ECN 111 Chapter 20 Lecture Notes

20.1 Financing International Trade

A. Balance of Payments Accounts
The balance of payments accounts are the accounts in which a nation
records its international trading, borrowing, and lending. The balance of
payments accounts are the:
1. Current account, which is the record of international receipts and
paymentscurrent account balance equals exports minus imports, plus net
interest and transfers received from abroad. In 2002, the United States had
a current account deficit.
2. Capital account, which is the record of foreign investment in the United
States minus U.S. investment abroad.
3. Official settlements account, which is the record of the change in U.S.
official reserves. U.S. official reserves are the governments holdings of
foreign currency.
4. The sum of the current account balance plus capital account balance plus
official settlements account always equals zero.
B. Borrowers and Lenders, Debtors and Creditors
1. A net borrower is a country that is borrowing more from the rest of the
world than it is lending to the rest of the world.
2. A net lender is a country that is lending more to the rest of the world than
the rest of the world is lending to it.
3. A debtor nation is a country that during its entire history has borrowed
more from the rest of the world than it has lent to it.
4. A creditor nation is a country that during its entire history has invested
more in the rest of the world than other countries have invested in it.
5. Flows and Stocks
Borrowing and lending are flows; debts are stocks. The United States is a
net borrower and a debtor nation.
C. Current Account Balance
The current account balance equals exports minus imports plus net interest
and transfers from abroad.
D. Net Exports
Net exports equals exports of goods and service minus imports of goods and
services.
1. The private sector balance equals saving minus investment, S I; the
government sector balance equals net taxes minus government
purchases of goods and services; T G.
2. Net exports equals the government sector balance plus the private sector
balance.
20.2 The Exchange Rate
A. Foreign Exchange Market
The foreign exchange market is the market in which the currency of one
country is exchanged for the currency of another.
1. The foreign exchange rate is the price at which one currency exchanges
for another.
2. Currency depreciation is the fall in the value of one currency in terms of
another currency.
3. Currency appreciation is the rise in the value of one currency in terms of
another currency.

B. Demand in the Foreign Exchange Market

Demand depends on the exchange rate, interest rates in the United States
and other countries, and the expected future exchange rate.
C. The Law of Demand for Foreign Exchange
Other things remaining the same, the higher the exchange rate, the smaller
the quantity of U.S. dollars demanded. The law of demand is the result of the:
1. Exports Effect
The lower the value of the exchange rate, the larger the value of U.S.
exports, and so the larger the quantity of dollars demanded on the foreign
exchange market.
2. Expected Profit Effect
The lower the exchange rate, the larger the expected profit from holding
dollars, and so the greater the quantity of dollars demanded on the foreign
exchange market.
D. Changes in the Demand for Dollars
1. Interest Rates in the United States and Other Countries
The larger the U.S. interest rate differential, which is the U.S. interest
rate minus the foreign interest rate, the greater is the demand for U.S.
assets, and so the greater the demand for U.S. dollars.
2. The Expected Future Exchange Rate
Other things remaining the same, the higher the expected future exchange
rate, the greater the demand for dollars.
E. Supply in the Foreign Exchange Market
Supply depends on the exchange rate, interest rates in the United States and
other countries, and the expected future exchange rate.
F. The Law of Supply of Foreign Exchange
Other things remaining the same, the higher the exchange rate, the larger the
quantity of U.S. dollars supplied. The law of supply is the result of the:
1. Imports Effect
The higher the exchange rate, the larger the value of U.S. imports, and so
the larger the quantity of foreign currency demanded to pay for these
imports. And when people buy foreign currency, they supply U.S, dollars.
2. Expected Profit Effect
The larger the expected profit from holding a foreign currency, the greater
is the quantity of that currency demanded and the grater is the quantity of
dollars supplied in the foreign exchange market.
G. Changes in the Supply of Dollars
1. Interest Rates in the United States and Other Countries
The larger the U.S. interest rate differential, the smaller the demand for
foreign assets, and the smaller the supply of U.S. dollars on the foreign
exchange market.
2. The Expected Future Exchange Rate
The higher the expected future exchange rate, the smaller is the supply of
U.S. dollars today.
H. Market Equilibrium
Market equilibrium occurs at the equilibrium exchange rate such that the
quantity of dollars demanded equals the quantity supplied and there is neither
a shortage nor a surplus.
I. Changes in the Exchange Rate
The exchange rate changes when the supply of dollars changes, the demand
for dollars changes, or both the supply of dollars and the demand for dollars
change.
1. Why the Exchange Rate Is Volatile
Supply and demand are not independent of each other in the foreign
exchange market. For example, a change in the expected future exchange

rate or a change in the U.S. interest rate differential changes both demand
and supply and in opposite directions.
2. A Depreciating Dollar: 19941995
During 1994, traders expected the U.S. dollar to depreciate against the yen.
They expected a lower exchange rate. So the demand for U.S. dollars
decreased and the supply of U.S. dollars increased. The exchange rate fell.
3. An Appreciating Dollar: 19951998
The dollar appreciated against the yen. Interest rates in Japan fell and the
yen was expected to depreciate. The demand for yen decreased and the
demand for U.S. dollars increased, and the supply of dollars decreased. The
exchange rate rose.
J. Exchange Rate Expectations
1. Purchasing Power Parity
Purchasing power parity means equal value of moneya situation in
which money buys the same amount of goods and services in different
currencies. If prices in the United States rise relative to prices in another
country, the U.S. dollar exchange rate falls.
2. Interest Rate Parity
Interest rate parity means equal interest ratesa situation in which the
interest rate in one currency equals the interest rate in another currency
when exchange rate changes are taken into account. Adjusted for risk, the
exchange rate changes so that interest rate parity always holds.
K. The Fed in the Foreign Exchange Market
1. If the Fed buys U.S. dollars (sells foreign currency), the U.S. dollar exchange
rate rises.
2. If the Fed sells U.S. dollars (buys foreign currency), the U.S. dollar exchange
rate falls.
3. The Fed cannot indefinitely buy or sell U.S. dollars because it either runs out
of foreign currency or it accumulates too much foreign currency.