C HAPTE R

13

I
.

National Income Accounting

and the Balance of Payments
etween 2004 and 2007, the world economy boomed, its totai real product
growing at an annual average rate of about 5 percent per year. The growth
rate of world procluction siowecl to around 3 percent per year in 2008, before
dropping to mimis 0.6 percent in 2009a reduction in world output unprecedented
in the periocl since World War il. These aggregate Iiatterns mask sharp differences
among individuaI countries. Some, such as China, siowecl relativey modestly in
2009, while the output of other countries, such as the United States, contracted
sharply. Can economic anaiysis heip US to understand the behavior of the giobal
econorny and the reasons why individuai countries fortunes often cliffer?
Previous chapters have been concerned primarily with the probiem of making
the hest use of the worlds scarce productive resources at a singie point in time.
The branch of economics calied microeconomics studies this problern frorn the
perspective of individuai frms and consumers. Microeconornics works from the
bottom UI) to show ho individuai econornic actors, by pursuing their own inter
ests, coliectiveiy cletermine how resources are used. in our study of international
rnicroeconomics, we have iearned how individuai production and consumption
decisions produce patterns of internationai trade and specialization. We have aRo
seen that while free trade usLlaily encourages efficient resource use, government
intervention or rnarket failures can cause waste even when ali factors of production are fully employed.
\Vith this chapter we shift our focus and ask: How caii economic poiicy
ensure that factors of production aro fully employed? And what deterniines how
an econornys capacity to produce goods and serices changes over time? To
answer these c;uestions, we must understand macroeconomics, the branch of
economics that studies how econornies overali leveis of ernployment. produc
tion, and growth are determined. Like microeconomics, macroeconomics is
concerned with the effective use of scarce resources. But while microeconomics
focuses on the economic decisions of individuals, macroeconomics analyzes
the behavior of an economy as a whole. in our study of international macroeco
nomics, we will learn liow the interactions of national econoniies influence the
wori dwide pattern of macroeconom ic activity.

293

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PA RT TH R L

Exclmiigc IZatcs iiitI ()pcn-Lconomy Mcroeconomics

cmphasizes four aspectS ol economic I ife that, unti

now, we have usually kpt in the hackground io simpli(y our dISCUSSIOn of inter
ntional econoniics:
Macroecononic a na lysis

I. Uneinployinvn!. We knov ihai in the real world, workers niay he unemployed

and factories ia he idIC. Macroeconomics studies the lactors thai cause

unemployment anci the steps overnments can iake to prevent it. A main con
cern of international macroecononhics is the probleni of ensuring fuil employ
ment in econoniies open lo international trade.
2. Saving. In earlicr chapters we usually assumed that every country consumes an
amount exactly equal lo its incomeno more ancl no less. in reality, though,
households can pui aside pari of their income to provicle for the future, or they
can horrow temporarily to spend more than they earn. A countrys saving or
borrowing behavior affects domestic employrnent and future levels of national
wealth. Froni the standpoint of the international economy as a whole, the
uickly the world stock of productive capital
1
world saving rate determines how .
can grow.
3. Trade irnbalances. As we saw in earlier chapters, the value of a countrys
imporis equals the value of its exports when spending equals income. This
siate of balanced trade is selclom attaineci by actual economies, however. in
the following chapters, trade irnbalances play a large role because they redis
Iribute wealth among countries and are a main channel through which one
countrys macroeconomic policies affect its trading partners. Lt should be no
surprise, therefore, (hai tracle imhalances, particularlv when they are large
and persistent, quickly can become a source of international discord.
4. Money and the price leve!. The trade theory you have studiecl so far is a
barter theory, one in which goocls are exchanged directly for other goods on
the basis of their relative prices. In practicu, it is more convenient (o use
rnoneya widely acceptable medium of exchangein transactions, and to
quote prices in terms of money. Because money changes hands in virtuafly
every transaction that takes pIace in a modem econonm fluctuations in the
supply of money or in the demand for it can affect both output and employ
ment. International rnacroeconomics takes mb account that every country
uses a currency anci that a monetary change (for example, a change in
nioney supply) in one country can have effects that spili across its borders to
other countries. Stability in rnoney price Ievels is an important goal of inter
national macroeconomic policy.
This chapter takes the first step in our study of intemnational macroeconomics by
explaining the accounting concepts econornisls use io describe a countrys level of
productioi and its international transactions. Io get a complete picture of the
rnacroeconomic lmnkages arnong economies that engage in intemnational trade, we
liave to master two related and essential tools. The first of these tools, natonaI
income accounting, records all the expenditures that contribute (o a countrys
income and output. The second tool, balance of payments accounting, helps us

C ti A PTE R

1 3

Natioii.tI Income Accounting and the Bahince of Iayments

keep tiack of hoth

295

in a countrys indehtedness Io foreigneis and the

Iorlunes ot Is export an(I imporlcompeting ndustrie. The balance of payrnents
a(:counts als() shov the connection between (orein transactions and national
fliflfley supplies.
changes

.LEARNING GOALS
Afler reading

this chapler, you wifl he ahte [o:

Discuss the concepi of the curreni accounl halance.
Use the (urrent accounl I)aIancc Io extend nfiona incorne accounting tu
upeli eCOflOmieS.

Apply nationa

incorne accoLlnting Io the interaclion of saving, investrnent,

ancl nel exports.
Descrihe ihe I)alance
payflleills accounts and explain lheir re(alionship lo
the current accounl halance.
Relate the current a coLini lo changes in a counlrys nel loreign wealth.

The National Income Accounts

Of central concerti lo macroeconomic analysis is a coun[rys gross natioiial product
(GNP), the value of all linal goods and services produced by the countrys factors of

duclion and suld on the market in a given time period. GNP, which is the basic measure of
a countrys output studied hy nmcroeconornist, is calculated hy adding up the rnarket
vahie of all expenditures on final output. GNP therefore includes the value of goods Iike
hread sold in a supermarket and texthooks so]d in a bookstore. as welI as the value of serv
ices provided hy stock brokers and plumbers. Because Output Cannot be produced without
the aid of factor inputs, the expenditurcs that rnake UJ) GNP are closely linked to the
employment of labor, capital. and other factors of production.
To clistinguish among the different tvpes of expenditure that make up a countrys GNP.
government economists and statisticians who compile national mcorne accounts divide
(INP among the four possible uses for hich a countrys final output is purchased:
consumplion (the amount consumed by private domestic residents), invesUnen! (the
amouiit put aside by private fitms to build new plant and equiprnent for future produc[ion).
golerinicnt piirehases (the amount used by the government), and the current account bui
once (the amount of net exports of goods and services lo foreigners). The terni ,zational
incoilze accounts, rather than no/tonni output a(count, is used to describe this fourfold
ctassittcation because a countrys income in fact equals its output. Thus. the national
income accounts can he thought of as classifying each transaction that contributes to
national incorne according to the type of expenditure that gives rise to it. Figure 13-1
shows how U.S. GNP was divided among its four components in 2009.1
Why is il useful to divide GNP into consumplion. inestment. governrnent purchases.
and the current account? One rnajor reason is that we cannot hope to understand the cause
of a particular recession or boom ithout knowing how the timin categories of spending

Our detinition ol the current uccount not s1rct1y accurate when country is i net donor or recipient of lireion
gifts. This possibility. along with some tithers. also complicates our dentilcttion of ONI with national incorne.
We describe later in this chapter hos the delinitions ot national neome md the current account Inust be chaned
in such CiISCS.

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PA

Figure

-i PE E

ExcIiiiige Rates atiti ()pen-Economy Macroeconomics

13-1

U.S. GNP ami IIs Componenls

$ 4.4 irilhon 2009 irnss
Ulfl h( I)l(1kI1 cInn

BiUions
of dollars
16000

111111)011 prlllIlJ( i
1011)

thC

fOLlI I ofllpoflents

Snurce: (iS.

IIIBCIU

pIIInI1I

shown.

GNP

14000

((

DI tI UIlOIllft AI1II\ Is.

i ooo
Consumption
10000
8000
6000

Government
purchases

4000
2000

Investment

I_I
2000

Clirrent
account

have changed. And withotit sueh an understanding, we cannol recommend a sound policy
response. In adclition, the nationai mcome accotints provide information essentiai for
studying hy some countries are richthat is. have a hih leve! of GNP relative to popu
lation sizewhile some are pooi.

National Product and National Income

Our Iirst iask in understanding how economists ana!yze GNP is to expiain in greater detail
why the GNP a country generates over some time period nust ecinai its national incorne,
the income earned in that period by its factors of production.
The reason for this equality is that every dollar used to purchase goods or serviccs auto
maticaiiy ends up in somehodvs pockel. A visit to the doctor provides a simpie example of
how an increase in nationai output raises national income by the same amount. The $75 you
pay the doctor represents the market value of the ser ics he or she provides for you, SO
your visit raises GNP hy $75. But the $75 you pay the doctor also raises his or her income.
So nationai income rises by $75.
The principle that output and incorne are the same also applies to goods, even goods
that are produced with the help of man factors ofproduction. Consider the example of an
econornics texthook. When you purchase a new book from the puhlisher. the value of your
purchase enters GNP. But your payrnent eniers the income of the productive factors that
eooperated in producing the book, because the publisher rnust pay for their services with
the proceeds of saes. First. there are the authors, editors. artists. and compositors who provide the labor inputs necessary i or the hooks production. Second. there are the puhlishing
companys shareholders, who receive dividends for having lnanced acquisition of the cap
ital used in production. Finafly. there are the suppliers of paper and ink. who provide the
intcrmediate mLlteriaJs tised in producing the book.

C HAPTE R

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Nt ion;il Incoiiw iccouiitim and the Balance of Piynients

297

ilie paper and ink purchased hy the puhlishing h()use Lo produce the book ai-e no!
separaiely in GNP becanse their contribulion io the aliie of natiunal output is
already included in the hooks price. li is io avoid such deuble counhing that we allow
only
the sale ol finul geods and services lo enter mb the deiinilion of GNP. Sales of intermedi
ate goods, such as H[)f and ink purehased by a puhlisher. aie noi couiited. Notice alse
hat the sale ei a used textbook does noi enier GNP. Qur dehniiion counts only una! goods
and services that aie jmdueed, and a used lextbook does noi qualify: li was counted in
GNP ai the time il was Iirsi sold. Equivalently. the sale of a used texlbook does noi gener
ate i ncome br any ketor ol production.
counied

Capital Depreciation and International Transfers

Because we have defined GNP and iiational income so that lhey are necessarily equal.
their equality ix really an identily. Two adjustnienls io the deinition of GNP must be
made. however, before the identilication e! GNP and national income ix entirely conect in
practice.

1. GNP does noi take mio aceount the economie bss due io the tendency of machinery
ami structures te wea out as they are used. This bss, called (Ie/)reL!ati(m, reduces the
income of capita! owners. To calcolate national income over a given period. we musi
therefore subiraci from GNP the depreciation of capita! over the period. GNP less
depreciation is called net nutional pmduct (NNP).
2. A countrys mcome may include gifts from residents of foreign countries, called
unilaie,vl 1v11s/l:v. Examples of unilateral transfers of income are pension
l)aYfllefltS
io retired citizens living abroacl. reparation payrncnts, and foreign aid such as re]ief
funds donated te droughlstricken naiions. For the United States in 2009, the balance
ei such payments amounted io around $130.2 billion. reprcsenting a 0.9 percent of
GNP nei transfer te foreigners. Nei unilaicral transfers are pari of a countrys income
bui are noi pari of its produci, and ihey musi be added te NNP in calculations of
national income.
National income equals GNP less depreciation plus net unilateral transfer. The dilier
ence. betwcen GNP and national income is hy no means an insignilicant amount, bui
macroeconemics has utile te say ahout it, and il ix of little importance br rnacroeconomic
analysis. Therefore, for the purposes of this text, we usually LISC the terms GNP and
nalional income interchangeahly, emphasizing the distinction hetween the two on]y when
li is essentiaL

Gross Domestic Product

Mesi countries other than the Unitcd States have long reported gross dornestic product
(GDP) rather than GNP as their primary measure of national economie acii\ ity. In 1991 the
United Siates began te folbow this practice as well. GDP is supposed te measure the volume
of production within a countrys borders, whereas GNP equals GDP plus nei receipts
of
facior income from the resi of the world. Fer the U.S.. ihese nel receipts are primarily the
2 Strwri

speaking. go ernmellt staflsiicians relr to what we have cailed national inconie as inul000! divposab
Their ollicial concept of national incorne omits torcign net Ijni1ater1 transhrs. Once again, however,
the
dilterence betw een n donai income and nationai disposabie incoirie is usually iinimportant for
macroeconornie
anaiysis. LniIatenLt trinster ale alternatively referred to assccoiidan Ico,,u pciiIJunt to distinguish
ilien trorn
J)17I7?(Jri jnCoil?t [)CLiIICIIV eUnsiStnL of crossborder wage and investillent
inconie. We wiii ee this tenninology
later w ben .s e study bai;uice o! 1 Yfl flt accouating.
jnCOflIe.

298

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P1 TII

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lxchangc

.ites

..iiid Open-i conomy Macroecononiics

incuifle dumestie residents eain on wealth they hold in otler eountries less the payiiients
domestie residcnts make to foreign owners of wealth that ix Iocated in the domestic colIIitry.
GDP does not correct. as GNP does. kw the porlion of countnes pmduetion caned out
u.sing serviccs providcd by foieignowned capital and labor. Consider an example: The earn
ins of a Spanish fttctory with British uwners are counted in Spains GDP hut are pan (li
T3iitains GNP. The services Brtish capita! provides in Spain are a service export from Britain.
therefoie they are added to British GDP in calculating British GNP. Ai the sanie time, tu gure
Spains GNP, we must subiraci from its GDP the corresponding service impari lrom Britain.
As a practica! matter. movements in GDP and GNP usual!y do noi ditler greatly. We
wiH ft)cu,s oii GNP in this book, however, because GNP tracks nationa! ineonie more
income
closey tlian GDP does, and national wel tire depends more direct!y un national
than on doniestic produci.

National Income Accounting for an Open Economy

In this section we extend tu the case of an open economy the closedeconomy national
income accounting framework you ma) liave seen in earlier economics courses. We begin
with a discussion of the nationa! income accounts because they highlight the key role of
international trade in openeconomy macroeconomic theory. Since a closed economys
residents cannot purchase foreign output or sei! their mvii to foreigners. al! of nationai
income musi be aliocated io domestic consumption. investment. or government purchases.
In an econorny open to international trade, however. the ciosedeconomy version of
national income accounting musi be modihed because some. clomestic output is exported
io foreiners whle some domestic income Is spent 0(1 imported foreign products.
The main !essc)n of this section is the re!ationship among national SaVing, invesimeni,
and trade imbalances. We xviII see that iii open economes. saving and investment are not
save
necessarily equa!, as they are in a closed economy. This occurs because countries can
dissme
in the forni of foi-eigii wealth hy exporting more than the) irnport, and the) can
that is. reduce their foreign eaIthby exporting !ess than the) irnport.

Consumption
The portion of GNP purchased hy private households to fuIfihl curreni tants Is called
ork, and washing machines ali
consuniption. Purchases of movie tickets, food. dental
fai! into this category. Consumption expenditure is the !argest component of GNP in inost
economies. In the United States, for example, the fraction of GNP devoted to consuniption
has fluctuated in a range troni ahout 62 to 70 percent over the past 60 years.

Investment
The pari of output used by private firms to produce future output is called investrncnt.
Investment spendin may be viewed us the portion of GNP used io increase the nations
as
stock ofcapital. Steel and bricks used to build afactory are pari ofinestrnent spending,
pur
Firms
computers.
are services provided by a technician ho helps buiid business
chases of insentories are aiso counted in irivesimeni spending because carrying in entories
is just another way for lirms to transfer output from current tise lo future use.
!nvestment is usual!y more variabie than consumption. In the United States, (gross) invesi
word
menI has Iluctuated between i I and 22 percent of GNP in receni ears. We often use the
hut
estate,
real
or
bonds.
stocks,
of
purchases
households
inltstment to describe individua!
economic
the
word
with
the
of
rneaning
you si-iouid be careful noi to confuse this everyday
you are
detnition of investment as a pari of GNP. When you buy a share of Microsoft stock,
GNP.
in
up
buyirig neithcr a good nor a service, so your purchase dues noi show

CH A PTE R

1 3

NaiioniI

AcC43LJn(in ;ind the IaIance of Payments

Inconie

299

Government Purchases
and services puichased hy federai, siate, or locai governments are ciasslied as
the nationai income accounts. ncluded in governmenl purchases
are federal miiimry spending. government suppori of cancer rcsearch,
and govemmeni
funds speni on highway repair and education. Government purchases include investment as
weil as consumption purchases. Govemmetu transftr paymcnts such as sociai security and
unemploymentbenefits do not requhle the recipient io give the government miv goods or serv
ces in return. Thus. transfer payments are noi inciuded in governmeni iiaS.
Government purchases currentiv tale up about 20 percent ol U.S. GNP, and ihis share has
noi changed much since the late I 950s. (The corresponding figure fr 1959, for example, was
arouncl 20 percenL) In 1929, however, government purchases accounted lor oniy 8.5 perceni
of U.S. GNP.
Afly goods

government purehascs in

The NatonaI Income Identity for an Open Economy

In a cioscd economv. anv fnal good or service that ix not purchased by househoids or the
government musi be used hy firms io produce new piani. eqtiipment, and inventories. If
consumption goods are noi sold immediateiy to consumers or the govcrnmcnl. firnis
(perhaps reluctantiy) add them io existing inventories. thereby increasing iheir investment.
This inforination leads io a fundamentai ideniity for ciosed economies. Lei Y siand for GNP,
C for consurnption, I fr investment, and G for government purchases. Since ali of a ciosed
econornys output musi be consumed. invesied. or bought hy the governmcni. we can write

C + I + G.

We derived the nationai income identiiv for a ciosed economy by assuming that ali
output Is consurned or invested by the counirys citizens or ptirchased by its government.
When foreign trade ix possible, however. SOme Output S purchased by foreigners whiie
some domestie spending goes to purchase goods and services produced ahroad. The GNP
identity for open economies shows how the national income a country earns by selling its
goods and sen ices ix divicled hetween saies io domestic residents and saies to foreign
residents.
Since residents of an open economy may spend some of their incone on imports, that
is, goods and services purchased from ahroad, only the portion of their spending that ix noi
devoted to imports is part of domestie GNR The value of imports, denoted by IM. musi be
suhtracted from totai domestic spending, C + i + G. io Ind the portion of domestic
spending that generates domestic national income. Imports from abroaci add to foreign
countries GNPs but do noi add directiy io dornestic GNP.
Similariy. the goods and services sold to foreigners make up a countrys exports.
Exports. denoted by EX, are the amount foreign residents purchases add io the natioiiai
income of the doinestic econorny.
The nationai income of an open economy Is iherefore the sum of dorncsiic and foreign
expenditurcs on the goods and services produced by domestic factors of production. Thus.
the national income identity for an open economy is

Y=C+I+G+EXIM.

113-1)

An lmaginary Open Economy

To make identity (i 3-1) concrete, iets consider an imaginary ciosed economy. Agraria,
whose only output ix wheat. Each citizen of Agraria ix a consumer of wheat, but each is
also a farmer and.therefore can be viewcd as a firm. Farmers invest by putling aside a

30()

PA

-r

Exchngc R.itcs and ()penEconomy Macroecononiics

TH REE

National Income Accounts for Agraria, an Opeil Economy

(bushels of wheat)

TABLE

= Uonsiinptioii + Invesirneni + Govcrnnient + Exports

GNP
purchases
(total Output)

100

75

55 hushe!s of whtii

(05 htih1

per

10

I-

25

a kn )

X (40

Irnports
b
20

bus of milk ).

0.5 bushel per pallouu X 40aIbons uf mibk.

portion nt each years rop as seed tor the iext years planting. There is also a govern
ment that appropriates part of the crop Io tceci the Agrarian army. Agrarias total annual
crop is 100 bushels of wheat. Agraria can import milk from the rest of the world in
exchange [ci cxports o[ wheat. We cannot draw up the Agrarian nationai income
accounts without knowing the price ol miik in terrns of wheat because all the compo
nents in the GNP identity (13I) must be rneasured in the same unis. If we assume the
price o1 milk is 0.5 hushel of wheat per gallon. and thai at this price, Agrarians ant to
consume 40 gallons oF miik, then Agrarias imports are equal in value to 20 bushels
of wheat.
In Table 13-I we sec that Agrarias total output is 100 hushels of wheat. Consuinption
is dvided betwcen wheat and milk, with 55 hushels of wheat ancl 40 gallons of milk (equal
in value to 20 hushels ot wheat) consumed over the year. The value of consumption in
terms of wheat is 55 + (0.5 X 40) = 55 + 20 = 75.
The 100 bushels of wheat produced hy Agraria are used as follows: 55 are consumed hy
domestic residents, 25 are invested. IO an purchaseci hy the goveniment, ancl 10 are exported
ahroad. National ineome (Y = 100) equals dornestic spending (C + I + G = 110) plus
exports (EX

10 Iess irnports (IM

20).

The Current Account and Foreign Indebtedness

In reality, a countrys loreign rade is exact]y balanced only rarely. The clifference hetwcen
exports ol goods and services and irnports of goods and services is known as the current
account balance (or current account). If ve denote the current account by CA, we can
expTess this definition in symbols as
CA

EX

IM.

