International Statistics

1
CHAPTER 20 International Finance
2
In this Chapter we will . . .

• Explain what is meant by a balance of trade
  deficit as well as its importance.
• Explain why the US changed from being a lender to
  being a borrower in the mid-1980s.
• Explain how the foreign exchange value of the
  dollar is determined.

3
Balance of Payments Accounts

• Definition the record of all payments from/to
  residents of a country to or from residents of
  other countries.
• Categories of the balance of payment accounts
• 1) Current Account- records payments for
  imports/exports of goods and services, net
  interest and other factor payments from abroad,
  and net unilateral unrequited transfers.
• 2) Capital Account- records foreign
  investments/loans into the US minus US
  investments/loans abroad.
• 3) Official Settlements Account- records the
  change in official reserves in the US.

4
Balance of Payments Accounts

• The current and capital accounts are financial
  accounts
• Items therefore enter the accounts according to
  who gets the payment exports are positives,
  because a US resident is paid imports are
  negatives, a foreigner is paid investment in the
  US from abroad is , spending by Japanese
  tourists in Orlando is , etc -- the payment
  comes in.

5
U.S. Balance of Payments Accounts in 1999,
billions

• Current account
• Imports of goods and services -1,221
• Exports of goods and services 956
• Net factor income from abroad 18
• Net transfers (mostly private) 48
• Current account balance 331
• Capital account
• Foreign investment in the United States 711
• U.S. investment abroad -442
• Statistical discrepancy 12
• Capital account balance 281
• Official settlements account
• Increase in official reserves (both US 50
• and foreign held in the US)

6
The Balance of Payments1975-1996
7
Balance of Payments Accounts (cont.)

• The balance of payments accounts add up to zero.
• In 1999 we had a trade deficit as we imported
  more goods than we sold abroad (exported).
• We paid for the deficit by
• 1) Borrowing net from abroad which translates
  into a capital account surplus.
• 2) Investing less abroad than foreigners invested
  in the US.

8
Balance of Payments Accounts (cont.)

• A country that in aggregate over its entire
  history has borrowed more from the rest of the
  world than it has lent is a debtor country.
• A partial list of debtor countries
• - Mexico
• - Brazil
• - The United States

9
Balance of Payments Accounts (cont.)

• Is there any reason to be concerned that the US
  is a debtor country?
• - No, if the borrowing is financing investment
  that is generating economic growth and higher
  income.
• - Yes, if the money is being used to finance
  consumption.
• This could result in higher interest payments to
  foreigners and lower consumption sometime in the
  future.

10
Is the US a debtor?

• The official data show the US as a debtor
• This is dubious actual loans are fairly
  accurately measured, but direct investment --
  e.g. the value of General Motors or Fords
  investments in Europe and Australia -- is very
  hard to estimate.
• Much US foreign direct investment is older than
  most foreign direct investment in the US -- so
  probably more valuable estimates of US foreign
  assets are probably too low.

11
Balance of Payments Accounts (cont.)

• The US has a large current account deficit, why?
• Our discussion of national income and product
  accounting taught us that expenditures and income
  are equal, when properly measured.
• Expenditure C I G X - M
• Income uses of income C S T

12
Balance of Payments Accounts (cont.)

• This says that a balance of trade deficit

(X - M) lt 0
is due to
1) A government sector deficit (T - G) lt
0 and/or 2) A private sector deficit
(S - I) lt 0
13
Numbers for 1999 approximate, national income
account estimates

• Variables
• Exports X 956
• Imports M 1221
• Govnment purchases G 1,536
• Net Taxes T 1,710
• Investment I 1,670
• Saving S 1,231

14
Net Exports, the Government Budget, Saving and
Investment
Surpluses and deficits, 1999

• Net Exports X - M 956 1221 -265
• Government sector T - G 1,710 1,536
  174
• Private sector S - I 1,231 1,670 439

15
Net Exports, the Government Budget, Saving, and
Investment
Relationship among surpluses and deficits

• National accounts Y C I G X M
• C S T
• Rearranging X M (S I) (T G)
• Net exports X M 265
• equals
• Government sector T G 174
• plus
• Private sector S I 439
• Overall balance 174 -439 -265 Net
  exports

16
The Twin Deficits
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Borrowing for what?

• Is the U.S. Borrowing for Consumption or
  Investment?
• Net exports were 265 billion in 1999
• Governments in the US buy structures (e.g.
  highways, schools, dams) worth more than 200
  billion/year.
• Governments also spend on education and health
  careincreases human capital.
• Looks like mostly investment, not consumption.

