on trade
• merchandise and service exports
• merchandise and service imports
• Trade deficits occur when the balance of trade is negative (imports>exports)
• trade surplus occurs when the balance on trade is positive
• Balance on current account
• Balance on trade (exports and imports)  + Net investment Income + Transfer Payments
• Official Reserves
• nationally change in CA + change in 7A + change in official reserve

Foreign Exchange (FOREX)

• The buying and selling of currency
• Example - In order to purchase souvenirs in France,  it is first necessary for Americans to sell (supply) their dollars and buy (demand) Euros.
• The Exchange rate (e) is determined in the foreign currency markets.
• Example - the current exchange rate is approximately 77 Japanese Yen to 1 US Dollar
• Simply put, the exchange rate is the price of a currency.
• Do not try to calculate the exact exchange rate

Changes in Exchange Rates

• Exchange rates are a function of the supply and demand for currency
• An increase in supply of a currency will decrease the exchange rate of a currency
• A decrease in supply of a currency will increase the exchange rate of a currency
• An increase in demand for a currency will increase the exchange rate of a currency
• A decrease in demand for a currency will decrease the exchange rate of a currency

Appreciation and Depreciation

• Appreciation of a currency occurs when the exchange rate of that currency increases
• Depreciation of a currency occurs when the exchange rate of that currency decreases
• Example - German tourists flock to America to go shopping, then the supply of euros will increase and the demand for dollars will increase. This will cause the euro to depreciate and the dollar to appreciate

Exchange Rate Determinants

• Consumer Tastes
• Relative Income
• Relative Price Level
• Speculation (stocks, interests, bonds)

Foreign Exchange Market Tips

• Always change the Demand line on one currency graph the Supply line on the other currency's graph
• Move the lines of the two currency graphs in the same direction (right/left) and you will get the answer
• If Demand on one graph increases, Supply will also increase
• If Demand moves to the left, Supply will move to the left on the other graph

Absolute Advantage vs. Comparative Advantage

• Absolute Advantage - faster, more efficient, makes more
• Comparative Advantage - lower opportunity cost (old/new)