When a countrys imports exceed its exports, we say the country has a current account
3
deficit. A country has a rurrent accounl siirplus when its exports exceed its irnports.
is important
account
current
the
why
reason
one
shows
The GNP identity, equation (13-1),
expenditures
total
gives
of(13-1)
side
in iniernational rnacroeconornics. Since the right-hand
on dornestic output, changes in the current account can be associated with changes in output

and. ihus, ernployment.

The current account is also important because it rneasures the size anci direction of
inuernational borrowing. When a country imports more than it exports, it is buying more
nel unulateral lransfers of
n addition lo net exports of oods and services, the comnt uccount buibance uncludes
i3
to inore such trarus
contnue
we
assumptuon.
income, wbiich we diseussed hriefly above. Fo1bosin! our earIer
of pa nuent., in
balance
the
ze
tJ.S.
unaI
ve
s
hen
ch.upter,
this
in
Later
discussion,
fers for now lo sirnplufv the
ccouflt.
ufetaib. we wilb sec how tr,unsfers ol curueuil incorne enter the curuent

CIIAPTER

Nationnl Income ccotintin and the Ralance of )aymcnts

301

ioreigners than il seils lo them and musi somchow finance this curieni aecounl
How does il pay for additionai imports once il has speiit its exporl earnings? Siiice
the country as a whoic can impuri more thaii it expoits only il il caii horrow the dilThrencc
(mm ftweiencrs, a country with a curreni account deficit musi be increasing its nel
ireign
dehts hy the amount of the deficit. This is currentiy the position of the United
States.
which has a signifcant curreni account deficit (and horrowed a sum equal
to roughiy
3 perceni of its GNP in 2009).
Similarly, a countrv vitIi a curreni account surpius Is earning niore (mm its exports
lhail it spends Ofi imports. This country hnances the current account deficit of its trading
partners by iending io them. The foreign wealth of a surplus country rises because foreigo
ers pay for any inlports not covered by their exports by issuing lOUs that
they wiIi eventu
liy h iv_ to I Ldccm Thc pi e(.eding ie isoning shows th 11 a ( aunhi
(1(1 Un! ( ( oifnt
balaiu t quals 1/IL ha,uc ai i1 IILI /01CM,,? o ca/I/i
We li we defiiid the cwient account as the dittulcncL bctween cxpoits md Imports
Equ ition (I 3 1) s ys th lt the LUI icnt accOunt is i.o equal to thL diii LIncL_
bLtwcLn
il ition il incom md domestic icsidents total spendtng C + I + 6
ff0111

deficit.

(C + I + G)

(A

li Is only by borrowing abroad that a country can Ilave a current account deficit and use
more output ihan it is currenhly producing. li ii uses less than iis output. li
has a curreni

account surplus and is Iending the surplus io foreigners.

5 International borrowing and
iending vere identified with interteinpora/ trade in Chapter 6. A country with a curreni
account deficit is importing preseni consumption and exporting future consunlption.
A country with a cui-reni account surplus is exporting present consumption and importing
future consumption.
As ari example, consider again the imaginary economy of Agrai-ia described in Table
I 3-i.
The totai value of its consurnption. investment, and government purchases, ai 110
bushels of
w heat, is greater than its output of 100 busheis. This inequaiity would be impossible
in a
closed economy; it Is possibie in this operi economy because Agraria now imports
40 gailons
of rnilk, worth 20 bushels of wheaL but exports only 10 bushels of vheat. The curreni
account
deficit of IO bushels is the value of Agrarias bolTowing from foreigners. which
the counlxy
wiil have to repav in the luture.

Figure 13-2 gives a vivid iUustration of how a siring of curreni account defcits cari add

up to a large loreien debi. The figure piots the U.S. current account halancc since the
late
1970s along v ith a measure of the nations stock of net foreign wealth. As you cari sec, the

United States had accumulated substantial foreign wealth by the early 1980s. when sus
a
mmcd current account deficit of proportions unprecedented in the 2Oth century opened
up.
In 1987, the countr becarne a net debior io foreigners for the first time since World War I.
That foreign debt has continued to grow, and ai the end of 2009, it siood at just below
20 percent of GNP.

4
A
tternativelv a counmr outd fimince a cuiTent iceount clelictm by usin previousv aceumulated foreign
weath
Io ay (or nwOrt. fhis country would be runnins down its neI trein svsalth. v lodi is ihe same is
ru noie sip
its net toreign dehts.
Our diseussion bere is Ignoring the possibility tua? a country receives gifis of toregn assets (or gives
such
ilts). such as whcn one country agrees Io torgive another.s debts. As v. e will diseuss below. such asset
transkrs
(unlike transters of Curreflt income) are nor pai? 01 the current accciunl. but they rionetheless do aflecr
nel foreign
wealth. The
3 ore rccordc-d in the capita? accouni o! the balance of pa inent-.
The surn t = C + I + G is often called domestie absorprian in the literature on international rnacroecohio
incs.
Usin this terminology. we con descrihe the curreni account surplus as the difference hetweeri income awi
ahsorp
11011. Y
A.

302

PART TH REE

Fxchiiigc Ratcs untI Opcii-Econoniy Nlacrocconomics

CLirrenI account,
net Ioreign wealth (biflions ol dotlars)

400
200

o
200

Current account

400
600
800
1000
1200
1400
1600
1800
2000
2200
2400
2600
2800
3000
3200
3400
3600
2004 2006 2008
1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002

Figure 13-2
Th U.S. Ciricnt A coLInt and Nt Freign VeaIth losition, I
wealth until, by the
A string of current account defic,ts start ing in the i J80s reduced Americas net foreign
deht.
foreigo
net
uIrmntiaI
a
early 2lst century, the (ountrv had
Source: U.S. Deparimeni

01 (umnwr C,

iii (tJ

>n Irn Analysis.

Saving and the Current Account

mosi
Simple as it is, the GNP identity has rnany illuminating inIpiicaiions. To explain the
portion
the
i.
thai
imporItnt of these irnplications, we define the concept of national saving,
or governrnent purchases. G.c
of output. Y, that is noi devoted to household COflSUmptiOH, C,
closed
in a closed econoinv, IIOt(vna/ .vating alwavs quaIs imestinent. This tefls us that the
capital.
new
accurnulating
by
only
wealth
ils
increase
economy as a who]e cm
Let 5 stand for national saving. Our defnition of 5 iells us that
5

G.

to eniar e the natlons capita]

he (iS. national incoine accounls assume that governnent puichases are not used
6
T
liommi
output io calculate nanonal
purchases
overnrnent
all
here
hy
ubtr cnnr
stock. Ne follow ths convent:on
consumflption and government
ernmenl
go
hetwccn
distinguish
.iccounts
national
countnes
other
Most
saving.
the latter us part of national
invcstment (ftr example. nvestment hy publiclv owned enterprises) and include
equipmnent.
rnditnry
of
puzchase
include
fure
csrrnent
in
ernmneni
howes
em.
savlng. Often.

C HAPTE R

Siice

liii
(

1 3

NaiionuI inconie

Accouiiling

Jn(l the Baiance of Paynicnis

ci sedeconuniy (3NP identiiy, )

303

C + I + G, may alsu hc writtcn as

(;. t)L)1

i.

and national saving mUSI cquii iiCs1mCfli ii a closed CCOflOmy. Whereas iii a c!osed econ
oiiiy, savtng and investineni illusi always be equa!, 1l all P CCOilOlly they can differ.
Reineinbeiing t[iai national saving, S. equais Y
C
6 ancl hat CA = LX
IM. we
can rewrite the GN P ideni ity (13 I) as

I + CA.

TIie equation highlighis an important difference hetween open and cIosed cCoflomies:
An open economy can save either hy bui!ding up its capita! stock or hy acquiring !oreign
weaiih. bui a closed economv can save on!y by buiiding up its capitai stock.
Un!ike a c!oscd economy. an open economy with pro!itab!e invesimeni opportumties does
noi bave io increase iIs saving in order lo expioit iheni. The preceding expression shows that it
5 possibie simuftaneousiy io raise investment and foreign bolToWing withotit changing sav
ing. For cxampie. if New Zeaand decides Io huild a new hydroekctric piani, il can import the
naleria!s it needs from the Unitec! States and borrow American funds to pay for them. This
transaclion raiscs New Zeaiands domestic investmeni because the imported materiaIs
contribute to expanding the countrys capital stock. The transaction aiso raises New Zeaiands
cunent account deficit by an amount equa! to the increase in investment. New Zealands sav
ing does noi have Lo change. even though invesimeni rises. For this to be possibie, howevei,
U.S. residents musi be wiiling to save more so that the resources needed to buiid the piani are
freed for New Zealands tise. The resuli is another exampie of intertemporai trade. in which
New Zea!and imports present consumption (when it borrows from the United States aild
exports future consumption (when it pays off the loan).
Because one countrys savings can be horrowed hy a second country iii order to
increase the second counirys stock of capital, a countrys current account suipius is often
referred to as ils nel foreigii iiive.vt,,ien!. Of course, when one country iends to another to
finance investment, pari of the income geiierated by the investrnent in future years musi be
used io pay hack the iendei Domesiic investment and foreign investment are two different
ways in which a country can use currcnt savings lo increase its future income.

Private and Government Saving

So far our discussion of saving has not stiessed the distinction between saving decisions
made by the pris ate sector and saving decisions made hy the government. Unlike priate
saine decisions, howevet government saving decisions are often made with an eyc
toward their effeci on output and empioyment. The national income identity can heip us to
analyze the channels through which government saving decisions influence macroeco
nomic conditions. To use the nationai income identity in this wa. we first bave [o di ide
national savin unto its private and povernment components.
Private saving is defned as the pari of disposable income that is saved rather than con
sumed. Disposable income is nationai uncome, Y. !ess the nei iaxes collected from house
holds and firrns by the government. 7 Privite saving, denoted S
, can therefore le
1
expressed as

taxes are iaxes ess overnrnent transier

Iocaf oscrnnwnts ons(ierec! as a singie Un!t.

py1neni.

C.

The terni

;oernh1u ni

refers to the lecleral. state. and

304

PAPT li--I REE

changc IZatcs and Opeii-[conomy

(Jmvi-nnunt vaiing is

Microcco,ionics

(lei ined similarly Io private saving. The governmenls income

is Is 11CL (ax reventie, 7, while iis conslimption is government purchases, CL lf we lei S

si and kw govern meni sav i ng, I hen

G.

ilie two types ol saving we have deiined, I)riIte ami government. add up to nalional
C
G. Then
saving. To sec why, recai! the delinition of national saving, S, as Y

(Y

T C) + (T

G)

8 +

sg

the dehni ions of private and government saviflg io rewrite the nationai
inCome identity in a forni that is useltil ir analyzing the etiects ol government saving
I + CA,
decisions Uil OCi eCOilOillieS. Because 5 = 8 + S
\Ve can

Lise

I + CA

I + CA

(T

I + CA + (G

G)

T).

U3-2

Equation (132) reiates private saving Lo doniestic iflvestment. the current account sur
pius, aiid government saving. To interpret equation (13-2). ve detine the governnient
T. that is, as government saving preceded by a mjnus sign. The
budget deficit as G
measures the extent to which the gOVerilnleflt is horrowing to
delicit
budget
government
.
linance its expenditures Equation (132) then states that a coimtrys pi-ivate saving can take
three forins: investment in domcstic capital (i). purchases of wealth from foreigners (CA),
T). The usefulness
and purchases ol the domestic governments newiy issueci debt (G
of equation (13-2) is illustrated by the following Case Study.

Case Study
Government Deficit Reduction May Not Increase the Current Account Surplus
I 1k linkage ;mlong ihe current ai-colinI haiance. investment, and private and government
tr thinking about the results of economic
saving given by equation (13-2) iS eT i
policies and evenis. ( )iir prL-Ll!e1n ,,hot,i such outcomes cannot possibly be correct unless
the current account, investment, and saving rates are assumed to adjust in line with (13-2).
Becausethat equation is an jdentii-,, huvesei, ami is not based on any theory ofeconomic
behavior, we cannot forecast the re uil of policies without some mode! of the economy.
Equation (13-2) is an identity because it must be included in any va!id economic mode!,
but there are any ,i,mhe of tiiodels consistent with identity (13-2).
A good example of how hard it can be io forecast policies effects comes from think
ing about the effects of govemment deflcits on the current account. During the adminis
tration ofPresident Ronald Reagan in the early 1980s, he United States slashed taxes and
raised some government expenditures. which generated both a big government deficit and
a sharply increased current account deficit. Those events gave rise to the argument that
the government and the current account deficits were twin deficits both generated pri
marily by the Reagan policies. If you rewrite identity (13-2) in the form

CA

(G

ln a closid econorny. ihe cune,lt accounu i atways 7rc). so

T),

eqilauion

(13-2)

irnpiy 5

I + (G

Tj.

C HA PT E P

1 3

Nat ional Income

iccount

nt intI the flalance of Payrncnts

305

you can sec how ihat onicoitie could have oecurred. If the govemmeni ilehcit nses
i oes up) and private saving and Incstmcnt dont chaiigc mueh. the cuneni
account surplus must ItII hy wuglily the sale amount as the increae i i the tiscal
dehcii. In the United States hetwe.en 981 and 1945. the gwernnient deticii IIcI
by a bit more than 2 Irm of GNP, whileY
I feli by abotii halt a IJeftei Il ol GNF
so the curreni account feil 1mm an approxiniaieI haianccd poSilioli io ahoui 3 perceni
of (iNP. (The variable. in identity (I 3-2) are expresseil a. peiceni
ol ( NP br easy
comparisOn.) Thus. the twin deficits prec1ictio is noi 100 fai off the ,nark.
The twin deteits thenry can Iead ns seriously aslray. however. when change. in gov
ernmeiit deficits lead to bigger changes in private saving and investmeni hehavior. A good
example ol these effects comes from Furopean conntries eliorts io cui their gmernment
budget delicits prior to the Iaunch of their new common currencv, the euro. in Janiuuv
1999. As ve vilI discuss in Chapter 20. the Furopean Union (FU) had agreed that no
member euuntry with a large government delcit would Le allowed ti) adopi the h\\ cur
rency along with the initial wave ol euro zone menbers. As 1999 approached. ihereiore.
FU goVemmerlis made trantic eltoils to cuI govei-nment spending and raise ta\es.
Under the twin delicits theor we ould have
ivJ the F(
current i e inc
surplus io i licrease sharply as a iesuI i ol 11k iicaI change. A. the tahle heI v. shows.
however. nothing of the sori acluali> hap
)ene(1. For the FU as a whole. governinent
1
delcits leil hy ahoui 1.5 peruenl ed output. yet the uurieiit account
plu ieinaiiied
ah )Lit the same
The table teveals the main reasiin the ctirreiil su uni didnt chaice much: a i
talI in the private saving rate. whiuh declincd h ahout 4 perceni of uipu1. alinost as
nnicli a. the increase in e
;n sI5 sa inc IIi\ estIieni rose .lichti\ at the same time.)
li hi case, the heha ior ol
i\ de savers us1 abotii nentralized tovernmenis efforts

(o iii.

li

national saving!

It\ 11w. ottset ocuurred. but theie are a number of possible

i haed on an economie theorv known as the Ricardian equivalence
of taxes iijd govenimeni deticits. (The theory is named after the saitie David Ricardo
who di)\ eicd the theory t compaianve advantagerecall (hapier 3allhough he
himself did not beliese in (
equivalence.) Ricardian equivalence argues that
ben the government cui. taxes and raises its delicii. consumers anticipate that they
xviII face higher taxes later to pay otf the resulting government debt. In anticipation,
they raise their own (private) saving to otThet the fali in government saving. Conversely,
govemrnents that lower their deficits through higher taxes (thereby increasing govern
mcm saving) wiII induce the private sector to !ower its own saving. Qualitatively, this Is
the kind of hehavior we saw in Europe in the late 1990s.
js (fititui.Il1 io kriow

\plan.I1I()i ()ne

European Uiiion (percentage of ( \ P

Year
1995
1996
1997
1998
1999

CA
0.6
1.0
1.5
1.0
02

1
S
259
24.6
23.4
226
21.8

I
19.9
19.3
19.4
20.0
20.8

Source: Organization for Lconornc Cooperalion and Devcloprnent. OECD Eronwniu Ouilook 68
(Decenber 2000). annex tihte 27, 30, and 52 ( ith investment caicutated a. the residuni).

GT

5.4
4.3
2.5
1.6
0.8

306

PART TH REE

Exchangc Ritcs

aiid

Opcii-Economy Macroccononiics

Ecoioiiiists statistica! si tiies Sucuesi. however, iIit Ricardian equlvalenie doesnt

hold exactiy in pitcriee. Most economists woukl iiirihuie io more timan lumi! the celimie
in Europcan pnvae sa im a Riemrdimn e! fecI. Vv[uit L\pIauIs the est ol i he deelmne?
The salues o! huwpe.mi Imn.uicia msseIs vere generulbv rising in the late I )9Os. a devel
hv opiimnmsm over the beneficiai eeoiiomiC eIfects o! tlc piaiined
oPmcni iueled in
com mori cu rre ncy. li i li kely i hai i me measei i household wea li h was a second faeti ir I( )W
ermng the private \ ii rate in Lumope.
Because private saving. iflvesiirefll. the CUIIeni acenuni. and the governmneni cldicii
are jointI determmned vai ,cbles. we can never tullv determmne the cause o! a curreni
account change nine identitv (I 3-a) a]tcne Noneilreless. the mdentity pro mdes m
essertmal francwork br thimiking ahommt the curremmi account and can !urnish uschil clues.

The Balance of Payments Accounts

In acidition to nationai income accounts. government ecOflOfliiStS and statisticiitfls aiso
keep balance of payrnents accounts. a detailed record of the COmpoSition of the current
9 Baiance of paynients figures
account balance and of the rnany transactions that finance il.
the attention that arious news
as
indicated
by
pubiic,
generai
the
are ot great interest to
different measures of interna
confuse
sometimes
media pay to thern. But press reports
tional payrnents flows. Should ve be alarmed or cheered by a WaIl Street .Iourna/ headline
pro uming, U.S. Chaiks Up Record Balance of Payments Deficit? A thorough uncler
standing of balance of payments accounting wifl help us evahmate the implications of a
countrys international transactions.
\ coun(ry s bafance ot payments account.s keep irack of both its payrnents io and its
receipts frorn foreigners. Any transaction resulting in a receipt from foreigners is entered
in the balance o! payments accounis asacr(djt. Any transaction resulting in a payment Io
foreigners is entei-ed as a debit. Three types of international transaclion are recorded in the
balance of payments:
1. Transactions that anse from the export or impori of goods or serviccs and thcreiore
enter directly into the curreni account. When a French consumer imports American
blue jeans. lor example. the transaction enters the U.S. balance of payments accounts
as a credii on the current account.
2. Transactions that anse from the purehasc or sale of financial assets. An asset is any
one of the forms in which wealth can be held. such as money, stocks, factorics, or
government debt. The financial account of the balance of payments records all
internationai purchases or sales of financial assets. When an American company
huys a French factory. the transaction enters the U.S. balance of payrnents as a debit
in the financial account. It enters as a clebit because the transaction requires a

lie L,S. oven1nment is in time process of changimcg its balance of payments presentation tu conform to prevail
9
T
ing nternatLona1 standards. o ocir discusson io ihis chapwr dctfers in some respeCis lioni thct in prior ditions o)
foilow the ncethodology dcscrihed hy Krist L. Howtl1 and Roberi E. Yuskasae. Modernizine
this book.
mcd Enhcincin Blis internationai Economie Accounts: Receiit Piogress and Future Directcons. Suncv of
Currcnt bzumevs (May 20101. pp. 020. As of tliis riting time U.S. has not completed a fuji iransilcon io the new
systeccc. but it cc expecwd to do so in er the eari3 20! Os

C HAPTE R 1 3

Nitjoii,J Iiicoiiie Accountin Jfl(l the Balance of Pavnients

307

payment troni the United Statcs to Iregners. Correspondingly. a LJ.S. sale of aSscts
lo Ioreigners enters the U .S. financiai accounl as a credt. The differcice between
a
countrys purchases md sales of flreign assets is caiicd itsfiiui,mtiul (l(c(nInI bairnue.
or its ne! finanerni 1/mis.
3. Certain other activities resuliing in transfers ol wealih hetween countries are rccorded
in the capital accoiint. These !nlernational assel movements---which are generali)
very smnail for the Unitcd Statesdiffer (mm those rccorded in the
(mancia! aCcOUnt.
For the iliosi pari they rcsult lrom nonmarket aclivil cs or represent the acquisilion
or
disposai of nonproduced, nonhnancial, and possibly intangible assets (such as copy
rights and trademarks). For ex.mple, if the U.S. government forgives $1 billion in debi
owed to il by the goernment ol Pakistan, U.S. weaith dcciines hy $1 hiilion and
a
$ i bili ion dehit is recorded in the U.S. capitai accoont.
You wiii ind the compiexities of the balance of payments accounts less confusing if
you keep in mmd the foilowing simpie rule of dotihleeniry bookkeeping: Eierv iliter
naiio,iaI transaetioil auto,naticallv en(ers the ba/urne
0/ JNIVInefltS titicC, once (IS a
credii and once as a debir. This principie nt baiance of paynlents accounting holds
true
because every transaction has two sides: TI you huy something from a foreigner,
you
must pay him in some way. and the ftreigner must then soincho spend or store your

payment.