18
Foreign Exchange Markets

• In the US, we use the US dollar as currency
• Most countries have their own currencies
• To exchange one currency for another, a price for
  one currency in terms of the other is needed --
  hence foreign exchange markets.

19
Exchange Rate Measures

• The foreign exchange market is the market in
  which the currency of one country is exchanged
  for the currency of another.
• The foreign exchange rate is the nominal price
  for which one currency is exchanged for another.

111.33
.00898
20
Wall Street Journal 9/98
21
An Example

• Suppose you can buy a CD in Canada or in
  the US, where should you buy it?
• PUS US 15.00
• PCA C 20.00 (CAN)

22
Exchange Rate Measures (cont.)

• PUS 15.00 PCA C 20.00 (CAN)

1.51
.65
23

• In order to make a decision, you must convert
  the Canadian CD to US dollars

• Recall the price of the same CD in the U.S. was
  US 15.00.

• Since the price of the US CD was more than
  the US Dollar price of the Canadian CD, you
  buy the CD in Canada.

24
Reality Check

• This ignores transaction costs
• Transaction costs on LARGE exchanges -- millions
  of s -- are small, fractions of a
• Transaction costs on small exchanges -- for
  tourists or travelers -- can be large in North
  America and Western Europe, a fixed fee (say 5)
  per exchange plus commission of 1 or 2 per cent.
  Travelers be warned!

25

• Some Terminology

• Currency depreciation- a currency depreciates
  if its value in terms of foreign currency goes
  down.
• That automatically means it costs more of the
  depreciated currency to buy a unit of the foreign
  currency - i.e. the price of the foreign
  currency has gone up in terms of domestic
  currency.

26

• Currency depreciation (an example)

• The US dollar buys less and has thus depreciated.

27
Depreciation and Appreciation

• One DM used to cost 0.50, 50 cents, but now it
  costs a dollar -- the price of the DM in dollars
  has gone up, the price of the in DM has gone
  down (from DM2 to DM1)
• The DM appreciated, the depreciated.
• German goods, priced in DM, now cost more in s
  so are more expensive compared to US goods, so
  German exports, US imports, go down. US goods,
  priced in s, now cost fewer DMs, US exports
  German imports go up.

28

• Exchange Rate Measures (cont.)

• The real exchange rate is the nominal exchange
  rate adjusted for prices
• That means we multiply the nominal exchange rate
  by the ratio of the US and foreign price indices

29
The Demand for Dollarsis a derived demand -- it
comes from holders of other currencies wanting US
dollars to make payments in dollars -- e.g. to
buy US goods, services, or assets.

• What determines the quantity of dollars demanded
  in the foreign exchange market?
• The exchange rate, the price of the in terms of
  the other currency.- other things remaining the
  same, an increase in the exchange rate reduces
  the quantity demanded (of dollars) and causes
  a movement along the demand curve (for dollars
  in the foreign exchange market).

30

• Quantity demanded for dollars (an example)

• The price of a dollar has gone up, so less
  willbe demanded.

31
The Demand for Dollars
ExchangeRate(Yen for )
150
100
50
1.1
1.2
1.4
1.5
0
1.3
Quantity (trillions of per day)
32
Other determinants cause the demand for
dollars curve to shift

• 1) Interest rates in the US and other countries.

Example Suppose US interest rates go up.
What will happen to the demand for the dollar?

• At the same exchange rate, Japanese investors
  will want to take advantage of the higher returns
  by investing more in (lending more to) the US.
• This means more US dollars will be purchased and
  the demand for dollars will shift to the right.

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Other determinants cause the demand for
dollar curve to shift (cont.)

