An Introduction to the Foreign Exchange Market and the Balance of Payments

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Chapter 7

• An Introduction to theForeign Exchange Market
  and the Balance of Payments

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Foreign Exchange

• Foreign ExchangeForeign money, including paper
  money and bank deposits that are denominated in
  foreign currency
• Foreign Exchange MarketA global market in which
  people trade one currency for another
• Exchange RateThe price of one countrys currency
  in terms of another countrys currency

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Trading Hours
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Exchange Rates

• There is one exchange rate for every currency in
  terms of every other currencyit is barter.
• The U.S. price of a foreign good is U.S.
  price foreign currency price
  x exchange rate
• If a shirt in a Canadian store is listed as CAD25
  and the U.S.Canada exchange rate is 0.6825, then
  the price in U.S. dollars is 25 x 0.6825
  US17.06.
• That is what it costs to buy 25 Canadian dollars
  with U.S. dollars.

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Exchange Rates March 10, 2003
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Appreciation and Depreciation

• A currency is said to appreciate when it buys
  more of a foreign currency.
• An appreciation of a nations currency will make
  foreign goods cheaper.
• This would likely cause an increase in imports
  and a decline in exports.
• A currency is said to depreciate when it buys
  less of a foreign currency.
• A depreciation will make foreign goods more
  expensive.
• This would likely cause a decrease in imports and
  an increase in exports.

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Current Account

• The categories of current account transactions
  are
• Merchandise trade-- import and export of goods
• Service trade-- import and export of services
• Income-- both investment income and
  employee compensation
• Unilateral transfers-- gifts to and from
  foreigners

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Surpluses and Deficits

• A surplus in a balance of payments account is the
  amount by which credits exceed debits.
• A deficit in a balance of payments account is the
  amount by which debits exceed credits.
• We say we have a merchandise trade deficit when
  the merchandise account has a debit balancewhen
  the country is importing more merchandise goods
  than it is exporting.
• The implication is that there is a net flow of
  payments to other countries.

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Current Account vs. Financial Account

• The balance of payments must balancethat is, the
  net balance must be equal to zero.
• Thus if there is a current account deficit, then
  there must be a financial account surplus that
  exactly offsets that deficit.

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Debtors and Creditors

• A net debtor (nation) owes more to the rest of
  the world than it is owed.
• A net creditor (nation) is owed more than it
  owes.
• The U.S. was an international net creditor from
  the end of WWI until the mid-1980s.
• In 1985, the U.S. became a net debtor.