Examples of Paired Transactons

Some exampies vi1i show how the principle of double-entry bookkeeping operatcs
in
practice.

1. Imagine you buy an inkjet fax machine from the italian company Olivetti and pay for
your purchase with a $J,000 check. Your payment Io huy a good (the hix machine)
from a foreign resident entcrs the U.S. culTcnt account as a debit. But where is the off
setting balance of payments credii? Olivettis U.S. salesperson musi do something
with your checkiets say he deposits it in Oiivettis account at Citibank in New York.
In this case. Olivetti has purchased. and Citibank has solci. a U.S. asseta bank
deposit worth $1 .000and the transaction shows UI) US a SI ,000 credit in the U.S.
financial account. The transaction creates the foilowing two offsetting bookkeeping
entries in the U.S. balance ofpayments:

Credit
Fax machine purchasc (Currcnt account.
Sale of hank deposit hy Citibank
(Financial account.

U.S. asset salej

U.S. good import)

Debit
SI,OO()

S1,000

2. As another example. suppose that during your traeIs in France, you pay $20() for
a
fine dinner at the Restaurant de IEscargot dOr. Lacking cash, you piace the charge on
your Visa ci-edit card. Your payrnent. which is a tourist expenditure. wiii be counted as
a service import lor the United States, and therefore as a current account debit. Where
is the offsetting credit? Your signature on the Visa slip entities the restaurant to receive
S200 (actually, its local currency equivaient) from First Card, the company that issued
your Visa card. It is therelre an asset, a clairn on a future payment from First Card.
So shen you pii lor your meal abroad with your credit card. you are selling an asset

308

PAPT TH REE

Excliangc Ratcs aiid Opdn-Economy Macrocconoinics

France and gcnelaling a $20() credit in the US. linancial account. The pattern oF
ollsetting dehiis and ciedits in this case is:

1(.)

Debil

(redit

Meal pnichase (Curreni account, U.S. service impurO

Sai e ol e ai in on Fi rst Card
Finmcial acc000t. U.S. asset sale)

$200
$200

of stock
3. Imagine next thai your Uncle Sid irom Los Angeles huys a nev ly issued share
stockbroker,
his
in the U.K. oil giant British Petroleum (BP). He places his order with
mar
Go-finBroke, Inc., paving $95 with a check drawn un his GoForBroke rnoney
ket acconni. BP, in turn, clepnsits the $95 Sid has paid mio its own U.S. hank account
in
ai Second Bank of Chicago. Uncie Sids acquisilion of the stock creaies a $95 dehit
BP).
resident,
toreign
a
rroni
asset
an
purchased
the LJ.S. linancial account (he has
whiie BPs $95 deposit ai its Chicago hank ix the offsetting financial account credit
bal
(BP has expanded its U.S. assei hoidings), The mirwrimage effecis un the U.S.
ance of payments therefore both appear in the financial account:
Credit
Uncie Sids urchase oCa share of BP
(Financial accon nt, U .S. OSSeI PLI rchasc)
BPs deposii of Uncle Sids payment ai Sccond Bank of Chicago
(Financiai account. U.S. assct sale)

Dehit
$95

$95

when
4. Finally, lets consider how the U.S. balance of payments accounts are affected
debi
in
U.S. hanks forgive (that Is, announce that they vill simply forgei about) $5.000
case, the
owed io them hy the government of the imaginary country of Bygonia. In this
as
a
$5.000
appears
which
Bygonia,
to
transfer
capital
United States makes a $5.000
in
account,
financial
the
in
is
credii
associated
The
debit entry in the capital account.
of
acquisition
negative
(a
ahroad
held
assets
the form of a $5,00() reduction in V.S.
foreign assets. and therefore a balance of payments credit):
Credit
U.S. banks debt forgivcncss
(Capita! accouni, U.S. iransfcr payment)
Reduclion in banks claims on Bygonia
(Financial acconni, U.S. assct sale)

Debit
55.000

$5.000

These examples show that rnany circumstances can alfect the way a transaction
certainty
generates iis offsetting balance ofpayments eniry. We can never predict wiih
that it
sure
be
can
where the (hp side oCa particular transaction will show up. but we
will show up sornewhere.

The Fundamental Balance of Payments Identity

credit and debit

l3ecause any international transaction automatically gives rise to offsetting
and the capital
balance
account
current
the
of
surn
entries in the balance of payments. the
balance:
account
(mancia!
account balance atitornaticahiy equals the
(13-3)
Financial account.
Curreni account + capita! account

C HAPTER 1 3

Naiion.iI Income AccountInt and the P.iIance of ryrncnts

309

In cximpes I 2, and 4 ahove, curreni or capilai accouni enirics have ollseiling

countcrpaiis
in the tinanciai accornt. while in example 3, two tinancial account entrics
ofisei each other.
Yoii can LIIderstand this idcntitv another way. Recai] the reiatonship
iinking
.

the cnr

reni account io international Iending and borrowing. Because the sun

o the current and
capita] accounis ix the lola] change in a counlrys nel foreign assets (including.
through the
capita] account. nonmarIei assel transfers), that sum necessariiy
equals the difference
hetwcen a countrys purchases of assets from toreigners
and its sales of assets (o thein
that is, the tnancia] account balance (also cai]ed net tinanciai
flows ).
We now turn lo a more detailed description of the baiance of payments accounts,
using
as an example the U.S. accounls for 2009.

The Current Account, Once Again

As you bave ]earned. the curreni account balance measures a counlrys
nei exports oi
goods ind services. Table 13-2 shows that U.S. exports (on the credit side)
were $2.]59.()
billion in 2009. whiie U.S. imports bn the debii side) were $2,4 12.5 hiilion.
TABLE 132

U.S. Balance of Payments Accounts for 2009 (biilions ol dollars)

Current Account
(1) Exports
2,159.0
Of which:
Goods
I ,068.5
S crvices
502.3
lncomc rcccipts (pri mary income)
588.2
(2)1 mports
2,412.5
Of vhich:
Goods
1.575.4
Scrvices
370.3
income paymdnts (primary income)
466.8
(3) Nei uniiatcral transfers (secondary ncome)
124.9
Balance on currcnt account
---378.4
[(1)
(2) + (3)1
Capita] Aceount
(4)
Financial Account
(5) Nei U.S. acquisition of tinancia] assets, cxc1udin linancial dcrivatives
Ofwhich:
Official reserve assets

Oiher asscts
(6) Nel U.S. incurrence of liabilities, excluding (mancia] deriv-atives
Ofwhich:
Official rcscrve asset.s
Oiher assets

140.5
52.3
88.2
305.7

450.0
--144.3
50.8
216.0

(7) Fnancial derivati es. nei

Nel financiai flows
(6) + (7)]
[(5
Nel errors and omissions

[Nel (mancia] flows Iess SUm of currcnt and capital accounts]

Suure:

ditTr

US.

Dei,ar1mnt of Commeree. t3ureiu

Ir(rn sums lecaue

oundn!.

of Lcon ornw Aiiutysis. iurie 17. 2010.

162.5
release. Totats rnay

.3 10

PA RT TH PE L

Excliange RiIes iiid OpcnIkonomy Macrocconomics

cate
The halance of PaYmentS accoti[its divide exports ami imports mb three liner
second
The
ndise.
mercha
s
of
import
or
s
export
is,
eories. The lirsi is goods trade, ihat
kw legai assistance, tourists expcndi
ealegory..wni(c.s. includes ilems such as payments
alionai
tures. ami shipping lees. The linal cateory. ln(VflC. is made up mostly ol mntern
mn
Operat
hrnis
()Wned
tically
interesi ami dividend payments ami the earnins ol donies
$5.
of
nt
nd
payme
abroad. If you nwn a share of a Cierman Iirms slnck ami receive a divide
Wages
of
$5.
bhat payment shows up in the accounts asa U.S. investment income receipt
t.
accoun
the
mncome
enter
also
cari
that workers carri ahroad
e that income
We include income ori ftreign investments in the current accouni becaus
idea. as we
really is compefl.sation tor the serikcs provided by foreign investinents. This
ralion
Corpo
U.S.
a
When
GDP.
and
n
GNP
saw earlier, is hehmnd the distinction hetwee
tes
are
genera
piani.
the
s
service
tve
htnlds a piani in Canada, br instance. the produc
prouits
to
the
value
in
a
viewed as a service export bmm the Uniied States io Canad equal
include these
the piani yields br its American owner. To be consisteni, we musi be sure to
definition of GNP
prolits in American GNP and noi in Canadian GNP. Rcmemhcr, the
it does iiot
refers io goods and serviccs generaied by a countrys laciors ol produclion, bui
owns them.
specify ihat those factors must work within the horders of the country that
onai
type of inter
adduti
e
one
includ
musi
we
t.
Before calculating the current accoun
relationship
ssing
the
discrL
In
now.
tintil
national transacilon that we have largely mgnored
ies as
countr
n
rs
hctwee
transfe
ral
betwcen GNP and national income, ve detined unilate
good.
any
of
se
purcha
the
io
ond
internationa] gi fts. ihat is, payments that do noi corresp
t as
t
accoun
curren
the
of
service, or asset. Nei. unilateral transfers are considered I,art
if
exactiy
holds
C + I + G + CA
vell as a pari of national inconie. and the identuty )
rs
transfe
ral
Y is interprete.d as GNP plus nei. transfers. In 2009, the U.S. balance of unilate
was $124.9hiliion.
$2.4 12.5
The table shows a 2009 current account balance of $2,1 59.0 billion
that cur
means
sign
e
negativ
.
The
deficit
.
a
billion $ 124.9 billion = $378.4 billion
ts nsed
residen
U.S.
ihat
s
and
rcceipt
t
rent paymcnts io foreigners exceeded curren
for
paid
were
tioris
transac
t
t
more output than they produced. Since these curren accoun
net
a
hy
offset
be
musi
entry
in sonie wav. ve know that this $378.4 billion net debit
nts.
payme
of
e
balanc
the
in
ere
elsewh
credit
$378.4 billion

The Capital Account

Staies paid out nei

The capital account entry in Table 3-2 shows that in 2009. the United
States are a nei
the
United
nts
by
payme
.
These
capital asset transfers of roughiy $0.1 biliion
d by the cur
implie
dcfcit
nbs
payme
the
bahince of paymeiiis dehit. Aler we add thern to
io foreigners
nts
payme
excess
ient account, we tind rhat the United States need to cover its
of national
excess
an
e
is raised ver slightly, from S378.4 billion io $378.5 billion. Becaus
e cur
negativ
this
er.
spendmng over income musi be covered by nei horrowing from foreign
net
of
e
e balanc
reni plus capita] account balance must be matched hy an equa] negativ
d io foreigners in
tinancial flows, representing the net ]iabilities the United States incurre
2009 in order to fund its deficit.

The Financial Account

and sers ices io foreigners

While the current account is the diffetence hetween sales of goods
t measures the differ
accoun
ai
linanci
the
and purchases of goods and services from them,
of liahiliiies io them.
p
buiklu
the
ence between acquisitions of assets from foreigners and
an asseta promise
them
When the United States horrows SI from foreigners, it is se]ling
the United States
when
that the) wilI be repaid SI, with interest. in the future. Likewise,
cnt from foreigners.
lends abroad. il acquires ari assel: the right to claim future repaym

CH APTER

1 3

Nationjl Incorne ccountin ind the Balance of Payrncnts

31 1

To (OVer its 2009 CUflCiI P

1 capital acenuni dctict of $378.5 billion, the United
Siates IiCC(lCd io hOITOW (mm I reigners (or oiherwise seil assets tu ihem) in the nei
amnuifl of $378.5 billion. Ne can look again ai tibIe 132 Io sec cxactly how Ihis nei. sale
nt asscts Io loreigiiers canie about.
The table records separately IJ.S. acquisitions of toreign tinancial asscts which
(
halancc ol piyIncnts debits. because the United States musi pay foreigneis (or ihose
assets) and increascs in Ioregn clainis un residents o! the United States (which are balance
ol paynients ciedils. becauxe the Uniicd Siates receives paymenls whcn il sells as.scts
overseas).
These data un increases in U.S. asset holdings abroad aiid foreign holdings of U.S.
assets do not include hoklings of financial d,-ivaiios. which are a c]ass ot assets that are
more complicatcd than ordinary stocks and honds, bui have aIiies that can depend on
stock and hond aIties. (We wilI describe some specitic derivative securities in the next
chapter.) Starting in 2006. the U.S. Department of Commerce was able io assembie data
un mt cmsshordcr derivative Ilows (or the United States (U.S. nei purchases o) Foreign
issued derivatives less foreign net purchases of U.S.issued derivatives). Derivatives trans
actions entei the balance of payments accounts in the same way as do other international
asset transactions.
According to Table 13-2, U.S.owned assets abroad (other than derivatives)
increased (on a net hasis) by $140.5 billion in 2009. The figure is on a net hasis
because some U.S. residents hought foreign assets while others sold foreign assets they
already owned, the difference between U.S. gross purchases and sales of foreign assets
hcing $140.5 billion. In the same year (again on a net basis). the United States incurred
new liahilities to foreigners equal io $305.7 billion. Sorne U.S. residents undoubtcdly
repaid foreign dehts, bui new horrowing frorn foreigners exceeded these repayments
by $305.7 billion. The balance of U.S. sales and purchases of financial derivatives was
$5().8 billion: The Uniied Staies sold more derivative claims tu foreigners than it
acquired. We calculate the balance on Inancial accounl (nel financial flows) as
$140.5 billion $305.7 billiori $50.8 billion = $216.0 billion. The negative value for
nel financial flows means that in 200). the United States increased its nei Iiability to
foreigners (liahilities minus asscts) by $216.0 billion.

Net Errors and Om[ssions

We come out with nei financial flows of $216.0 billion rather than the S378.5 billion
that wed expected. According to our data on trade and financial flows, the United States
found less Iinancing abroad tban it needed to fund its cuneni plus capital account deficit. If
eveiy balance ofpavments credii automatically generates an equal counterpart debit and vice
versa, liow is this difference possible? The reason is that information about the offsetting
debit and ciedit ilems associated with a given transaction rnay be collected from difirent
sources. For exarnple. the iniport debit that a shipment of DVD players frorn Japan generates
rnay come (mm a U.S. customs inspectors report and the corresponding financial accouni
credit from a report by the U.S. bank in which the check paying for the DVD plavers is
deposited. Because data fiorn differeni sources may differ in coverage, accuracy. and timing.
the balance ofpayments accounts seldorn balance in practice as they musi in theory. Account
keepers force ilie lwo sides io balance by adding io the accounts a net eriv:v and o,nissions
itern. For 2009, unrecorded (or misrecorded) international transactions generated a balancing
accounting credit of S162.5 billionthe difference between the recorded nel financial flows
and the sum of the recorded current and capital accounts.
We bave no way of kiiowing exact]y how lo allocate this discrepancy among the current,
capitaL and financial accounts. (lf we did, il wouldnt be a discrcpancy!) The financial

3I 2

PA RT

H REE

Exchaiigc IZatcs and Opcn[cononiy

Macroccononiics

accoiint is the musi iikely ciilpii(. since il iS nokwiuIISIy (lillicLilI tu keep track ol the Cunpli
cated financiai trades hetween residents ol diUerent countries. i3tit we cann()t conclude that
t
nei linanciai flows were $1 (-2.5 bili bn lower ihin iecurded, hecause the cuneni accoun Is
also highly suspeci. Balance ol iirens accountants cunsidei inerchandise trade data rela
iively reliable. hut data 01) services aie noi Service transaclions such as sales of tinancial
advice and computer pmgramming assistance may escape deteclion. Accurate measurement
of international interest and dividend receipts is paiticularly difliculi.
.

Official Reserve Transactions

Although there are many types o linancial account transactions, one type is bmportant
enough tu merit separate discussion. This type uI transactior Is the purchase or sale ot
ol licial reserve assets hy central banks.
All economys central bank Is the instilutbon iesponsihle for managing the suppiy of
l
money. In the United Staies, the central bank is the Federal Reserve System. Officia
t
agains
n
cushio
as
a
banks
central
by
held
interiiational reseres are loreign assets
bui
goki,
of
tcd
largely
consis
s
national economie mislortune. Ai one time, otticial reserve
larly U.S.
today, central banks reserves include suhstantiai foreign flnancial assets. particu
levei of
smali
a
only
doJlar assets such as Treasury bills. The Federal Reserve itself hoids
Coli
not
olficial reserve assets other than gold; iis own holdings ol U.S. dollar assets are
sidered internationai reserves.
s
affect
Central banks often buy or sei] internationai reserves n private assei niarket io
called
are
type
this
tions
of
transac
Official
ies.
macroeconomic conditions in their econom
ntion
official foreigii exchange iiitervention. One reason why Ioreign exchange interve
money
io
inject
bank
ccntral
the
for
can alter niacroeconomic conditions is tiiat it is a way
much more Lo say later
mio the economy or withdraw li from circulation. We wi li have
ntion,
about the causes and consequences of foreign exchange interve
reserves and intervene
foreign
hold
niay
hanks
centrai
[hall
other
es
agenci
nient
Govern
Exchange
oflicially in exchange markets. The U.S. Treasury. lor exaniple. operates an
that at times has played an acilve mie in market trading. Because the

Stabilization Fund
supply. how
operations of such agencies usualiy have no noticeable impaci on the money
as if the
ding)
misiea
too
noi
is
it
(when
ng
ever. ve will simplify our discussion by speaki
nes.
centrai bank alone holds foreign reserves and interve
s in its
When a centrai bank purchases or sclls a foreign asset, the transaclion appear
private
a
by
out
carried
counlrys i nancial accountjust as if the same transaction had been
s
doliar
acquire
ciiizen. A transaction in which the centrai hank ofiapan (the Bank of Japan)
and
assets might occur as foiiows: A U.S. auto dealer imports a Nissan sedan from Japan
the money
pays the auto company with a check for 520.000. Nissan does noi want lo imest
Japanese
Nissan
give
io
willing
is
Japan
of
Bank
the
in doilar assets, bui iL so happens that
rise
reseres
tional
interna
s
Japan
of
Bank
The
money in exchange tor the $20.000 check.
of
pari
s
are
reserve
doliar
s
Japan
of
by 520,000 as a resuit of the deal. Because the Bank
tion
transac
This
0.
$20,00
total Japanese assets held in the United States, the latter rise by
of the
therefore resuits in a $20.000 credii in the U.S. financial account, the other side
10
$20.000 debit in the U.S. current account due to the import of the car.
tions involving the
transac
reserve
official
of
on
directi
and
size
the
Table 13-2 shows
s heid by
United States in 2009. U.S. oflciai reserve assetsthat Is. internationa] reserve
billion
sed
$450.0
purcha
banks
central
n
.
Foreig
billion
the Federal Reserve--rose by $52.3
toreign
e
in
increas
the
less
s
i
reserve
olficia
U.S.
e
to add to their reserves. The nei increas in
the same Se(UenCc of actions causes a S20.000
test vour undertandini see f VOU can expiain why

T
0
in 115 net tinanciai floss.
inciease
a
and
S20,000
account
currelit
in
Jap.ins
iiiprcn emcnt

C HAPTL R

1 3

NaIion.,I

Iliconie

IcCflLII1Liflg

and the IJI.i!iCC

Of

Panicnts

31 3

the L.Jnited SLites is the level o nel central hank financial fiows.
which sinod ai $52.3
$15ft() hii lion = $397.7 billion in 2009.
Y0LI can think ol tliis
$397.7 billiun nei central hank linancial llow as measuring the
degree (o which Ilmnetary aiithorities in the United Statcs and ahioad joined with other
leiiders tu cover the U.S. cuiient account deficit. In the exampic above. the Bank of Japan.
1w acquiring a $20.000 li .S. hank deposil indirectiy finances an American import of a
$20,00() Japanese car. The levei of nel central hank linanciai lows Is called the official
sefllements balance or (in iess frmal usage) the balance of payrnents. This balanee is
the siim of the currcnt account and capital account balances, iess the nonreserve portion of
the hnanciai account baiance. and il indicaies the payments gap that olhcial reserve trans
actions need to cover. Thus the U.S. balance of payments in 2009 was $397.7 billion.
The balance ol Iayments played an important historical role as a ireasure of diseqiiilih
niim in international payments. and for many countries it stili plays this role. A negative
balance of paymcnts (a deficit) may signai a crisis, for it means that a country is running
down its internationai reserve as.sets or incurring dehis to forcign monetary authorities. lf a
country faces the risk ot being suddenly cut off from foreign ioans, it wiI] want to rnainain
a war chest of internationai reservcs as a precaution. Deveioping countrie.s, in particular,
are in this position (sec Chapler 22).
Like any summary measure, however, the baiance of paymenls must be interprcted with
caution. Tu return to our running example. the Bank ol Japans decision to expand its U.S.
bank deposit hoidings by $20.000 swells the measured U.S. baiaice of payments deficit by
the same amount Suppose the Bank of Japan instead places its $20.000 with Barclays
Bank in London. which in turn deposils the money with Citibank in New York. The United
States incurs aii extra $20.000 in liahilities to prilate Foreigners in this case. and the U.S.
baiance of payments deficit does not rise. But this irnprovement in the baiance of pay
ments is of utIle economic importance: lt rnakes no real diIerence lo the United States
whether it horrows the Bank of Japans money directly or through a London hank.
()IIICIaI reserve elaims m

Case Study
The Assets and Liabilities of the Worlds Biggest Debtor
We saw earlierthat the current account balance measures the flow of new net claims on
treign veaith ihat a counuy auuuircs hy exporting more goods and services than it im
ports. Ihis flow is not, lioweser. the only important factor that causes a countrys net
fea
th to change. In addition, changes in the market price of wealth previously
acquired can alter a countrys net foreign wealth. When Japans stock market Iost titree
quarters of its va]ue over the 1 990s, for example, American and Luropean owners of
Japanese shares saw the value of their claims on Japan plummel, and Japans nel
foreign wealth increased as a result. Exchange rate changes have a similar effect. When
the dollar depreciates against foreign currencies, for exantple, foreigners who hold do!
lar assets see their wealth fali when measured in their home currencies.
The Bureau of Economie Analysis (BEA) of the U.S. Departrnent of Commerce,
which oversees the vast job of data collection behind the U.S. national income and bal
ance of payments statistics, reports annual estimates of the net international investment
position of the United Statesthe countrys foreign assets less its foreign liabilities.
Because asset price and exchange rate changes alter the dollar values of foreign assets
and Iiabilities alike, the BEA must adjust the values of existing claims to reflect such
capita! gains and Iosses in order Lo estimate U.S. net foreign wealth. These estimates

3 14

PART TH PE E

Exc1ianic Ratcs and Open-Ikonomv Macroeconornics

show th t the end ol 2OO). the t niied St.tlcs hB_l a iIcatn neL loreigi eaILh poStH)n
I i r g reat e i ha n that il a ny oi her eou n i iv.
UnLII I9)I, toreien di i iflVeti1ici1tS nch aS toreigii laCtL)rieS owned hy I_IS. COi1)OflL
Liois vcie a1tied al their histoiical. Ihat
oiieiiiai, iurc1itse prwes. Now the I3EA uses
two rliflereiit Ireth(xis lo plaee curient valiies on torcien direct inwstments: the (Ifrr(nt (o,t
niethoil. whieh alues (biLel investincnts ti ihe CUSI of buying them iodav. and the iiiarkd
ai \\ liteli the III\ Lstmenis eotild he sold.
ta/tu method, vhich i nei to measure the
litese methocis ean Iead tu diflereni valuations because. the cost ol re)acing a partidul.ir
direct iivestment aud i lie price il would cuinmand if uId on the mai ket mav be hard to
Ineasure. (Ihe net hweien wealth data eiaphed in Figure 132 ai current eust estimates.
Table I 33 reprnditces the B[iAs account ol how it imide iK valuation adjustmcins
Lo fnd the U.S. net loreign position al the end of 2OO). This headline estimate values
TABLE 13-3

International Investment Position of the iJnited States at Year End,

2008 and 2009 (millions of dollars)

LN$IIOU (.4)
,WdIL.