• 2) relative prices in the United States and
  other countries affects X and M, which require
  currency transactions.
• 3) GDP in the foreign country affect our
  exports -- income effect
• 4) the expected future exchange rate affects
  asset holdings -- foreigners wont hold s if
  they expect the value to fall

34
Changes in the Demand for Dollars
150
Exchange rate (yen per dollar)
100
50
D0
0
1.1
1.2
1.3
1.4
1.5
Quantity (trillions of dollars per day)
35
Summary Changes in the Demand for Dollars

• The U.S interest rate differential increases
• Japanese prices rise, relative to US prices.
• Japanese GDP rises.
• The expected future exchange rate rises

• The U.S. interest rate differential decreases
• Japanese prices fall, relative to US prices.
• Japanese GDP falls.
• The expected future exchange rate falls

36
The Supply of Dollarsis derived -- it arises
from holders of dollars wanting foreign currency
to make payments in foreign currency -- e.g. to
buy goods, services, or assets abroad.

• What determines the quantity of dollars supplied
  in the foreign exchange market?
• The exchange rate, i.e. the s price - other
  things remaining the same, if the exchange
  rate rises, the quantity of dollars supplied
  increases and causes a movement along the
  supply curve (of dollars in the foreign
  exchange market).

37

• Quantity supplied of dollars (an example)

• Japanese goods are cheaper so you will supply
  more dollars in order to get the yen needed to
  purchase the cheaper Japanese goods.

38
The Supply of Dollars
ExchangeRate(Yen for )
150
100
50
1.1
1.2
1.4
1.5
0
1.3
Quantity (trillions of per day)
39
Other determinants cause the supply of
dollars curve to shift

• 1) Interest rates in the US and other countries.
• 2) relative prices in the United States and
  other countries.
• 3) GDP in the US
• 4) the expected future exchange rate
• reasoning is all symmetric to the demand curve
  shifts -- supply of s is demand for Yen if we
  just consider these two currencies

40
The Supply of Dollars
S0
150
Exchange rate (yen per dollar)
100
50
1.1
1.2
1.3
1.4
1.5
0
Quantity (trillions of dollars per day)
41
Summary Changes in the Supply of Dollars

• The U.S interest rate differential decreases
• Japanese price level falls relative to the US
  price level.
• U.S. GDP increases.
• The expected future exchange rate falls

• The U.S. interest rate differential increases
• Japanese price level increases, relative to the
  US price level.
• US GDP decreases.
• The expected future exchange rate rises

42
Equilibrium Exchange Rate

• The equilibrium exchange rate occurs where the
  quantity of dollars demanded is just equal to the
  quantity of dollars supplied.

43
Equilibrium Exchange Rate
ExchangeRate(Yen for )
150
100
50
1.1
1.2
1.4
1.5
0
1.3
Quantity (trillions of per day)
44
An Application Interest rates
fluctuate up.

• If the US interest rate goes up, what will
  happen to the dollar?

S1

• With higher interest rates in the US,
  investors abroad demand more dollars
  with which to invest in the US.

e1

• With higher interest rates in the US,
  investors in the US are less willing to
  buy foreign currency (supply dollars) and
  more willing to invest at higher interest
  rates at home.

D1
Q1
0
Quantity of
45
An Application Interest rates
fluctuate up.

• The equilibrium exchange rate occurs where
  the quantity of dollars demanded is just
  equal to the quantity of dollars supplied.

S1
e1

• The new equilibrium results in a higher
  exchange rate (yen for ).
• Prediction The dollar should
  appreciate in relation to the yen.

D1
Q1
0
Quantity of
46
An Application Foreign Exchange
Intervention.

• Foreign exchange intervention is when a
  govt. tries to maintain an exchange rate
  in the foreign exchange model.

S1

• Suppose the Japanese yen is rising
  w/respect to the US dollar.

e1

• The Fed could intervene in the market to
  prop up the dollar.

D1

• Without intervention, the exchange rate
  will fall to e2.

Q1
0
Quantity of
47
An Application Foreign Exchange
Intervention.

• In order for the Fed to intervene and
  attempt to maintain the exchange rate
  between dollars and yen at e1, it would have
  to demand (buy) dollars to shift the
  demand curve back to D1

S1
e1
e2
D1
D1
Q1
0
Quantity of
48
Reality Check

• Nowadays, intervention rarely works
• The volume of foreign exchange transactions is of
  the order of 2 trillion a day
• This is massively larger than any countrys
  foreign exchange reserves, so in most cases
  intervention alone is inadequate -- it does not
  shift the curves enough.