4d bmeIv.w

i qtHIII,m bMI

.4 .,,-

W4

r.d b.g.. ..

1l4

b 44

I44

k .44J,l r

...* ..
b44.4

p.e 149

md ti.. WIC alta..

be w.4Ia, sJ.44tell 441 I..X. 4...apa W P?*4&* (*
lifri..4
pta4a
a,., aai 41a ,d.a
aa. h
fra
a. ,,
4 s414
fl1O
n Cc,,*fl (arI, , tay t cr ,nn 4 5 . a
41 at. fl,Vfl hett. P41 La 441 t Mt
4 CMl Lt ,.sw,ltj ns1b. 44 P.Ia.
SLMfll

Attui

4d4RLt 15 r..y .t
I
ldI apIIWLdI t44q4 ta.a t4111 pLttULt I* i_dU..IL. SI
aSI IdOt frL
.aa.aa 41 a*paM AmwaA*qIIIc.a4.Ama acLdmap.d

i.i. frtia, Dat Iditil lat .ata.b a,mabbIoIDIUS

at, 141
I
4441i. SAmDI di
.
I 4IAmAm WdIbDtSI IS la tata. a.y cartae I t
yI,afr.Am
Latia 01 41IIDi.
4aay. ctIa.5 41414

I flUSI b.q

I4141y.d.ILtDIALI oa

a.Ii.i.S

Sc.q

1 I lalI

ttttd laot aa. I aii.q

dttto Stat ad
b54 ISa.. i.,d, .41 aoAdmrtpIII
*taD; 414154141
4
414 a.D 4141441
a..,.., o eLtal. tt
1,,,.,, taifle va., De .41.41441) arn Fan SAD 0 *41 41 *4450,
411.41.41410 ,flm.a.o,4i.1
k410 ,,*t,,
444*410 L,.4114141 (Vt tali 51
O (ELda tI
USAtI 41 45(0104 411(41.11 .aqn 041 lSOA

SI... fl

Sonrce: U.S. Departmen o Conirnerce. Burean of Economie Anatvsis. S,uin o/

Curreni

Buvintcs. July 2010.

HAPTE P 1 3

Natioii.iI Iflcoflic iCCOLiiitiflL ..iII(1

the

BJkuIICC Of

1iyiiicnts

315

direci incstnky)ts a! current cosi. SiarlinL: wiih its csiinate o 2()08 ud !orctn
weaiti
$34.)3.9 billion ai curieni cosO. the 131A (eoliim u) added
n
the aflu)unt of the 2009
i.J.S. neI financial flow o!
$216 bilhontecall the figure repoited iii flible IS 2.
Then the REA adjustcd the vaiues ot pre\1ously heid assets and Iiahilities for
variuus
changes in thcir dollar prices (columns b, e, and (i i. As a result of these
valuation
ehanges, U.S. nel toreign weaith teli hy an am unt inuch smailer than the
$2 16 billion
in ness nei borrowing fiom foreigners in taci. li .S. nel h)reign eaIih actuai
y rose, as
shown in Figure 132! Based oti the curreni cost rnethod br valuing direct
investments.
the BEAs 2009 estimate of U.S. neL foreign wealth was
737 billion.
,
2
b
8
.
This debt is larger than the total fregn debt owed by all the Centrai and
Easterii
Furopean uountries, whieh was about $1.101) hillion in 2009. To put these fgures
in per
spective, however, it is importani io realize that the U.S. nei [oreign debt amoun
ied tu just
under 20 percenl of its GDP. while the foreign liahility of I-Iungarv. Poland.
Romania, ami
the other Centrai and Easterui European dehtors was neariy 70 percent o! their
col lecti e
GDP! liitis, the U.S. exiernal tlehi represenls a nudi lower doniestic mcorne dratii.
Changes in exchange rates anci secunties priccs have the potential to change the
U.S.
net boreign debi sharply. howeer. because the tv.s toieign aseIs
and 1iahiliiie o! the
L.Jnited Sriws have hecoiue su) lirge in receni veai. Figure I 33 illusirates this tuleul
di
le
trend. In l)76. U.S. foreign assets stood ai only 25 pereent o! (IS. (1)P
and iiahilities
ai 16 percent (making the Unuted States a net torcign creditor in the anionni o! roughl
v
rercnt ot its (ii)P). In 2009. however. he countr s fiein ;uu amuuinied tu 129
perceni o! (i)P ami i iiahililics tu I 4 perceni. Flie iiemenduus
growth iii i1uee

Assets, iuabiiities
(ratio fo GDP)
1.6

1.4
1.2
i

::
:;

Gross foreign iiabiities

//

GrosS foreign assets

-

1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000
2002 2004 2006 2008
Figure 13-3

U.S. Gross Foreign Assets and I iahililie%, 19762009

Since 1976, both the foreign assets and the Iiabilities of the United States have iricreased sharply.
Bui !iabihties
have risen more quickly, Ieaving the United States with a substantial net foreign deht.
Sowce: U.S. Department of Commerce, Bureau of Economic Anatysis, June 2010.

316

PART E [IREE

IxcIiangc IZaLcs aiid Opcn-fconomy M:roconomics

s ol itllI i leet. the ripid glk)hali/atiOii ul iii tnciil in;iikcts in the Irne 201h
sto
k
1
I
ceiitur. a phen(inhen()n se s iii isuus $uither in (1
of ih n,ie,iittide anplily the e11eet ol exeJidngc
Ihiuk tI)uLLt ho iea1th 1
L.S loicien issets are denoininated j
rate cianies, 11owe\LLr. Sui mse thai 70 rercIt ol
taICd in dollars
forcigo curi lcies. bui. Ilial iii US. iiabililics tu hueiiners are (II)iiil
w-.
aiuurid 14.4
(I)P
L
2009
.S.
eaiise
I
r
niinihe
correci
).
(thcsc are proimiteI the
ed but
unchan
hi)ities
li
U.S.
leave
souIcI
dullar
the
trilliun. a 1(1 percent depreciation ol
1.21.)
ol
percent
9.()
=
X
X
0.7
0.
)
hy
woiild inerease US. assets (ineasu,ed in doliars
t
curren
the
U.S.
times
v
3.5
inatel
GDP. or abotii S 1.3 trillion. This miinher Is approx
stock
and
r;ite.
ee
icnts in exelan
account deficit ol 2009! liideed. due tu sharp muven
way hets ecu 2007 and 2008 ancl
this
in
hillion
IO
$8(
iibout
y
lost
econom
the
(iS.
plices,
Ihe correspon
zained a compaithIe amount hctween 2{)0 aiid 2009 (sec Figure I 32).
been
din redistribution of wealth between lc eiuner and the United Stales would have
mueh smaller haek i a 1976.
ies eurrent
I)nes this pussihilitv inean that polic iLiIa_l .hOUI(I Igru ae their countr
ps ol nei
huildu
large
prevent
Io
values
cy
accountsand insiead try tu inanipulate curren
chap
nc\i
the
sec
in
e.
sull
we
heeaus
as
liewn deht2 I Iii s ould be a periluus strategv
hehavior.
panI
pwtici
tei. expectaflons ui tuture esehange is are central to market
h exuhange
Syslemaic governrnent Luca pt tu reduce lurcign investors wcalth throug
tlius
cv
rate changes s oiild sharplv reduce I ieiiei deiuand br domestie curren assets.
\.
deereasing or eiiminating any wealth henLIIt tioin depteeatin the huine ctirrciK
.

SUMMARY
1. International

macroeco,io;ucs

is concerned with the fuil employment of scarce eco

e they
nomie resources and price level stability throughoui the world economy. Becaus
national
reflect nationai expenditure patterns and their international repercussions, the
g
studyin
for
al
tools
essenti
are
ts
accoun
nenls
e
inconie acoimts and the ba/onc o[pavi
nies.
econor
the macroeconomics of open. i nterdependent
factors of
2. A countrys gros na!ionalprocluct(GNP) is equal to the income received by its
types of
the
ing
Lo
accord
produclion. The national income accounts divide national inconie
curreni
the
ves.
and
spending that generate it: consnlnpfion, invevln:e,it, governlnent jnnrha
of
iess net receipts factor
account balaiwe. G;vss doniesiic produci (GDP). equal to GNP
ten-itoria! borders.
income lom abroad, ireasures the output produced within a countrys
invested. or pur
ed,
consum
be
must
GNP
trade.
tional
3. In an economy closed lo interna
equipment, and
plant.
build
to
t
output
curren
chased by the government. By uslng
. For a closed
output
future
into
output
t
inventories. investment transforms presen
of the saving
sum
the
so
ate.
aggreg
economy, investment is the only way to save in the
ent.
investm
equal
,
must
carried out hy the private and public sectors. mitional saving
ment
govern
ent,
4. In an open economy, GNP equals the sum of consumption. investm
ed if
balanc
be
purchases. and netexports of goods and services. Trade does not hase to
The difference
the economy can borrow from and Iend to the rest of the sorld.
e, equals the
hetween the economys exports and imports. the current account balanc
s.
service
and
goods
of
use
total
its
and
output
ys
difference hetween the econom
closed
a
Unlike
ers.
foreign
to
lending
net
ys
5. The current account also equals the countr
al
Nation
ent.
investm
foreign
and
tic
economy. an open economy can save by domes
e.
t
balanc
t
accoun
saving therefoie equals dornestic investment pius the curren

CH APTE P

1 3

Mational Incornc iccounting and (1w IkiIance of Piymcnts

317

6. Iialarice of payments accotints provide a detailed pieture of the cnmpoxiiion ami

finaneing
o! the colTelli acconni. All transactions heiween a country and the
resi o! the world are
recorded in the counirys balance of paynents accounts. The accounts are hased oii
the
conventon that any transaction resuliing in a payment io k)relgners is entered
as a debii
while any Iransaclion resulting in a receipi from foreigners is entered as a credii.
7. Transactions inolvmg goods and services pear in the Curreni account of the balanc
e o!
paymenis. while iniernational sales or purchases of (Iss(ts appear in the fi,anc
iul
(uconhIl. The capita? oceano! records mainiy nonma
rket assei transier.s and iends lo be
smali for the United States. The sum of the curreni and capital account balanc
es musi
equal the firtancial account balance (net lnancial flows). This feature of the acCOtifltS
relects the fact that discrepancies between export earnings and i mport expenditures
musi
he matched by a promise lo repay the difference. usually with interesi, in the future.
8. international asset transactions camed out by central banlev are included in the financial
account. Any central bank transaction in private markets ftr foreign currency assets is
called offuial foreit,n Lxch(nlgc inIcneflhion. One reason intervention is import
ani is ihat
central banks use it as a way io change the amouni of money in circuia
tion. A country has
a deficit in its balance o! pavlnehlts when it is running down its 0/77(10/
inte7iaiona/
reveroes or horrowing from foreign central banks, il has a surpius in the opposi
te case.

KEYTERMS
asset, p. 306
batanee ol payments
accounling, p. 294
capital accoun(, p. 307
eentrat hank. p. 312
consumption. p. 298
curreni accouno batance. p. 300
(inancial accnunt. p. 306
government hudget deficit. p. 304
goveiiiment purchases p. 299

PROBLEMS

gross doinestic prndtici

(GDP), p. 297
gross national produci
(GNP). p. 295
nvesment. p 29$
macroeconomies, p. 293
rncroeconomics p. 293
nationat income. p. 291)
nationat income accounting.
p. 294

nalional saving, p. 302

ofticiat foreign exchange
inter ention. p. 312
offeiat internationat reser cs
p. 3 t 2
olficiat setrlements balance
(or batance o! paYnie1(s).
3 13
.
private saving, p .303

uujeconIab
1. We stated in this chapter ilmt GNP accounts avoid double counting by inciuding only
the value of fino! goods and services sold on the market. Should the measure of im
ports used in the GNP accounts thcrefrc be defined io include only imports of final
goods and services from ahroad? What about exports?
2. Equation (13-2) tells us ihat io reduce a current account deficit, a countrv musi increas
e
its private saving, reduce domestic investmeni, or cui its governrnent budget deficit.
Nowadays, some peopie recomrnend restrictions on omports from China (and other coun
ines) io reduce the American current account deficit. How would higher U.S. barriers to
irnports affect its private saving, domestic inveslment and governnent deficit? Do you
agree that impori restrictions would necessarily reduce a U.S. current accounr deficit?
3. Explain how each of the following transactions generates two entriesa credit and a
debiiin the American balance of payments accounts, and describe how each entry
would be classiticd:
a. An Arnerican buys a share of German stock, paying by writing a check on un
account with a Swiss bank.
b. An Arnerican buys a share of German stock. paying the seller with a check on an
American bank.

31$

PART THP EE

IxcIianc IZitcs aiitl

()p&zn-Econoiii 11acrocconoinics

e. The Korean government carries out an otheial ioreign exehange intervention iii which
it uses ( Iais held iii an American bank io hiiy Korean curency troni its eitizens.
,
d. A tounst troni Detron huys a meal at ati expensive restaurani In Lyons. France
JflL! with a travelers check.
n
e. A California winemaker conlributes a case of cahernet sauvignon br a Londo
wine tasting.

I. A U.S.owned fuctory in Britain uses local earnings to buy additional machinery.

4. A New Yorker travels io New Jersey lo huy a $100 ielcphone answering machine. The
its
New Jersey company that sells the machine then cleposits the $100 check in
01
e
balanc
the
in
up
acconni ai a New York hank. How would these transactions show
cash
pays
Yorker
paymcnts accounts of New York and New .Iersey? What if the New
bz the mach me?
nonreserve
5. The nation of Pecunia had a curreni account deficit of $1 billion and a
2008.
in
million
hnancial account surplus of $500
ed to the
a. What was the balance o( payments of Pecunia in that year? What happen
countrys net k)rcign assets?
How did
b. Assume that foreign central banks neither huy nor selI Pecunian assets.
this ofli
would
How
the Pecunian central banks foreign reserves change in 2008?
a?
Pecuni
cial intervention show up in the balance of Iiayments accounts of
banks had
e. I-low would your answer to (h) change il you learned that foreign central
l pur
purchased $600 million of Pecunian asseis in 2008? How would these officia
ts!
accoun
nts
payme
e
of
chases enter foreign balanc
ption
d. Draw up the Pecunian halance of payments accounls for 2008 under the assum
year.
in
that
that the event described in (c) occurred
Jarge cuzTent
6. Caii you thirzk of reasons why a eovernment niight be concenied ahout a
its o0cial
about
ned
account deficit or surplus? Why rnight a government be concer
settlcments balance (thai is. ils balance of paymentsY?
the extent
7. Do data on the U.S. official settlements balance give an accurate picture of
io which foreign central banks buy and seli dollars in currency markets?
time il has a
8. Is it possible tor a country to bave a current account deficit at the same
tigures
etical
hypoth
using
,
answer
your
n
nts?
Exptai
surplus in its balance of payme
le
the
possib
s
discus
to
sure
ts.
Be
accoun
al
foi the curreni and nonreserve tinanci
implications for official international reserve flows.
se that the V.S. net foreign deht is 25 prcent of U.S. GDP and that foreign
Suppo
9.
be the
sets and liabiiities alike pay an interest rate of 5 percent per year. What would
Do
deht?
dram on U.S. GDP (as a percentage) from paying interest on the net foreign
t
percen of
you think this is a large number? What if the net foreien debt vere 100
e worried
GDP? At what point do you think a countrys government should becom
ahout the size of its foreign debt
Surie ofCuriciil
10. If you go to the BEA website (htip://www.bea.gov) and look at the
you vi11 find
ctions.
Transa
tional
Busimss for July 2010. the table ozi U.S. Jnterna
(line 131,
billion
were
$585.2
that in 2009, U.S. income receipts ozi its foreign assets
(line 30).
biilion
while the countrys payments on liahilities to foreigners were $456.0
foreign
io
Yet we saw in this chapter that the United States Is a substantial nei debtor
asset incorne
ers. How. then. is il possible that the United States received more foreign
than it paid out?
a 10 percent dollar
il. Return to the example in this chapters linal Case Study of how
of the effecton
size
the
Show
316).
(page
depreciation affects U.S. nel foreign wealth
GDP).
t
of
U.S.
percen
(as
a
foreigncrs nei forcign wealth rneasured iii dollars
nei foreign
ys
countr
a
on
12. We mentioned in the chapter that capital gains and losses
t. I-low
t
accoun
curren
assets are noi included in the nationa] incoine measure o] the

CII

A PT E F

I 3

National I neorne iccounhing and the Balance of Payincrits

3 19

woukl economie si sliciafls havc to modity the national ineone identity

( 3I) if they
wish to include such gains and losses as pu1 of the detinition of the current account?
In
yuur opinion, would ihis makc scuse? Why do you think this is bL done in praclice?
13. Using the data in the Memoranda Lo Table 133. calculate the U.S. 2009 neL interna
tioial investment position wiih direct investments vaued ai market prices.

FURTHER READINGS
IZui-opean Comiu ission, I nteriiational Monetary Fu id, Organisation fir Economie Cooperatio
n and
Development. Llnited Nations, and World Bank System a/ National Accomu,ts 2005.
New York:
Uni ted Nai ions. 2009. De li n ti ve guidel nes 6w constructing national i nconie and product
accounts.

Williani Grievei, Gary Lee. and Francis Warnock. The U.S. System [or Measuring CrossBord
er
Investmcnt in Sccurities: A Primer vitIi a DJSCLISSIOn of Reccnt Devclopmen
is. Fedemi Rcscne
liulkiin 87 (Ocloher 2001 pp. 633650. Critica! description ol U.S. procedures
[or nieasurmg
loreign assets and Iiabilities.
I ntcrnationai Moneiary Fund. I3alance o/ Paimenis mmid IntermiatIonal Inie.si,nent Posnion Manna!,
fiih edition. Washington. D.C.: tnternationa! Monctary Fund. 2009. Authoritative trealmeni
o[
balance (il paynleniS accounti ng.
International Monctary Fund. Funi! RtpO,1 a/the lVorking Part on the Statistica!
i)iscrepancv in
,Vorld Curremii .4ccoiimii l3olomu es. Washington. D.C.: Iniernational Monctary Fund.
September
1987. Discusses the statistical discrepancy in the world current account balance. its iniplications
br po!icy analysis, and reeornmendations 6w more accurate mCasUrement.
Philip R. Lane and Gian Maria Milesi-Ferretti. The Exiernal Wealth o[ Nations
Mark Il: Revised
and Extended Estiniates of Foreign Assets and Liabilities, 19702004. .loimrnal oflnternation
al
Lco,,omu-,v 73 (Noveniber 2007), pp. 223250. Applies a common methodology to conslruct
inlernational position data [or a large sample of countrics.
Robcrt E. Lipsy. Changing Paitcrns of Iniernational 1nesimeni in and by the Uniied
Siates, in
Martin S. Feldstein, ed. The Uniie/ S!aics in the World Economv. Chicago:
Uniersity of
Chicago Press. 1988. pp. 475545. Flisiorical perspective on financial flows to and
from the
Uniied Siaics.
Catherine L. Mann. Pcrspeciives on the U.S. CUiTent Account Deficit and Sustainability.
Journol
of Econo,nic- Pervpcciimev 16 (Summer 2002). pp. 131152. Examines the causcs and
conse
(]UCICCS of recent U.S. current accouni deficits.
James E. Meade. The Bobine of Pavmnenis, Chapteis 13. London: Oxford Universitv Press. 1952.
A classic analytical discussion ol balancc ol payments concepts.
Cdric Tulle. The Impact of Exchange Rate Movemcnts on U.S. Foreign Dcbt. Curreni
Issues in
Economics and Finance (Federal Rescrve Bank of New York) 9 (January 2003),
pp. 17.
Discusses the iniplications of asset price changes for U.S. foreign asscls and liabilities.

ueconIab

MYECONLAB CAN HELP YOU GET A BE11ER GRADE

Il your exam were tomorrow, would you be ready? For each chapter,
MyEconLah Practice Tests and Study Plans pinpoint which sections you have
mastered and which ones you need to study. That way, you are more efficient
with your study time, and you are better prepared for your exams.
To see how it works, turn to page 9 and then go to
www.myeconlab.com/krugman

C H A P T E R

r
:
I
;
:
A:
j

Exchange Rates and the

Foreign Exchange Market:
An Asset Approach
n the first years of the millenni um, Americans flocked lo Paris to enjoy French
cuisine while shopping for ciesigner clothing and other specialties. When
measurcd in terms of dollars, prices in France werc so much lower than they
of an
had been a few years hefore that a shoppers savings could offset the cost
airpiane ticket from New York or Chicago. Five years latei; however, the prices of
French goods again Iooked high to Americans. What econornic forces made the
dollar prices of French goods swing so widety? One rnajor factor was a sharp fali
in the dollar price of Frances currency after 1998, followecl by an equally sharp
rise starting in 2002.
At
The price of one currency in terrns of another is called an exchange rate.
.3018
1
4 ia. Lonclon time on November 30, 2010, you would bave needed
s
dollars to buy one unit of the European currency, the euro, so the dollar
exchange rate against the euro was $1 .3018 per euro. Because of their strong
ge
influence oii the current account and other rnacroeconomic variables, exchan
rates are arnong the most importani pr;ces in an open econorny.
Because an exchange rate, the price of one countrys money in terms of an
others, is also an asset price, the principles governing the behavior of other asset
from
prices also govern the behavior of exchange rates. As you will recall
, a
wealth
Chapter 13, the defining characteristic of an asset is that it is a forni of
price
way of transferring purchasing power from the present into the future. The
sing
that an asset commands today is therefore directfy re)ated to the purcha
future.
the
in
power over goods ancl services that buyers expect it to yie!d
a
Similarly, toclays do!lar/euro exchange rate is close!y tied to peoples expect
rises im
tions about the future leve! of that rate. Just as the price of Google stock
ge
exchan
do
so
rnediately upon favorable news about Googles future prospects,
.
rates respond irnrnediately to any news concerning future currency values
rates in
Our genera! goals in this chapter are to undersiand the role of exchange
ined. To be
international irade and lo understand how exchange rates are determ
us to compare the prices of differeni
gin, we first learn how exchange rates allow

320

CH APTE P

ExcIizintc Rates .iiitl the Ioieiii l:xchinge 1arkc: An Asset 1

iAp
oach

counlries goods

afl(l

32 1

Next We dcscnhe the intemationa asset market in

whuh cnrrencies ie tmded md Show how equitibriurn exchange rates are deler
mined in that market. A final seclion underiines oLir asset rnarkei approach by
ShoWiflg hOW Iodys exchange iite IeSpondS to changes in the expected future
VaIUOS of eXchal1ie rales.

SeEV1UeS.

LEARNLNGGOAL
After reading ilis chap[ei you wil I be ahle lo:
Relale exhangc rate
IngeS lo chan4es in the relative prices of countnes
expurts.
Des;rihe the slructure and functions of the foreign exchange rnarket.
Use exchange Mles lo calcLIIale and compare reiurns on assels clenominaled
i i di fferen I currencies.

Apply the interest parily condition Io (md equilibriurn exchange rales.

Find the effects of interest rates and expectation shifts on exchange rates.

Exchange Rates and International Transactions

Exchange ralcs play a cential role in international trade because they allow us to compare
the prices of goods and services produced in different countries. A consumer deciding
which of two American cars lo buy must compare their dollar prices. for example,
$44,000 (lor a Lincoln Continenial) or S22,000 (for a Ford Taurus). But how is the same
consumer to compare either of tliese prices with the 2,500,000 Japanese yen (Y2,500,000)
il costs lo huy a Nissan from Japan? To make this comparison. he or she musI know the
relative price of dollars and yen.
The relative prices of currencies are reported daily in newspapers financial sections.
Table 14-1 shows the dollar exchange rates for currencies traded in London ai 4 RM. on
November 30, 2010. as reported in the Financial Times. An exchange rate can be quoted in
two ways: as the price of the foreign currency in terms ofdollars (for example. $0.01 194
per yen) or as the price of dollars in terms of the foreign currency (for exarnple. 83.77 per
dollar). The frst of these exchange rate quotations (dollars per foreign currency unii) is
said lo be in direct (or American) terms, the second (foreign currency units per dollar) in
indinct (or European) terms.
Households and firms use exchange rates Lo transiate foreign prices mio domestic cur
rency terms. Once the moiey prices of domestic goods and imports have been expressed
in terms of the same currency, households and tirrns can compute the relative prices that
affect internalional trade flows.

Domestic and Foreign Prices

If we know the exchange rate between two countries currencies, we can compute the
price of one country s exports in terrns of the other countiys money. For example, how
many dollars wotild it cost to buy an Edinhurgh \Voolen Mili sweater uosting 50 British
pounds (50)? The answer is found by multiplying the price of the sweater in pounds, 50.
by the price of a pound in terms of dollarsthe dol]ars exchange rate against the pound.
At an exchangc rate of $1.50 per pound (expressed in American terms). the dolhu price of
the sweater is
(150$tC) X (f50)

$75.

322

Exchange Rntcs 1incl ()pcii-Economy Microcconoiuics

PART TH REE

Exchange Rate Quotations

TABLE 14-1

wWw.fLco8n/cwt.ncydta

CURRENCY R3TLS
(1)90

0.LA11
CL.--,
4,43,)
(P.r)
(09

A)74i7fl.4

A,,, ),I.,
6,033,

(8?

6..,
4Oa i

(340)
lli)
01-8)

12)7,03
o 0o)

CLaR,ca
Czect, P,-p

(6)13,,,

Irvp)

(OK-)
()4v1. 1
(4367)

I4,)4 Oirng

([0,83)
(33)03,404

(;0,0)

3)1.,))
(2,3,43

C)

1.3,1,
I1 .4331,3
0

l7ft MolO
0,33*1,
4Ch1Ir4)

3,3,4)3

(413)
(NwP33oo4

73r,,cp,Sind
0,0.0,

11rw,r)
Pk,3).
4
P3,
P6)hpp,,,,

(513:
(7433.3)
(SOr)

.6).))
I 04.7
o /n
701(03
0))
112,L
4, 7 70
664370
(929120
507 690
3

8.34

?8(3
I. 0:))
71,,)
2(43.1,0
4, 3,1,1
14471
114910
,,N0
61)700
12).,,)
3,4 f.3)
I) ((/3)
6,3101
0,0.143
I)
I: 4149
1 131,

1)0533
I
I- 2 -0
-

3444,4544)
(04*)

441202

90714
00Do
-

ooqo

00079
043 31)
0003,4
(7 I00
.3404
0 1141
00297
000.1,
00)43)
0997,
)) 74)0
00,40
190000

C00r
Mo
Il.
I 99)3
04906
9)11:
-,

.3,

3.,?,
1,4 3
0673),
1,1
.4,2) 083
4 928
74-33
11,??
,

1)3)03
1
09 7300
(7690
30000 I,-l
4 lO,).
-00027
04(03 :09646
000?. 106 00)
-0012. 1011 133,,
034051
0043,,
020120
0),)
1)6:,
0000?
41211
001,:)
-0064. 161434
(7498
00007,
31,9,,
0)140)
8004))
-000)4
1)2)1
00)07)
3,11,,
08)3,,
-1) 102)3 1,7 73)01

0.340

001480
1144)
Clo,l
44,)

C-r.))

003)90
C1o:,n
44.4
Cio,*

,oji,,

C024C)

0)33394

007)7
12
-007431
I0?9
o 0(214
000)1
000)7
00076 0 141.
00)0)
80.11, 8317?
-00)1)
00241
(10(70
000
710-.)
2 84.:) I.) 44?
00)61,
00435 103679
:13,3 1110-412 21)1,4,,
4 10,63,
4., /(0 3.,,
0413,
0 443) 18,417
007120
00(1(4 3,31125
00)00
131(11,), 40)7)
07.2)
7) 7189
00))
33) I
00,412
111)5
I (-1,04 4/-ol
01!).
-0 33)90 . I 4, 0
,84.?7 1471,)) 0,6 .42
7)46 1)2011 49 1020
1124
od)),
0013,
2 07) lO 4. -090/I
0000, 1)0 3--) -00001
0009), 14)),), -00116
0044) 1,-) 1.) 00151
o 044,9
08319 127, 8131
01)0)).
I 0018 04409
0031,
-000.) 49179
01908 1941,9 00)2).
.31,4
003 .0
03(01
01)1)
09)73, 774 9k,,
00,4.
704). 13,111
07789
012)3 21) 12)3
00727
1)0)15 44(/(1
000123
-0,406 1205)90

)\3,n$

097,
(03
i: 0)1
4,35
132(9
70)21
115940
40126
0991,7
7043?.
4) 300
2 4)/)
,074
31,030
ln74
5,70
943,
(-37
7 )),,,S
700000

(?),ly)

00,,),,,,

47w
3
(

)4.,,,114)
(Lj
.,,oOArl,l
(12)
1))
,0,I, 4)30.3
))9,o)
00(33:,
(76,,
:,*,oo
(O,
1)wll
(III
(6))
(0,4,744
141,343
(00(34
r,,,k,
((ao)
034
(04,))
06(03,42w
10)
03o 2,14),
lhr Mo,),
((0,4,
(4,43333))))
0\,,
(P374)
1h3),-.14
019
(5)
3),, Monlh
I),,,,) 7*)),

))uo,,,

080 643(1 ((4

.*lr.(ir-

0,10)0 0642)
Oro (.440(0

4794)
(94-3)3

(0 0)

([o,)

3,44,))),

0,,
5,00

--

03)
C)or,;,

40171
-003,7,)
0031,
4 404,
.003)7
00)1,,
(321)4
1)7033 42007)
4111,
0025)
0000)
(7.09
0 0-101
-0000)
71.4
00,,?
-0 1,
79,77
70)2)3 11,),),,
01249,
4(439
0001,,
007.143
00)391)
I 27.
-014:0
00.h4 1)4.40),
003(4,) 1) 2)) -0 (1).
415)4 -0001.
11 (012)
(4),) -00(2)
-000).)
4)41)
00250
00001
1)00129
011,)
00441
08)59
0000))
0 0070
01)).,)
00001
(1)Q3,,
00804
0431,0
00,),),
-00075 (0 ./(3
014(0
2).) 3,0
007)
1)2)14
120000
I 01)00801
I -011
00011
00
00)0?
.10,,
15000 253828 -(3 (0)

1 (1)
13016
I .30(3
13007

00071
00000
03001
0(7011

3)1,74

00004

P0060

7090
CI... .7,
4.4.,)

0852)

80047

1)39.

03301

434.3
48030,

3,1430
0..)
17484
,-053b
(04.?
(8-3-,,:

4)

(lo,,

3
42.7)10
4111-7.)
7? 1
7 (4?),
5)701
,,,

1)4!!)
003/,
1) 80,
027)1)
0 304
1)21,.)
1. 4.-
1)0)1)
00003
02169
01013
00(4,
0004),
00)54

7.731.
.1 (.1,)
(55)4
--(4
1 2.
15537
2.-
30,63,3

00)!,
0)41,1
00043
001,)lJ
000(1)
0201212
0)13,,
(9.2142

:19124
1 2997
I 9(1
11950

131,98

I (72(34,

0002)
1210005
-

000)4

(0879 Fu

o,,o,
0X 7 1) 01h33 7,403e 2 6)
(0 508 (0
975,9,
4,o) 0674174,)) 7) 3
730130.7 (e ?o 6)
WWPt ,,
44,1,?, ,nIoiuMoo (,,n lI) 7004 Conio,y r0)fl010n4133412/ (0?) 80.1 .7ue0.yo,our.8.cb, 3)367
,roixa,,) 7044,34312,00.31,1)1)11)0.31: o, I lo ,,,,e,,.1,, 4,,
70, 3,0?034510,3)I: p.oIr4 I, (12 .7*)) ,,,ko,,o, 8.9,, )4, ,0(r-(,, http//.w.FO.0Om.fr03r6200d404
01,33033
544, 71.4(031(0 I,,n,6 979.) C,rfl3fl 8..,, /11,03
/L-,we,do ) 41, 33(0)) 3,3 .057/4 Fw,,,
o,, 10.16,,, P10, o.(I.- 8.1)34119 1.3/60.3,433
(13,4 :401:), (lI-) I IO.
340 (3,) 3,33)0 ))7.(,A LI Il, 1841)13, 70 64,1.30 4, 3 ),103I1,o) .1,3 .l2,)D)2 11,043111,1)0837, 700 33? ?JC 13,,,?

Rafr-red. ,4(

71.3)1974*0.333.1(124

,,,.-

Source: Data

from

FillnIuioIl Tunes, Decembor

20 0, p. 2$.

A change in the dollar/pound exchange rate would alter the swcaters dollar price. At
an cxchange rate of $ 1.25 per pound, the sweater WOUld cost only
(1.25 $I.C) X (50)

$62.50,

a.ssuming its price in terrns ol pounds remained the same. At an exchange rate o! $1.75 per
pound. the sweaters dollar price wotild be higher, eqtial to
(1.75 $I)

CC5O)

$87.50.

Changes in exchange rales are descrihed as depreciations or appreciations. A depreciation

of the pound againsi the dollar is a fali in the dollar price of pounds, for example, a change in
the exchange rate from S 1 .50 ier pound to $1 .25 per pound. The preceding example shows
that all e/se cqua!, a demcia!ion of a cowitr 5 currency inakes its goods cheaper for far
eigIle?s. A rise in the pounds price in terrns of dollarsfor exarnplc, frorn $1.50 per pound
to $ 1.75 per poundis wi appreciation of the pound against the dollar. All e/se equa!. un
appreciation ota countrvs currcncv inakes its goods more (rpenslve far foreigners.
The exchange rate changes discussed in the example simultaneousl alter the prices
Britons pa for American goods. At an exchange rate of $ 1.50 per pound, the pound price
of a pair of American designer jeans costing $45 is (S45)/(] .50 $[E) = 30. A change
in the exchange rate from S 1.50 per pound to $ 1.25 per pound. while a clepreciation of
the pound against the dollar. is also a rise in the pound price of dollars, an appreciation of
the dollar against the pound. This appreciation of the dollar makes the American jeans
more expensive for Britons by raising their pound price from 30 to

(S45)I(1.25 S/f)

36.

CH A O t[J 0

1 4

1
JxCIla
c
n Ra(cs aiid lie iorcgn lxchangc Marke: An Asset Approacli

323

ihc iha nge in the cxc hange raw lo un $ I .50 per flli nd o $ I .75 per poundan
appre
ciai i on o I the pou id agai usi the do! Iar hu i a depicc i ai 1011 ol the do! r
la agai nst the

pound

Iowers the Poufl(l price ol the eans lrom [3(1 io

([45)/(1.75 $I[)

[25.71.

As you can sec, descriptions o exchange rate changcs as depreciaiions or appreciations

can hc hewildering. hccausc when one currcncy depreciates against another. the
second
currency musi simultancously appreciate against the lirsi. To avoid confusion
in dix
cussing exchanee rates, we musi always keep irack of which of the two currcncies
we are
examining has depreciated or apprecialed against the other.
If ve rememher that a depreciation of the dollar against the pound ix ai the same time
an appreclation ol the pound againsi the dollar, ve reach the following conclusion:
When i,
(ountrv s cuiiv,zcv dc/nCLiates, /reit,ne,:v /ind 1/1(1/ its exporis are cieaper and do,uesiic
rc.side,it.v fi,uI 1/1(1! iIl/)OrlSfiflhI a/nvad ere i,ioi-e (.upclISirc. /tii a/)J)recialioIl
Iia.v o/)/)osite
L/f((lS: !-(neigIlerv 0(1V Inor( /01

1/le

ji/ieigi prodl((lS.

(OlliltI) S /)l)dllCtS (111(1 (/oliICsli( (.0llSlllll(l

)Xli /esS

Exchange Rates and Relative Prices

Import and cxport demands, Iike the demands for all goods and services. are influenced
by
re/atile priceS. such as the price oi sweaters in terms of designer jeans. We have
just seen
how exchange rates al low individuals io compare domestie and foreigii
mOflCy prices hy

expressing them in a common currency unit. Carrying this analysis

one step further. we
can sec that cxchange rates also allow individuals io compute the relative prices of
goods
and services whose money prices are quoted in differeni currencies.
An American trying io decide how rnuch io spend on American jeans
and liow much io
spend 011 I3ritish sweaters musi transiate their prices mio a COOfl
currency to compute
the price ol sweaters in Ierms of jeans. As ve have seen. un exchange
rate of $ 1 .50 per
pound means that an American pays $75 tr a sweater priced ai 50 in Britain. l3ecause
the

price of a pair of Anierican jeans ix $45. the price of a sweaier in terms of pair
a
ofjeans
is ($75 per sweater)/( $45 per pair of)eans) = 1.67 pairs of jeans per sweater. Nawrally,
a
Briton ftces the same re1atic price of ([50 per seater)/([30 per pair ofjeans)
= 1.67
pairs ofjeans per sweater.
Table 14-2 shows the relative prices irnplied by exchange rates of $1.25 per potind.
S 1.50 per pound, and $ 1.75 per pound. on the ussurnption rhat the dollar price of jeans
and
the pound Prie of sweaters are unaffected by the exchange rate changes. To tesi
your un
derstanding, try io calcolate tilese relative prices for yourself and conlirm that the
outcorne
of the calculation is the same for a Briton and for an American.
The table shows that if the goods money prices do not change, an appreciation
of the
dollar againsi the pound niakes sweaters cheaper in Ierms of jeans (each pair
ofjeans buys
more sweaters) while a depreciation of the dollar against the pound makes sweaters
more

fi:1I[ S/ Exchange Rates and 11w Relative Prke of American

Designer Jeans and British Sweaters

Exchange rate ($L[)

Relatie price (pairs ofeans/sweaier)

1.25
1.39

1.50
1.67

1.75
1.94

Note: The above calculaiions assume unchangcd nioney prices of $45 per
oair ofjeans and 50 per sweater.

324

PART

TI-i

REE

Exchangc Ratcs aiid Opeii-Econoiny Macroccononiics

cxpensive in tcrns ol eans (each ir ol jeHns htiys wer sweaters). The compuLaIions
iiius(rae a generai principle: All e/ve equal, (lfl (q)/)re(ia!ioli o/o eounlri v urnnci rai.se,V
Ilu re/utili Inue ot it,v evport.v (111(1 Iowei-s the rela(iie /riei (i/ its ifllpoii.v. Con iervelv, a
ie prue o/
llepr((-Iatioii /oi iei:v the le/utile pi-/Le o/a eountri .v e.vpor!.v and rarve,v the re/ali
i,v iiporlv.

The Foreign Exchange Market

Just as other prices in the economy are deterrnined by the interaclion of buyersind seilers.
exchange ra[es are determined by the interaclion of the househoids. hrms. and Imnanciai in
The market
stitutions that huy and seil foreign currencies to make international payments.
iuarket.
in which internationai currency trades take piace is caiied the foreign exchange

The Actors
The major participants in the foreign exchange rnarkt are commerciai banks, corporations
that engage in internationai trade. nonbank tinancia] institulions such as assetmanagement
firms and insurance companies. and central banks. lndividuais may aiso participate in the
foreign exchange marketfor example, the tourist who buys loieign currency itt a hoteis
ot torni foreign exchange
front deskbut such cash transactions are an insignificani fraction
trading.
\Ve now describe the major actors in the rnarket and their roles.