49
Changes in the Exchange Rate

• Why the Exchange Rate is Volatile
• Supply and demand are not independent of each
  other.
• A change in the expected future exchange rate or
  U.S. interest rate differential changes both
  supply and demand.
• Day-to-day movements in exchange rates are
  dominated by the large amounts of internationally
  mobile liquid capital and changes in sentiment --
  i.e. expectations about the future

50
Exchange Rate Fluctuations
1994 to 1995
Exchange rate (yen per dollar)
100
84
D94
D95
0
Q0
Quantity (trillions of dollars per day)
51
Exchange Rate Fluctuations
S95
1995 to 1997
123
Exchange rate (yen per dollar)
84
D95
0
Q0
Quantity (trillions of dollars per day)
52
The Exchange Rate

• Exchange Rate Expectations
• Three influences on expectations that affect
  the international value of a currency are
• 1) Purchasing power parity ideas
• 2) Interest rate parity expectations
• 3) Other influences on expectations about
  future exchange rates e.g. political
  developments

53
Influences on the Exchange Rate

• 1) Purchasing Power Parity
• Money is worth what it will buy.
• Purchasing power parity means equal value of
  money as purchasing power -- the idea that,
  ceteris paribus, 1 ought to buy the same amount
  of real goods and services anywhere.
• PPP is misleading -- much of output is
  nontradable -- most services, most low
  value-to-mass or -to-bulk, or perishable, goods
  (e.g. haircuts, restaurant meals, fresh bread,
  housing, bricks, cement, gravel, etc)

54
Purchasing Power Parity

• If prices of traded goods increase in Canada
  (for example) and other countries but remain
  constant in the United States, people will
  generally expect that the value of the U.S.
  dollar is too low and will expect it to rise.
• Supply of and demand for dollars change
• The exchange rate should tend to change --
  eventually. It may take some time, because
  buying habits and supply chains dont change
  instantaneously, and other influences are at
  work.

55
Influences on the Exchange Rate

• 2) Interest Rate Parity
• Money is worth what it can earn.
• Interest rate parity means equal interest rates
  -- i.e., ceteris paribus, interest rates should
  be the same everywhere.
• Again, they arent -- because risk differentials
  differ, there are transactions costs investing in
  other currencies, and because possible future
  changes in exchange rates have to be taken into
  account.

56
Interest Rate Parity

• If the rate of return on the dollar is higher in
  the United States than the rate of return on
  local currencies in other countries, the demand
  for U.S. dollars rises and the exchange rate
  rises until interest rates are closer to equal.
• If you are the treasurer of a multinational (e.g.
  Ford), you will put your liquid funds (cash) in
  the market (and the currency) where you expect
  the biggest return, ceteris paribus e.g.
  allowing for risk.

57
3) Other Influences on Exchange Rates

• The problem is, small differentials in interest
  rates a percent or two a year can be swamped by
  small changes in exchange rates a few percent
  right now
• So expectations about likely future changes in
  exchange rates tend to be much more powerful
  influences on supply and demand to foreign
  exchange markets in the short run than
  fundamentals like relative price levels and
  interest rate differentials.

58
Example Speculation Runs

• Suppose an exchange rate was stable for a long
  time -- e.g. 1 25 Thai Baht
• Suppose lots of foreign investment goes into
  Thailand at that rate
• Then suppose some bad financial and political
  things happen in Thailand -- the property market
  goes bad, some finance houses and banks get in
  trouble

59
Speculation Runs

• A few investors figure the exchange rate might
  fall, and withdraw their money from Thailand
• This increases demand for s and supply of baht,
  so the price of baht falls -- i.e. more baht per
  dollar
• Others notice, and think they had better get
  dollars before the price of dollars gets even
  higher in baht

60
Speculation Runs

• You get a rush for the exit -- and the exchange
  rate collapses July 1997 1 25 baht December
  1997 1 43 baht
• Conclusion If there is a lot of so-called
  liquid capital -- money that can be exchanged
  and transferred quickly -- exchange rates may be
  very volatile, i.e. can change a lot quickly.