1. Coininercial bank-s. Commercial banks ai-e at the cente.r of the foreign exchange

rnarket bccause aimost every sizable internationai transaction involves the dehiting
and crcditing of accounts itt commercial banks in various financial centers. Thus, the
vast ma jority of foreign exchange transactions involve the exchange of bank deposits
denominated in different currencies.
Lets look at an example. Suppose ExxonMobii Corporalion wishcs to pay
i 60.00() lo a German supplier. First. ExxonMohil gets an exchange rate quotation
from its own commerciul bank. the Third Nationai Bank. Then it instructs Third
the suppliers
National to dehit ExxonMobiI.s dollar account and pay 160,00() into
by Third
ExxonMobii
to
quoted
rate
exchange
account ai a German hank. If the
from
dehited
Is
X

160.000)
euro
1.2
per
National i $ 1.2 per euro. 5 192,000 (= $
192,000
a
of
exchange
the
$
is
ExxonMobils account. The final result of the transaclion
deposil at Thrd National Bank (now owned by the German bank that supplied the
euros) for the 160.000 deposit used bv Third National lo pay ExxonMobils German
stipplier.
As the example shows. banks rotitineiy enter the foreign exchange rnarket to rneet
the needs of their customersprimarily corporations. in addition, a bank vi1i also
quote to other banks exchange rates at which it is wiliing to buy currencies from them
and seli currencies to them. Foreign currency trading among bankscalled interbank
tradingaccouuits for rnuch of the activity in the foreign exchange market. In fact. the
cxchange rates Iisted in Table 14i are interbank rates, the rates banks charge each
other. No amount iess than $1 million is traded at those rates. The rates available to
corporate customers, calied retail rates, are usually less favorable than the whole
sale interbank rates. The difference between the retail and the whoiesale rates is the
hanks compensation for doing the business.
Because their internationa] operations are so extensive, large commercial banks are
vc11 suited lo bring buyers and sellers ofcurrencies together. A multinational corpora
tion wishing lo convert 5100.000 mio Swedish kronor might fnd it difficult and costly

C HA PTE P

1 4

Exchne IZitcs and the Ioicnn FxcIiaite Mirkct: An Asset Aj,j,ioicli

325

(o beate othei eorporations wishing io seil the iiglil arnonni oF kmnor. [3 serving
nany custoners simtiitaneously ihroiigh a singie large pLIfthiSe ol kronor, a bank can
eeoiloIili/e 00 illese seareh cosls.
2. Cor)l),wio,l,v. Corporatioiis with operations iii several countries frcquently make
(>1 receive payments in currencies other than (hai ol the
country in which ihcy are
headtiuaricred. To pay workers al a piani in Mexico. or example. I [3M may need
Mexican pesos. li IBM has only dolkirs earned by setling coinpu(ers in the United
States, il can acquire the pesos il needs hy htiying them wiih its dollars in the toreign
exehange markei.
3. iVoiibunk /j,l(lliLicJ( iiIs(i!iflioiIs. Over the years, deregulation of tinancial markets
in the United States, Japan, and other countrics has encmiraged nonbank tinancial insti
tutions sueh as mutua) funds to offer their eustomers a broader range of services, many
ol them indistinguishahle troni hose oltered hy banks. Among these have been xervices
involving foreign exchange transactions. lnstitutionab investors such as pension funds
otten trade foreign currencies. So do insuranee companies. Hedge funds. whicbi cater io
very wealthy individuais and are
noi bound by the government rcgulaiions that limit
mutua) funds trading strategies, trade actively in the foreign exchange market.
4. Central hanks. In the previous chapter we Iearned that central banks sometimes
intervene in foreign exchange niarkets. VVhile the volume of ccntrai bank transactions is
i.ypically noi barge. the impact of these transactions may be great. The reason foi this im
pact is that participants in the foreign exchange market waich central hank actions
closeby
for clues abotii future macroeconomic poi icies that may affeci exchange rates. Government
agencies other than centrab banks may aiso trade in the foreign exehange rnarket. bui eco
tral banks are the rnost regular oflcial participants.

Characteristics of the Market

Foreign exchange trading takes piace in many tinanciai centers, with the largest volumes
ol (rade occurring in such major cities as London (the iargest nlarkct), New York, Tokyo.
Frankfurt, and Singapore. The worldwide volume of foreign exchange trading is enor
mous, and it has hailooned in recent years. In Api-il 1989, the average total value ofglobal
foreign exchange trading was dose to $600 billion per dar. A total of $ 184 billion was
traded daily in London, $ 115 biblion in the United States, and $ Iii billion in Tokyo.
Twenty-one years later. in Aprii 2010, the daily global value of foreign exchange trading
had jumped io around $4.0 trillion. A totai of $ 1.85 trillion was traded daily in Britain,
$904 billion in the United States. and S312 billion in Japan)
Teiephone. fax. and Internet links among the major foreign excbiange trading centers
make each a pari of a single world market on which the sun never sets. Economie news
released at any time of the day Is immediate]y transmitted around the world and may
set
off a flurry of activity by rnarket participants. Even after trading in New York has finished,
New Yorkbased banks and col]orations with affliates in other time zones can rernain
active in the rnarket. Foreign exchange tradcrs rnay dea] from their homes when a
late
night communication alerts them to important developmcnts in a fnancial center on
another conti nent.

tAprit (989 lgures come Iiorn surveys carried out simulianeousi3 hy the Federal Reserve Hank
of New York.
the Bunk of Iiniand. the Bank of Japan. the l3ank of Canada and inonetarv auihorities from
France, Iialy, the
Netherlands. Siiwnpore. Hone Kong. afld Australia. The Aprii 2010 surve was carried
out by 53 central banks.
Reviscd tigures are reported in Triennial Central bank Survey of Foleigii Exchange
ami Derivatises Market
Activty in Aprii 2010: Pre]iminury Giobai Results: Bank for International Settlenents,
Baset. Switzerland.
Septernhcr 20 10. Dail) U.S. foreign currencvtrading in 1980 averugedoniy around S18
hiihon.

326

PAPT TH PE E

Exchangc lZatcs and ()pcii-Econorny Macrocconomics

The i nlegrat ion o) li mineiiI centers i inpl ies that there caii he no signi icant di tThrence
hetween the doilar/euro exchange rate quoted in New York itt A.M. and the dollarleuro
exclange rte ijuoted in I ondon al the same time ( which corresponds (o 2 RM. London
lime). Il the euio were sellng tor $ I i in New York and S 1 .2 in London. prolits couid he
made through arbitrage, the process ol huying a cunency eIleaj) and selling it dear. Ai the
I
Ilrices iisted above. a trader could. br instance, purchase I million in New York br $ I
of
probi
a
pure
making
million,
(or
1
.2
London
in
$
euros
the
seIl
mi Ilion and imniediately
$ I 00.000. Il al I iraders tried to cash in on the npportunity. however, their clemand ft)r
euros in New York wouid cirive up the dollar price of cmos ihcre, and their supply ofeuros
in London would drive down the doilar price of euros there. Very quickly. the difference
hetween the New York and London exchange rates would disappear. Since foreign
exchangc traders careftilly watch their computer screens tr arhitrage opportunities. the
few ihat anse are smali and very short1ied.
While a freign exchange transaction can match any two currcncies. most transactions
(rotighly 85 pcrcent in Aprii 2010) are exchanzes of loreign currencies lor U.S. dollars.
This ix true even when a banks goal ix to sei] one nondollar eurrency and buy another!
A bank wishing to sei] Swiss francs and buy Israeli sheke]s, tor example. wilJ usuallv xcii
its francs lor dollars and then use the dolars to huy shekels. Whi]e this procedure may
appear roundabout. it is acwaily cheaper for the hank than the alternative ol trying to lind
advantage of trading through the
a hoider of shekels who wishes lo buy Swiss francs. The
dollar isaresult of the United States importance in the world economy. Because the
volume oF internationai transactions involving dollars ix so great, il ix not hard to (md
parties willing Lo trade doilars against Swiss francs or shekels. In contrasL relativeiy few
.

2
transaclions require direct cxchange.s of Swiss francs for shekels.
deals. the U.S. dollar is sogiie
exchange
foreign
Because o) its pivotal role in so many
is wideiy used [o denomi
that
one
is
linies calied a vehicle currency. A vehicle currency
nate international contracts made by parties who do noi reside in the countrv that issues
the vehicle cuncncy. Il has heen suggested that the euro, which was introduced al the stanI
of 1999, vi11 evolve mb a vehicle culrency on a par with the doliar. By Apri] 2010, ahout
39 percent of foreign exchane tradcs were against eurosIcss than half the share of the
doilar. albeit ahove the figure of 37 percent clocked three years earlier. Japans yen ix the
third most imporlant currency, with a market share of 19 percent (out of 200). The pound
stenling, once second only lo the dollar as a key international currency, has dec]ined
3
greativ in importance.

Spot Rates and Forward Rates

The foreign exchane transictions ve have been discussing take piace on the spot: Two
parties agree [o an exchange of bank deposits and e\ecute the deal immediately. Exchange
rates governing such on-the-spot trading are cal]ed spot exchange rates, and the deal is
called a spot transaction.

rates
The Sws. tranc/sheket exchange rate eco be catcutated from the dollar/t ranc and uottat!sheket exch,tnee
the
and
franc
per
50.80
Is
rate
dotlarltranc
the
I!
rate.
as the doltar/shekel rate dividcd bv the doltar/!ranc
0.25
5/frane)
0
is
S/shekeh/(0.8
rate
(0.20
franc/sheke)
Swiss
the
then
shckel.
per
50.20
is
rate
(Ioltar/sheIeI
sws tranc/sheket. Exchange rates hetseen noridollar currer:cie are c,iiled cross r;ites hy toreign exchangc trader.
1:or a more detaited dicuss:on of vehicte currencies. sec Richard Portes and Hdine Rey. The Eniergence of
3
307343. Data on currency share
the Euro as an tnternationat Currency. IZcanoimc PoIici 26 (Aprit 998).
o! the future roies ot the
assesment
recent
Far
3.
a
tabtc
come froin Bank for International ScttIement. op. ce..
Eom ai TL o: The Nei!
The
eds..
Posen.
Adain
S.
y
and
PisaniFerr
ieaii
essays
n
sec
the
euro.
ant
the
dollar
Ciba! (un tu e. (Washineton. DC.: Peterson institute far tntenictionat Fcononucs. 2009).

CH A PTE R

1 4

Ech.iiic Iites ind the Ioreitn Exchanie Market:

Aii

isset Approch

327

Forei gn exchaiige de1 s soinet i fliCS speCi ly a /1, 1lire t ransaci i OlI dateone that n ay
be
30 days. 9() days. i 8() days, or even several years away. The exchange rates t
uoied in
1
such transactions are calied ftrward exchange rates. In a 30day forward transaution.
br example. two parties may commit themselvcs on Aprii i (o a spol exchange ol
100.000 fi)r $ I 55.00() on May I The 30day torward exchange rate is therelore 1.55
$
per potmd. and il is generally diiferent hom the spol rate and from the forward rates
applied to dibferent future daes. When you agree to scil pourids br dollars on a future
date al a forward rate agreed un loday, you have sold potinds borward and bought
dol
Iars forward. The future date on which the currencies are actuaily exchanged is called
the tolio dote.
4 Table 14I shows forward exchange rates for some maor currencies.
Forward and spot exchange rales, while not necessarily equal, do move closely together,
as illustrated for monthly data on dollar/pound rates in Figure 141. The appendix to
this
chapter, which discusses how forwarci cxchange rates are determined, explains this dose
reiationship hetween movements In spot and forward raws.
An exarnple shows why arties may wish lo engage in borward exchange transac(IOns.
Suppose Radio Shack knows that in 30 days il must pay yen to a Japanese supplier for
a
shipment of radios arriving then. Radio Shack can seli each radio for $ 100 and must pay
its supplier Y9,000 per radio; its prolt clepends on the dollar/yen exchange rate. At the cnr
rcnt spot exchange rate of $00105 per yen, Radio Shack would pay ($0.01 05 per yen) X
(9,000 per radio) = $94.50 ier radio and would therefore rnake $5.50 on eaeh radio
imported. But Radio Shack will not have the funds to pay the supplier until the radios ar
rive and are soid. Ef over the next 30 days the doilar unexpectediy depreciates (o $0.01 15
ier yen, Radio Shack will have to pay ($0.0 115 per yen) X (9,000 per radio) = 5 103.50
per radio and so wiIl take a $3.50 los,s on each.
To avoid this risk, Radio Shack can make a 30-day forward exchange deal with Bank
of
America. If Bank of America agrees io seli ycn lo Radio Shack in 30 days at a rate of $0.0 107.
Radio Shack is assured of paying exactly ($00107 per yen) X (Y9,000 per radio) $96.30
per radio lo the supplier. By buying veii and seiiing dollars forwud, Radio Shack is guaranteed

Exchange rates ($/f.)

2.5
Spot rate

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

2007

2009

2011

Figure 14-1
DoIIar/Pound Spot and Forward Exchange Rates, 19832011

Spot and forward exchange rates tend to move in a highly correlated fashion.
Source: Datastream. Rates shown are 90-day forward exchange rates and spoi exchange rates, at end of month.

days past. it voukI take up lo two days io sente even spot foregn exchange transaciion.
In other word. the
value date tor a spol trailsaclion was actually two days after the deal was siruck. Nowadays.
rno5t spol trades of

ma or currcncies settle on the same day.

328

PA PT TH REE

LcIiaiige Ratcs and Opcn-Fconomy Macroeconornics

a prohl oF 3.70 per radio and Is insured againsi the possibi liiy that a udden exchange rate
change will ttim a proitaNe importing deal iuta a bss. In the jargon of the Ioreign exchange
maiket, we woiild say (hai Radio Shack has I,ded its Ircign currency risk.
Froin now un, wheii we mention an exchange rate bui dan i si)eci fy wheher it is a SJ)Oi
rate or a lorward iaie. We wiIl abways bc relerring il) the spol rate.

Foreign Exchange Swaps

A lorelgn exehange swap Is i spot sale of a currency cambi ned with a forward repurchase al
that culTency. Far example, suppose the Toyota auto company has just received $1 million
lrom American sales and knows it wil bave [o pay those dollars lo a Calilrnia supplier in
three months. Toyolas assetmanagement department would meanwhile like to invest the $ I
million in euro bonds. A threemonth swap of dollars into euros may result in bower brokers
Iees than the twa separate transactions of selling dollars for spot euros and selling the euros
far dollars on the frward market. Swaps make up a signifcant proportion of all foreign
exchange trading.

Futures and Options

Several other tinancial instruments tracled in the foreign exchange rnarket, like forward
contracts. involve future exchanges of currencies. The timing and terms of the exchanges
can differ. however. from those speciled in forward contracts. gi ing traders additional
flexihility in avoiding foieign exchange risk. Only 25 years ago. sorne of these instruments
were not traded on organized exchanges.
of
When you buy a Jitiires conl.vc!. you buy a promise that a speci fed amount
contract
forward
A
future.
the
in
[reign currency will he delivered on a specified date
hetween you and some other lirivate party Is an alternative way to ensure that you receive
the same amount of foreign currency on the date in quesuon. But while you bave no
choice about fulllling your end of a forward deal, you CaTi seli your futures contract on
an organized futures exchange. realizing a proht or bss right away. Such a sale might
appcar advantageous. for example. if your views about the future spot exchange rate
were to chane.

Aftreign exchange optioli gives its owner the right to buy or seil a specitieci amount of
at any time up to a specited expiration date. The other
foreign currency at a specifed
party to the dea], the options seller. is required Lo seil or huy the foreign currency at the
discretion of the options owner, who is under no obligation [o exercise his right.
Irnagine that you are uncertain about when in the next rnonth a foreign currencv pay
ment vill arrive. To avoid the risk of a IOSS, you may wish io buy a Jmt option giving yOU
the right lo sei] the foreign cunency at a known exchange rate ai any lime dunng the
month. If instead you expect to make a payment abroad sometime in the month. a cali
ojiion. which gives you the right to buy foreign currency lo make the payment ai a known
price. might be attraeti\e. Options can be written on maiy underlying assets (incbuding
foreign exchange futuresi, and, like futures, they are freely hought and sold. Forwards,
swaps, futures, and options are all exarnples ofjinancial cler,vatiics. .s hich ve encoun
tered in Chapter 13.

The Demand for Foreign Currency Assets

We bave now seen how banks. corporations. and othcr institutions trade foreign currency bank
deposits in a worldwide foreign exchange market that operates 24 hours a day. To understand
how exchange rates are determined by the foreign cxchange m&ket, we first rnust ask how the
major actors dernands far different typcs of foreign currency deposits arc determined.

CHAPTER

I 4

Exchange IZaIes and the Lot-cign Exchange Markci:

Ati Asset

Approach

329

Flie demand for a foreign currency hank deposit is inuluenced

hy the same considera
tht inl]uence the demand for any other asset. Chief among tliese
consdcrations Is
our view o! what the deposil wiII be worth iii the future.
A foreign currency deposits
future value depencls in turn ori two factors: the interest rate it
OFfCIS and the expected
change in the currenc-ys exchange rate against other currencies.
110115

Assets and Asset Returns

As yoti vil1 recai!, people can hoid weaith in many Iormsstocks
, boncls, cash, rea! estate,
rare wines. diamonds, and so ori. The object of acquiring weaith
of savingis to transfer
purchasing power mio the future. We may do this to provide for
our retirement years, for
our heirs. or simply because ve carri more than ve need to spend
in a particular year and
preler to save the baiance for a rainy day.
Defining Asset Re(urns

Because the object of saving Is io provide !r future consumption,

we judge the desirability of ati asset iargeiy ori the basis

of its rate of return, that ix. the

percentage increase in value it oIers over some time period. For examp
le, suppose that at the
heginning of 2012 you pay $ 100 for a share of stock issued by Financ
iai Soothsayers, Inc. if
the stock pays you a dividend of $1 at the beginning of 2013. and
if the stocks price rises
from $ 100 to $ 109 per share over the year. then you have earned
a rate of returri of IO percent
on the stock over 201 2that ix, your initial $ 100 investment has grown
in value Lo $ 110. the
sum of the $ I dividend and the $ 109 you could get hy selling your
share. Had Financial
Soothsayers stock stili paid otit its $1 dividend bui dropped in price
to $89 per share. your
$100 investment woud be worth only $90 by years end, giving a rate
of returri of iiega!iee
10 percent.
You often cannot know with certainty the returu that ari asset wilI actuail
y PY after you
huy it. Both the dividend paid hy a share of stock and the shares resale
price. for examp!e.
may be hard io iredict. Your decision therefore rnust be hased ori
ari e.vpccied rate of
returri. To calculate ari cxpected rate of re[urn over some time period
, you make your best
forecast of the assets torni value at the periods end. The percen
tage difference between
that expected future value and the price you pay for the asset
today equals the assets
expected rate of return over the time period.
When we measure ari assets rate of return, ve compare hos ari investm
ent in the asset
changes in torni value between two dates. In the previous exarnp
le. we compared how the
value of ari investment in Financial Soothsayers stock change
d between 2012 ($100) ami
2013 ($1 10) to conclude that the rate of return ori the stock was
10 percent per year. We
cali this a do/br rate of return because the two values we compa
re are expressed in terms
of dollars. It is also possible. however. to compute diffrent rates
of returri by expressing
the two values in ternls of a treign currency or a cornmodity such
as gold.
The Real Rate of Return The expected rate of return that savers
consicier in dcciding
which assets to hold ix the expected real rate of return,
that is, the rate of return
computed by measuring asset values in terms of some broad
representative basket of
products that savers regularly purchase. I ix the expected rea] return
that inatters because
the ultimate goal of Sa ing is future corisumption. anci only the
real return measures the
goods and services a saver cari buy in the future in returri for giving
up some corisurnption
(that Is, saving) today.
To continue our example, suppose that the dollar value of an
invcstrnent in Firiancia]
Soothsayers stock increases by 10 percent between 2012 arid
20! 3 hut that the doliar
prices of all goods and services a/so increase by IO perceni. Then
in terms of outputthat
ix, in real terinsthe investnlent would be worth no more in
2012 than in 2013. With a
rea] rare of return of zero Financiai Soothsayers stock would noi
bc a very desirable asset.

PART TH REE

330

)xclinngC iZatcs aiid Open-i:conomy

Macrocconomics

NondeIiverabIe Forward Exchange Trading in Asia

siaiidard iorssard exi.haie contraet. 1540 parlies
agree tu e \ eh a ige i wo di fleren i ei i ire i e ies ai a a
agreed ia te ori a tu a re date. I he cane ne es ol nany
ire. hi 1W eve r. noi In i iy
deve I op ng ci i atri e s
(f)IflC1tibh. n)eanine that they cambi he freely
traded ori intera tionai Ioreign exehange markcls.
Ari i mportant cx ampi e ol a n i nei in ert i bi e e urre ney
is Chinas reniuuiihi, whieh ean be traded within
Chinas horders (hy residents) bui not freely oniside
ol them ( heeause (hinas gnvernneni does noi
aliow nonresidenis unrestricted onership of ren
In

minhi deposits in China). Thus. for curreneies sueh

as the reami nhi the eustomar wav of tradi ng for
ward exchange is not possibie.
Developing countries Wiih ineonverlibie eurrencies
sueh as Chinas have entered the ranks of the worlds
largesi parteipants in international trade and invcst
meni. Usuaiiy, traders rise the forwaid exehange mar
ket lo hedgc thcir currency risks. but in eases sueh as
Chinas, is ve bave seen, a standard forward market
eannot exist. Is there no vay for foreigners to hedge
the eurrcncy risk they may take ori whcn they irade
with i neonvertibleeurrcney eountries?
Since the early 1990s, markets in nondeliie,able
fmiiard exehange have sprung up in centers sueh as
1-ion Kong and Singapore tu facilitate hedging in in
(unvertible Asian eurrcncies. Among the currencies
traded in olfshore nondchverahie trward markets
are the Chinese renminhi. the Taiwan doliar, anci the
Indian rupce. [3y using nondei iverabie torward con
tracts. traders cari hcdrc currcncy risks without ever
actuaily lia ing lo trade inconvertible currcneies.
Lets )ook ai a hypotheiical cxamplc to sec ho
this hedging cnn be accornpiished. Generai Motors
has just soid some car components to China. Its con
traci with the Chinese imporiel staies lhat in thrce
months. GM vi1i rcccivc the doilar equivalent of IO
niiiiion yuan in parnent for its shipnient. (The yuan

Chinis currencv regime i. an

in Chapter i 8.

exanipie

is the unii in wh ieh amounts f rcnminbi are meas

ured. jusi as Brii ish sieri i ng is measured in pounds
the Peupie s Bank ui Chi ui ( PBC ), the eentrai hank.
Iightiy eontrois its curreneys exchange rate hy trad
ing doiiars that il hoids br renminbi .viih doinestic
residents.* Today, the PBC viiI huy or seil a U.S.
doi lar for 6.8 yuan. Bui assume that the PBC has
heen graduaiiy aliowing its eurreney io appreeiate
agai nst the doi i ai. and that the rate il w i I i quote in
three months is uncertain: It eouid be anywhere
helween, say. 6.7 and 65 yuan per doilar. GM would
Iikc io Ioek in a forward exehange rate of 6.6 yuan
per doliar. which the eompanys ehief hnaneial otti
eer might typicaiiy do simpiy by selling the expected
IO milhon yuan receipts borward tor doiiars at th:it
rate. Unforiunately, the renminbis inconvertihility
means that GM Wi il aetuaiiy receive, noi renniinhi
that il cari seil torward, hut the dollar equivaient of i O
miilion yuan, doilars that the importei cari huy
through Chinas hanking systeln
Nondehverahle forwards result in a irtuai for
ward market, howcver. They do ihis by aliowirig

non-Chincse traders tu make hets ori the renrninbis

vaiue [hai are oivobIe in do//or.. To Iock in a non
dell. erable for..ard exehange rate of 6.6 yuan per
doliar. GM cari sign a contraci rcquiring it io pav the
differenee beiween the nurnber ol doiiars il actuau]y
receives in threc months anci the arnount il woukl
receive if the exehange rate .verc exaetiy 6.6 yuan per
cloilar. equiaient io 1/6.6 doliars per yuan = $0. 1515
per yuan (after roundin. Thns. if the cxchange rate
torri. oni io be 6.5 yuan per dollar (whieh otherwise
wouid be good Iuck for GM), GM wiil have io pay
1/6.6 dollars per yuan) X
oni ori il. contraci (1/6.5
$01515 per. uan) X
1538
10,000,000 yuan) = (SO.
(10,000.000 yuan) = S23 .310.
Ori the other hand, b giving up the possibiiity of
good iuck. GM also a. oids the risk of bad iuck. 11 the

ol a tixed exchaue rle system. x hich

we

si

iii stuuy in greato detaI

of retum expressed in terms

Afthough savers care ahout expected real rates of return, rates
nI assets. Even if all dollar
llffire
on
of a currency cu stili be used to compari reai returns
..hose dollar price rises
wine
of
prices rise by 10 pereent between 2012 and 2013, a rare bottie
doliar value rises by 20 percent.
by 25 percent is stili a betier investnient ihan a bond vhose

CH AP C F

1 4

l:xeli.iiigc Ratcs .ind the orciin Exch.inge M.irkci: An Assct Apioach

331

Excharige rate (yuan per U.S. Dollar)

Nondeliverable Forward Exchange Rates, China Yuan per Dollar

Source; Data se&anl

exehangc rate turns out instead to be 6.7 yuan pci

dollar (which otherwise would be unfavorable ftr
GM). GM wilI pay the negative arnount ($0. 1493
$0.15 15 per yuan) X (10.000.0(X) yuan)
$22.614,
that is, it wiIl receive $22,6 14 from the othcr contiact
ing party. The nondeliverable trward contract allows
GM Lo immunize itsclf fmn exchangc risk, cven
though the parties Lo the contract neccl never actually
cxchange Chi nese currcncv.
The chart ahovc shows daily data on nondeliver
ablc forward rates of yuari for dollars with value
dates oiw month, one year, anci two years away. (Far
longer matunties are also quoted.) Changes in thesc
rates are more variable at the longer maturities
because the ratcs reflect cxpcctations about Chinas
future cxchange rate policy asid because the far fu
ture is relatively more uncertain than the near future.
How hae Chinas exchange rate policics evolveci?
From July 2005 unti) July 2008. China followed a

widcly undcrstood policy ol gradually allowing its

currency to appreciate against the U.S. doIIai I3ecause
of expectations during this period that the yuandollar
rate woulcl tali over time, the forward rates at which
people were wiiling to trade to cover transaction.s two
years away are helow the onc-vear-ahcad for&arcI
ratcs. which in tuoi are heiow the one-month-ahead
forward rates.
China changed ils policy in the summer of 2008,
pegging the yuan rigidiy to the clollar without any
announced end date for that policy. That aclion ai
tered the relationship among the three forward rates.
as you can sec in the chart. Two vears later, in June
2010, China announced its return to a supposediy
more flexible exchange rate for the yuan.
Chinas exchange rate system and policies hae
bcen a focus of internationa) controversy in recent
years. and wc vi1i say more about them in later
chapters.

The rea) rate of return offered by the wine Is 15 percent (= 25 percent 10 percent) while
that offered by the bond is oniy 10 percent ( 20 percent 10 percent). Notice that
the dii
ference hetwecn the dollar returns of the two assets (25 percent 20 percent) must equa)
the
difference between their rea) returns (15 percent 10 percent. The reason fer this equality
is

332

PART THFEE

Exc1iingc IZatcs .iiid ()pcii-Ecoiiorny M.wroecoflnlks

of
that. given the tw() assets doi lar returns. a chailge in the rate ai whch the doilar
anlolint.
same
goods are rising changes both asseis real retunix by the
The distinction hetween real ratcs or retuni and (ioiIar rates ol reiurn iiiusiiates an
important concept in studying hov savers evaiuate ddiereni ;lsseis: The reiurns on two
iL
aSSCIS cannot be eoinpared unless they are measured in the SaIn( unitS. For exampie.
makes no sense io compare directly the reul reiurn on the bottie ot wine (15 perceni in our
example) with the doliar return OI the hond (20 plrceni) or Lo compare the doliar reium on
oid paintings with the euro return oii gold Only after the returns are expressed in terms of
a common unii of measurefor example. all in terms ot dollarscan we teli which asset
oflers the highesi expected real rate of return.

Rkk and Uqudity

All (l.e ((filai, iiidiidii(lis /)il/( 1) 1101(1 thsc ((SSe(S 0ffLIUl tue iug/iest expected real
rate of return, Our later discussions ot particular assets will show. however. that all else
often is noi equal. Some assets may be valued by savers br attributes other than the
expected real rate of return they oller. Savers care about two main chaiacteristics of an
asset other than its return: its risk, the ariabiIity it contrihutes Lo savers wealth. und its
liquidity, the case with which the assei can he sold or exchanged for goods.
1. Risk. An assets real return ix usuaiiy unpredictable and may turn out io be quite dif
ferent from what savers expected when they purchased the asset. In oiw last example.
savers found the expected real rate of return on ari investment in bonds (10 percent) by
subtracling lmm the expected rate of incrcase in the investments dollar vaiue (20 percent)
the expected rate of increase in dollar prices (IO percent). Bui if expectations are wrong
and the bonds doilar va}ue stays constani instead of rising by 20 percent. the saver ends
IO percent). Savers dislike
up with a real retum of negative IO percent (= O perceni
highly variable. An as
wealth
their
that
rnakc
assets
hold
Lo
reluctant
uncerlainty and are
Lo savers if its reaiized
undesirable
appear
thus
relurn
may
sei with a high expected rate oF

rate of return fluctuates wideiy.

2. Liquiditv. Assets also differ according to the cost and speed at which savers can
dispose of them. A house. for example, is noi very liquid because its sale usuaiiy
requires time ami the services ot brokers and inspectors. To sell a house quickly. one
might have to seli at a relaiively low price. in contrasi, cash is the mosi liquid of all
assets: It is always acceptable ai face value as payment for goods or other assets.
Savers prebr io hold some iiquid assets as a precaution againsi unexpected pressing
expenses that might force ihem to xcii less iiquid assets aL a bss. They wiil therefore
consider an assets liquidity as vel1 as its expected return and risk in deciding how
much of it io hoid.

Interest Rates
As in other asset rnarkets. pariicipants in the foreign exchange market base their demands
for deposits of difbrent currencics ori a comparison of these assets expected rates of
return. To compare returns on different deposits, market PariICiPants need two pieces of
information. First, they need to know how the money values of the deposits iii change.
Second. they need io know how exchange raies wiil change so ihat they can translate rates
of retum measured in different currencies mio comparabie terms.
The frst piece of information needed to compute the rate of return oti a deposit of a
particuiar currency is the currencys iiiterest rate, the amount of that currency an indi
viduai can earn by lending a unii of the currency for a year. At a dollar interest rate ol
0.10 (quoted as 10 percent per year, the lender of $1 receives $1.10 ai the end ob the

CH A PTE

P I

ExcIinic IZates md the Ioieitn ixcliangc I\iarkct: An Asxct pproach

333

year, $1 ol which ix principil and lo cents ol which ix interesi. L(u)ked ai troni the other
side ot the trarisaclion. the inteiext rate on dollarx is also the amount that niust he
(o
horrow $1 trir a year. Wher yoti htiy a LJ.S. Treasniy hill, yOu earn the intelest rate (in
dollars heeause you are Iending dollars to the U.S. government.
Interesi ralex play ari important ole in the toreign exchange market becauxe the large
deposits traded there pav interesi. each al a rate reflecling ii.s CLIITCflC oi denomination.
Fur exainple. when the interest rate on dollars ix 10 percent per vear, a $ 100,000 deposit
ix worih $ I I 0.001) atter a year; when the interest rate on eurox ix 5 perceni per year, a
100,000 deposil ix worth 05,000 after a year. Depoxits pay intcrest hecause they are
really loans honi the depositor ti) the hnk. Wheii a corporaliofl or a linancial institution
deposilx a cun-ency in a hank. it ix Iending that currency io the hank raiher than llsing it br
some current expenditure. In other words, the depositor is aCquiring ari asset denomi nated
in the currency it depositx.
The dollar interest rate is simply the dollar rate of return on dollar deposits. You buy
the deposii hy Iending a hank $ 100.000, and when you are paid back with IO percent
interesi at the erid of the year, your assei ix worth $110.000. This gives a rate of return of
10.000
I 00.000)! 100.000 = 0. IO, or 10 percent per year. Similarly, a foreign cnr
rencys interest rate measurex the foreign currency retui-n on depositx of that currency.
Figure 142 showx the monthly behavior of interesi rates on the dollar aiicl the Japanese
yen from 1978 to 2010. These inlerest rates are noi measured in comparable terms, so
there is no reason for them to be dose to each other or to move n similar ways over time.
5

lnterest rates (percent per year)

21
18
15

12

Figure 14-2
Interest Rates on Dollar and Yen Deposits, 19782011
Since dollar and yen interest rates are not measured in comparable terms, they can move quite differently
over time.
Source: Data stream. Three-month interesi rates are shown.

5
C
tiapter 6 detined leal interest rates. which dtC simpl rea! rates at return on toans. that is. interest rates
expressed in terms of a consumprion basket. tnteres rates expressed in errn of currencies are culled nominai
nieresi rates. The eonnctimn helween rea! and nominai inlerest raies is discussed
in detail in ChpLer 16.

334

FAR-r TH PE E

Exchangc IZates iiitl ()pcn-[conorny Macroecoiiomics

Exchange Rates and Asset Returns

1The intciest ratcs ollered hy a dollar and a curo deposo teli us how iheir dollar and curo
values wilJ change over a year. The oiher piece ol lnlormail()n we need in order Io com
pare the rates of return otiereci by doliar and curo del]osits ix the expected change in the
dollar/euru cxchange rate over the year. To sec vhich deposii, CU() or doliar. olters a
highcr expected rate oi return, you musi ask the question: lf I use doilars to huy a euro
deposit. how many doilars wiII I get back after a year? When you answer this question,
you are calculating the do//ar rate of return on a curo deposil because ) ()u are comparing
its (101/ar price today with its do//ar alue a year from today.
To sec how io approach this type ol calculation. lets iook at the following situation:
uoted in American terms) is $ i. IO per euro. hut that
1
Suppose that todays exchange rate (c
euro in a year (perhaps because you expect untavor
.165
per
i
rate
be
lo
$
voti expect the
Suppose LdS() that the dollar interes[ rate is
economy).
the
U.S.
ahle developments in
is 5 percent per year. This means a deposit
rate
10 percent per year whi!e the euro interest
of $ i .00 pays $ I IO after a year whilc a dcposit of I pays I .05 atier a year. Which of
these deposits offtis the higher return?
The answer caii be Found in hve sleps.
Step 1. Use todays doiiarleuro exchange rate to figure out the doliar price of a curo
curo, the dollar price of a I
deposit of, say, I. If the exchange rate tociay is $1.10
.

deposit ix just $1.10.

Step 2. Use the euro interest rate to hnd the arnount of eums you wiIi have a year
from now il you purchase a I deposit tnday. You know that the interest rate on euro de
posits ix 5 percent pci year. So at the eiid o! a year. your I deposit viIl be vorth 1.05.
Step 3. Use the exchange rate you cxpect to prevail a year from today to calculate the
expected dollar value of the euro amount deterrnined in Step 2. Silice you expect the dollar
to depreciate againsi the curo over the coming ycar so ihat the exehange rate 12 months
from today is $1.165 per euro. you expect the dollar value of your euro deposil aftcr a year
$1.223.
io be $1.165 per euro )< 1.05
dollar
price of a I deposit today ($1.10) and can lore
the
know
Step 4. Now that you
the expected dal/ar rate of return on a euro
calculate
can
casi its value in a year ($1.223), you
0.11, or Il percentperyear.
depositas (1.223 1.10)/1.10
Step 5. Since the dollar rate of relurn on dollar deposits (the doilar interest rate) ix
only 10 perceni per year, you expect to do hettcr by holding your wealth in the form of
euro deposits. Despite the fact that the dollar interest rate exceeds the euro interest rate by
5 perceni per year. the euros expected appreciation against the doDar gives euro holders a
prospective capita! gain that is 1are enough to make euro deposits the higher-yield asset.

A Simple Rule
A simple rule shortens this calculation. First. defne the rate of depreciation of the dollar
against the euro as the percentage increase in the dollar/euro exchange rate oer a year. In
the last example. the dollars expected depreciation rate is (1.165 1.10)11.10 = 0.059.
or roughly 6 percent per ycar. Once yti have caiculated the rate of depreciation of the
dollar against the curo, our rule is this: The do//ar rate of return (in euro deposits Is
appivximatclv the curo interesi rate p/us the mie o/deprccialion of the do//ar a,aiist
the euro. In other vvords. to transiate the euro return on curo cleposits into dollar terrns.
you need to add the rate at which the euros doflar price rises over a year to the euro
interest rate.
In our example. the sum of the euro interest rate (5 liercent) and the expected deprecia
tion rate of the dollar (roughly 6 percent) ix about I! percent. which ix what ve found to
be the expected dollar return oli euro deposits in our first calculation.

CH A PTL R

1 4

ExcIhIne 1Zites and the 1oicirn Exchaiigc i4arket: An Asset Appio

ach

Sttt1illalitC OlH (IISLLISSOfl

hy

335

iflhIi)dLILin) SUII1C notalion:

todays iltCltSI Tale OlI OI1CyT.lr L[IIO (Ie[ThSILS.

lodays doIlar/euro cxchaiige ltte (nuiuher of dollars per euro),

dollar/curu exchange rate ( nuiiher ol do! iars per curo)
expected to prevai I a year Irom today

Lsf(-

(The stiperscript atiached lo this last exchange rate indieates ihat

il is a ioreeast o! the
future exchange rate ba.sed un what peopIe know today.)
Using these symhols. wc write the expected rate of relurn un a culo
clepusit. measured
in terms oC dollars. as the sum o! (i) the euro interest rate and
(2) the expeeted rate of
do! lar deprec lati un agai nsl the eti io:
Re + (E,c

This expected rcturn is what nust be cotupared \vlth the interest rate
un oneyear dollar
deposits. Rs, in deciding whether dollar or curo deposits offer the higher
expected rate of
6 The expected rate of return difference between doilar and euro
return.
deposits is there
fore equa! tu R less the above expresslon.

[R + (E
7

Es,cVEsicl

Re

)IE
5
E
1
,.

(1411

When the di//e renLe oboe i.v posi!itc, do//ar deposit.s v,e/d the
higler evpected rate of
iiheji it ix ilegalive. euro deposit.v iieId the higher e.vpected rate o/relur
n.
Table 14-3 carries out sorne illustrative comparisons. In case 1,
the interest difference
in favor of dollar deposits is 4 percent per year (R
0.10
0.06
0.04). and no
change in the exchange rate is expected [(E
c
1
Eje)/E, = 0.001. This means that the
expected annua! rea! rate of rei urn un doilar deposits Is 4 percen
t higher than that un curo
deposits. so that, other things equal, you would prefer to hoid your
wealth as dollar rather
than euro deposits.
retl!171,

Comp ring Dollar Rales of Rdurn un Dollar and Furo Depos;ts

Dollar
Euro
Expected Rate of
Rale of Rcturn
Interest
lnterest
Dollar Depreciation
Difference Between
Rate
Rate
Against Euro
Dollar and Euro Deposits

Case
1

2
3
4

0.! 0
0.10
0.10
0.10

0.06
0.06
0.06
0.12

0.00
0.04
0.08
0.04

(EjE,)

0.04
0.00
0.04
0.02

you compute the expected dollar returo on euro deposits using the exact
lve-srep method we described before
introducing the imple mie. oull (md that t actuaily equals
(I + R t
tE
1
)(E

I.

This exaet formula can be rewruten, however, as

R + (E
14

)/E +
4
&
X (L
The epre.sion aboe s cry dose to the formula derved from the
simple mie when. as is usually the case, the
product R
4 X (Ej
Esf()IES/t is a smali number.

--

336

PART TCIREE

Exchangc Ratcs md Opcn-Economy Macroccoriornics

oIiset hy an
Ii case 2 the interest dilYerence Is the same (4 percent). bui il Is just
re liave the
therefo
assets
two
The
i.
cxpected depreciatiori rate of the doilar ol 4 percen
same expecied rate o rewrn.
nce in tavor o!
Case 3 is sirnilar to the one discus.sed earlier: A 4 percent ilterest differe
the dollar. so
of
dollar deposits is more than offsei by un 8 percent cxpecied depreciation
euro deposits Lire pre!erred hy market participants.
dollar
In case 4. there is a 2 percent interest difference in favor of euro depoxits, bui the
ol
rate
ed
expect
The
year.
the
over
i
percen
4
by
euro
is expected to ap/mciafr against the
its.
clepos
euro
on
that
than
higher
year
t
per
retuni on dollar deposits is therefore 2 percen
rate of rewrn dii
So far ve have heen translating all returns into dollar terms. Bui the
s returns in
expres
to
chosen
we
ferentials we calculuted woukl have been the same had
wanted to
we
le.
examp
terms o! euros or in terms of some third currency. Suppose. for
mie, we
simple
our
measure the return on dollar deposits in terrns of euros. Following
euro
the
iation of
would add to the dollar interesi rate R the expected rate of deprec
t the dollar is
againsi the dollar. Bui the expectecl rate of depreciation of the euro agains
euro, that Is. the
t
approximately the expected rate of appa-eciation of the dollar agains the
in front of it.
sign
minus
a
with
euro
the
t
agains
expected rate of depreciation of the dollar
is
t
deposi
tiollar
This means that in terms of euros. the return oii a

(E/(

Es/f)/E/(.

sion (14-I).
The diffemence hetween the expression above and R is identical io expres
in terms of
returns
re
measu
we
r
Thus, it makes no difference io our comparison wheihe
cy.
culTen
sarne
the
dollars or euros, as long as we measure them both in terms of

Return, Risk, and Liquidity in the Foreign Exchange Market

the asseis
We ohserved earlier that a saver deciding which assets io hold rnay care ahout
Similarly, the
iiskiness and liquidity in addition to their expected rea! rates of return
on risk and
also
bui
returns
on
only
s
noi
dernand for foreign currency assets depend
on dollar
that
ihan
is
higher
ts
deposi
euro
liquidity. Even if the expected dollar retura on
to hold
payoff
if
the
ts
deposi
euro
deposits, for example. people rnay be reluctant io hold
ing thern varies erratically.
the foreign
There Is no consensus among economists about the importance of risk in
. For
debate
of
exchange market. Even the definition of foreign exchange risk is a topic
all
de
returns on
now we wilI avoid these complex questions by assuming that the rea!
In other words. we
posits have equa! riskiness. regard!ess of the currency ofdenomination.
currency assets.
foreign
for
d
deman
ce
the
anfluen
not
are assuming that risk differences do
r 18.
Chapte
in
r,
howee
detail.
greater
in
We discuss the role of foreign exchange risk
cnr
which
g
decidin
in
ty
factors
liquidi
Some mai-ket participants may be iniluenced by
interna
ting
conduc
uals
individ
rencies io hold. Most of these participants are frrns and
for exanip!e, may
tional trade. An Arnerican importer of French fashion products or wines,
ed rate of return on
find it convenient to hold euros for routine payments even if the expect
inteniational trade
euros Is ]ower than that on do!lars. Because payrnents connecied with
.

make a distinction butween foreign

n discussing spot and forward ireign exchange tranactions, sonw te\tbooks
7
1
returnand Thedgers
cpected
about
ecliange speculatorsinaiket parti p.mts .s ho allegedly care only
textbook tiadition becauc it can tnislead the
market participants whose concern is io avoid nsk. We depart tiorn llus
iniportani in echange rate dcterrnination.
potential]y
are
hoth
rnntives
ami
hedgine
e
speculato
the
Whiie
unwaiy:
1clurn and risk. Our tenlati e assump
hoth
ahout
care
she
the same person Lan 1w hoth a )ecu1ator md a hedger f
rneans. in terms o) the traditionai
assets
currency
foreien
for
the
dernand
in
determinine
Iton that risi is unimportant
ihan the hedgng motive.
iiiport.ntt
more
far
is
Lngu.tge. that the speculative inotive for holding treign cuncneies

CH APTL R

I 4

Exchanc lZtcs and the lorcigu Excliatige M.irket:

Ali

Asset

Appioach

337

make up a erv sniali fraction of total foreign exehange tnmsactions. ve ignore the liquid
ity )uotiVe br holding Iorein currencies.
Wc are therebore asstlming br nOW ihat participanlx in the boreign exchange market
base their dernands bor freign currcncy assets exclusively on a coniparison o those as
sets expected rates of retirn. The main reason for making this assumption ix that il sim
plibies our analysis of how exchange rates are determined in the boreign exchange market.
In addition, the risk and Iiquidity nwtivcs for holding foreign currencies appear to be o
secondary importance ft)r many of the internalional macroeconomic issues discusscd in
the next tw chapters.

Equilibrium in the Foreign Exchange Market

We 110W tise what we have learned about the demand lor foreitzn cuirency assets to
describe how exchange rates ire determined. We will show that the exchange rate at
which the market settles is the one that makes market participants content to hold exist
ing suppiies of deposits of all currenciex. When market participants willingly hold the
existing supplies of deposits of all currencies, we say that the foreign exchange market
is in equilibriun.
The description of exchange rate determination given in this section is oniy a first step:
A fuil cxplanation o[ the exchange rales current level can be given only after ve exarnine
how participants in the foreign exchange market form their expectations about the
exchange rates they expect lo prevail in the future. The next two chaplers look at the fac
tors that influence expectations of future exchange rates. For now. hovever, we vlll take
expected future exchange rates as given.

Interest Parity: The Basic Equilibrium Condition

The /oreign exchange inarkei is in equilibrinin when deposits of ali ctlrrcIICICS offre the
same expeeted rate o/ retul7l. The condition that the expected returns on deposits of any
two currencies are equal when measured in the same currency is called
the interest parity
conditioii. It implies that potential holders of foreign currency deposits iew them all as
equally desirable assets, provided their expected rates of retui-n are the sanie.
Lets sec why the foreign exchange rnarket ix in equilibriurn only when the interest par
ity condition holds. Suppose the dollar interest rate is 10 percent and the euro interest rate
Is 6 percent, but that the dolJar is expected io depreciate againsL the euro ai an 8 pcrcent
rate over a year. (This is case 3 in Table 14-3.) In the circumstances described, the
expected rate of return on euro deposits would be 4 percent per year higher than thai on
dollar deposits. We assunied at the end of the last section that individuals always prefer to
holcl deposits of currencies ottering the highest expected return. This irnplies that if the
expected return on euro deposits ix 4 percent greater than that on dollar deposits. no one
vil1 be willing to continue holding dollar deposits, and holders of dollar deposits will be
trying to seli them for euro deposits. There will therefore be an excess supply of dollar
deposits and an excess demand lor euro deposits in the foreign exchange market.
As a contrasting exarnple, suppose that dollardeposits again offera l0percent inter
est rate but euro deposits offer a 12 percent rate and the dollar ix expected to a/)preciate
against the euro by 4 percent over the corning year. (This is case 4 in Table 14-3.) Now
the return on dollar deposits is 2 percent higher. In this case no one would dernand euro
deposits .so they would be in excess supply and dollar deposits would be in excess
demand.
When. however. the dollar interest rate is 10 percent. the curo interest rate is 6 pcrcent,
and the dollars expected depreciation rate againsi the curo is 4 perceni, dollar and euro

338

PAPT TH R

e: E

c IZitcs iiid Opcn-Fconomy lVlacrocconoiiiics

Exch.iii

sits otter the xaiie file ot letuil and participiints in the kreign exehange market me
de
w
1
((luaIlY W1IIiHLZ (O hold eiihei. (This ix case 2 in
(.)nly when all exl)ected rates ol return are equalthat ix, when the inleres parily con
dition lioldsis there no excex.s supply o! some type oC deposit and no cxcess demand fr
;inother. The flreign exehange marLet is in equilibiium when no type ol deposii ix in
excess demand or cxcess supply. We can iherelore say that the Ioreign exchange market is
in equi Iihnum when. and only when, the interesi parity condition hoJds.
li) represent interesi parity bctwecn dollar and curo deposils symholicallv. we tise
expression (14.I which shows the difterence hetween the two assets expected rates of
return measured in dollars. The expected rates of return are equal when
.

1
l?c + (E,

(14-2)

You prohably su.spect that when dollar deposits nOer a higher return than euro deposits,
the dollar wiIl appreciate againxt the euro as investors all try to shift their funds into dol
lars. Conversely, the dollar shoukl depreciate againxt the euro when it ix euro deposits that
initially ofler the higher return. This intuition ix exactly correct. To understand the mecha
nism at work, however, we must take a caretul Iook at how exchange rate changes like
these help ti) maintain cquilibrium in the 1oreign exchatige market.

How Changes in the Current Exchange Rate

Affect Expected Returns
As a Iirst xtep in understandinp how the loreign exchange market finds its equilihrium. we
examine how changes in todays exchange rate affect the expected return on a foreign cur
rency deposit when interest rates and expectations about the future exchange rate do not
change. Our analysis will show that. other things equa), depreciation of a countrys cur
rency tuday luiiers the expected doinestic cuiency ielum on foreign currency deposits.
Conversel. appreciation of the domestic currency today, all else equa), raives the domes
tic currency return expected of foreign currenc deposits.
it ix easiest Lo sec why the.se relationships hold by looking al an example: Ho does
a change in todays dollar/euro exchange rate, all cisc held constant. change the
expected return, rneasured in terms of dollars. on euro deposits? Suppose that todays
dollar/euro rate ix S 1.00 per euro and that the exchange rate you expect for this day
next year is S 1.05 per euro. Then the expected rate of dollar depreciation against the
1.00)/1.00 = 0.05, or 5 percent per year. This rneans that when you
euro is (1.05
huy a euro deposit. you not only earn the interest Rf but also get a 5 percent bonus
in terms of dollars. Now suppose that todavx exchange rate suddenly jumps up LO
Sl.03 per euro (a depreciation of the dollar and an apprccation of the curo) but that
the expected future rate ix stili $1 .05 per euro. What happens Lo the bonus you cx
pected io get from the euros increase in value in terms o) dollars? The expected rate of
0.019. or 1.9 percent instead of
i .03)11.03
clollar depreciation is now only (1.05
on euro deposits, which is the
return
dollar
the
changed.
not
has
5 percent. Since R
has fallen hy 3.1 percentage
depreciation,
dollar
of
rate
surn of R and the expected

points per vear (5 percent 1.9 percent).

In Table 14-4 we work out the dollar return on euro deposits lor various leveis of todays
dollar/euro exchangc rate Es,, alxs ays assurning that the expected fluliur exchange rate
remains lxed at 51.05 per curo and the euro interest rate ix 5 percent per year. As you can
sec, a rise in todays dollar/euro exchange rate (a depreciation of the dollar againsi the euro)
always loiiers the expected dollar return on euro deposits (as in our example), while a lali
in todays dollar/euro exchange rate (an appreciation of the dollar against the curo) always

raises

this rcturn.

CHAPTER

1 4

1:xcIi;ine R.itcs .ind the Iore0ii ExcIiane Maiket: An Asset Approach

339

Todays DnIIar/Euro Exchange Rate and the [xpected Dollar Return

on Euro Deposits When
= $1.05 per Euro

Iodays DoIiar/Euro
Exclange Rate

Interest Rate on
Euro I)eposit.s

Expcctcd Dollar
Dcpreciation Rate
Agaiust Euro
1.05

Expected Dollar
Rcturn oii Euro
Deposits

1
Ls

Rc

1.07
1.05
I .03
I .02
1.00

0.05
0.05
0.05
0.05
0.05

R +

0.019
0.00
0.019
0.029
0.05

1.05

0.031

0.05
0.069
0.079
0. I O

lt may run countcr io your intuition that a depreciation of the dollar against the
CU()
makes euro deposits less attractie relative to dollar cleposits (by Iowering the expccted
dollar return on curo deposits) while an appreciation of the dollar makes euro deposits
more attraclive. This result wiIl seem Iess surprising if you remember wc have assumed
that the expected future dollar/curo rate and interest rates do not change. A dollar deprec
i
ation today. for example. means the dollar now needs to depreciate by a sinai/cr amount
to
reach any given expected future level. 1f the expected future dollar/euro exchange rate
does not change when the dollar depreciates today, the dollars expected future deprecia
tion aeainst the curo therefore falls, or, alternatively, the dollars expected future apprecia
flon rises. Since interest rates also are unchanged, Iodays doHar depreciation thus makes
euro deposits Iess attractive compared with dollar deposits.
Pui another way. a current dollar depreciation that affects neither exchange rate expec
tations nor interesi rates leaves the expected future dollar payoli of a euro deposit the
same
bui raises the deposits curreni doilar cost. This change naturally makes euro deposits less
attractive relative (o clollar deposits.
lt may also run counter to your intuition that todav s exchange rate can change while
the exchange rate expected for the /iturc does not. We wil] indeed study cases later
in this
book when both of these rates do change at once. We nonetheless hold the expected
future
exchange rate constant in the present discussion because that is the clearest way to illus
trate the ellect of todays exchange rate on expected returns. If it helps, you can
imagine
we are looking at the impact of a teinporal-v change so brief that it has no effect
on the
exchange rate expected for next year.
Figure 14-3 shows the calculations in TaNe 14-4 in a graphic forni that wiII be helpful
in our analysis of exchange rate determination. The vertical axis in the figure measures
todays dollar/euro exchange rate and the horizonal axis measures the expected dollar
return on euro deposits. Forfixed values of the expected future dollar/euro exchange rate
and the euro interest rate, the relation between todays dollar/euro exchange rate and
the
expected dollar return on euro deposits defnes a downward-sloping scheclule.

The Equilibrium Exchange Rate

Now that we understand hy the interest parity condition must hold for the foreign
exchange market to be in equilibrium and how todays exchange rate affects the cxpected
return oli foreign currency deposits, ve caii sec how equilibrium exchange rates are deter
mmcd. Our main conclusion wiIl be that exchange rates always adjust to maintain interest
parity. We continue to assume that the dollar interest rate R, the euro interesi rate R, and
the cxpecied future dollar/euro exchange rate E are all gircn.

34()

PART i FI REE

Fxcliangc iZatcs LIfl(I Opcn-Fconoiny Macrocconomics

Figure 14-3
The Reiation Between the Curreni
DoIIar/Euro Exchange Rate ami the
Expecled Doilar Re(urn on Euro
Deposits
- = 0.05. i
4
G ivcn I , = I .05 and R
ip 11CL IdlIOfl O thl dollar 1aint th euro
ra iscs tilI expected ntu rn I)fl CLI O) de
posits. nnasund in t(.rIfls (Il dI)IIIr.

Todays dollar/euro
11
exchange rate, Er

1.07

1 05

1.03

1.02

1.00

0.031

0.050

0.069

0.079

0.100

Expected dollar return on

,
1
E
E,
euro deposits, R +
11
E
;

Figure 144 illustrates how the equilibrium dollar/euro exchange rate is determined
under these assumplions. The vertical scheduie in the graph indicates the given leve] ofR.
the return on dollar deposits measured in terms of dollars. The downward-sloping sched
dollars. depends
tue shows how the expectcd return on curo deposits, measured in terms of
in the sarne way
derived
is
scheduie
on the curreni dollar/euro exchange rate. This second
as the trne shown in Figure 143.
The equilihrium dollar/eui-o rate is the oiie indicated hy the intersection of the two
At this exchange rate, the returns on dollar and euro deposits
schedules at point 1,
are equal, so that the interest parity condition (14-2).
Rs

R + (E

is satisl-ed.

Lets sec why the exchange rate will tend io settie at point I in Figure 14-4 if it is mi
tially itt a point such as 2 or 3. Suppose iirst that we are al pomI 2. with the exchange rate
equa] to E-. The downward-slnping schedule rneasuring the expected dollar return on
euro deposits te]ls us that at the exchange rate E,, the rate of return on euro deposits is
Iess than the rate of return on dollar deposits. Rs. In this situation anyone holding euro
deposits wishes to sei] them fr the more lucrative dollar deposits: The foreign exchange
a
market is out of equilibrium because participants such as hanks and multinationai corpor
tions are unwilling io hold euro deposits.
How does the exchange rate adjust? The unhappy owners of euro deposits attempi to
sei] them for doliar deposits, bui because the rewrn on doilar deposits is higher than that

C HAPTEP

1 4

I:xch.iiigc IZates ind the Ioieign Lxch.iiigc Market: An Assct Appioach

Figure 14.4
I)eterniination o( the Equihibriuni
Dohlar/Euio Exchange Rate
lE(
1
IiIihrIUfl in the tnrein
al
1)11

exehan;e mtrket

341

Exchange rate,

ET/(
Return on

is

doliar deposits

i ni
vvht re the txp I tci (io a i reI o rn
(101111 tiid curo deposils ate (quaI.
,

E3
5/4

-1--Expected return
on euro deposits
Rates ot return
(in dollar terms)

on curo deposits ai the exchange rate E

c, no holder of a dollar deposii is willing to sei] il
1
lr a euro deposii ai that rate. As euro holders try to entice dollar holders to trade hy offer
ing them a better price for doliars. the dollar/euro exchange rate fails ioward E,; that is,
euros becorne cheaper in terrns of dollars. Once the exchange rate reaches E, euro and
dollar deposits offer equal returns, anci holders of curo deposits no longer have an incen
uve io try to seil then for dollars. The foreign exchange market is therefore in dquilibrium.
In failing from E/f [o E, the exchange rate equalizes the expected returns on the two
types of deposii hy increasing the rate at which the dollar is expected to depreciate in the
future, therehy making euro deposits more attractive.
The same process works n reverse if we are initiaily at pomi 3 with an exchange rate of
At point 3, the return on euro deposits exceeds that on dollar dcposits. so there Is
now an excess supply of the latter. As unwilling hoklers ofdollar deposits bid for the more
attraclive euro deposits. the price of euros in terms of doiiars Iends to rise; [hai is. the dol
lar tends to depreciate against the euro. When the exchange rate has moved to
rates
of retunl are equalizeci across currcncies and the market Is in equilibrium. The deprecia
uion of the dollar from Eff to Ei makes euro deposits Iess attractie relative io dollar
deposits by reducing the rate ai which the dollar is expected lo depreciate in the future.
5

Interest Rates, Expectations, and Equilibrium

Naving scen how exchange rates are detcrmned by interest parity, we now take a look tt
how culTeni exchange rates are affected by changes in interest rates and in expectations
about the future, the two factors we held constant in our previous discussions. We wiiI sec
5
W
e eould have developed our diagram from the pcrspective of Europe. with the etiro/doilar exchane rate
1 (i/&,4) the verticai axiii. a schedule vertical at R indicate the curo return on euro deposits. and down
E
a
ward-sioping schedule showing how the euro returu on dollar depnits varics with E. An exercise at the end nt

the chapter asks you lo show that this alternative way of looking at equi]ihriunt in the ireign uxchane market
gies the sarne answers as the rnethod used here in the tct.

342

PAPT TH I E E

ExchaflLc Ralcs iiid ()pen-Econoiiiy

Figure 14-5
Eftect of a Rise in the Dollar Iiiterest Rate

Maerocconornics

Exchange rate,
E$f,

A ri in Ihu inI(ruSt rilc oIfred 1w (fOildi

Io I? (OUS(S hO (loollar IO)
depnsils H)fl(
(pomi 2o.
(poont 1) In
Iroom
1
E
oppr(ci)I(

Doilar return

----.

so
Expected
euro return

Rates of return
(in dollar terms)

factors that
that the exchange rate (which is the relative price of two assets) responds te
alier the expected rates of return on those two a.s.sets.

The Effect of Changing Interest Rates

on the Current Exchange Rate

are high
t
Ve often rcad in the newspaper thai the dollar Is strong because U.S. interes rates
ents be
statern
tliese
Can
.
falling
are
rates
t
or that it Is failing because U.S. intcres
?
market
ge
explained using our analysis of the frorcign exchan
in the
Th answer this question ve again turn te a diagram. Figure 145 shows a rise
ts
deposi
interest rate on dollars, from R te R. as a rightward shift of the vertical dollar
the expected rewrn on dollar deposits is
return schedule. Ai the initial exchange rate
points I
now bigher than that on euro deposits by an amount equa) Lo the distance beteen
2).
(point
Eiate
te
and 1. As we have seen, this difference causes the doliar te apprec
future
ed
Because there has been no change in the euro interest rate or in the expect
on euro
exchange rate, the dollars appreciation today rases the expected dollar return
the
future.
in
iate
deprec
to
ed
expect
is
deposits hy increasing the rate al which the dollar
causes
Figure 14-6 shows the effect of a rise in the euro intcrest rate Rc. This change
euro
on
return
dollar
the downward-sloping schedule (which measures the expected
t
rate
interes
euro
deposits) te shift righlward. (To sec why, ask yourselfhow a rise in the
ed
expect
alters the dollar return on euro deposits, given the cuiTent exchange rate and the
future rate.)
is the
At the initial exchange rate E,. the expected depreciation rate of the dollar
on
that
s
now
exceed
ts
deposi
euro
on
rcturn
ed
same as before the rise in R, so the expect
ate
the
elimin
to
to
(frorn
E,)
rises
E,
dollar deposits. The dol]ar/euro exchange rate
t the
excess supply of dollar assets at point 1. As before, the dollars depreciation agains
of
rate
dollar
ed
the
expect
ng
euro eliminates the e\cess supply of dollar assets by Ioweri
iation
deprec
a
relurn on euro deposits. A rise in European interest rates therefore leads lo

C HAPTEIR

I --I

Lahin

1
c IZiIcs anil the 1oriiii Ixchanc M.iiket An Asset Appio.ich

343

Figure 14-6
Effect of a Rise in the Euro Interesi Rate

Exchange rate,

A rise in the intere) rite pid hv cuo

deposits -iuses the dollar to depreciate
mm
(pomI 1)10 E (pomI 2). ([bis

figure a Rc desciihes the effeci o) i rise

thm (xpecIecI lulure S/C exchan;e mite.

Dollar return

mi

Rise in euro
interest rate

euro return

5
A

Rates of return
(in dollar terms)

il

oC the dollar against the euro or, Iooked at from the European perspective, an appreciation
of the euro against the dollar.
Our discussion shows thai. all else equal, (UI ,,icreos in the int(rext paid mi deposits o,t
(i currencv causes tliat currencv to uppreciate cu,(u,I.vtforeign
Cn rrencies.
Before we conclude that the newspaper account of the effect of interest rates on
exchange rates is correct. .e inus rernember that our assumption of a co,istant expe.cted
future exchange rate often is unrealistic. In many cases. a change in interest rates will
be accompamed by a change in the expected future exchange rate. This change in the
expected future exchange rate wilI depend, in turn, on the economic causes of the interest
rate change. We compare different possible relationships between interest rates and
expected future exchangc ratcs in Chapter 16. Keep in mmd for now that in the rea! world,
we cannot predict how a given interest rate change wiIl altcr exchange rates unless ve
know whv the interest rate is changing.

The Effect of Changing Expectations

on the Current Exchange Rate
Figure 14-6 may also be used to study the effect on todays exchange rate of a rise in the
e\pected future dollarleuro exchange rate. Ei.
Given todays exchange rate, a rise in the expected future price of euros in terms of
dollars raises the dollars expected deprecialion rate. For example. if toda) s exchange rate
is $1 .00 per euro and the rate expected to prevail in a year is S 1.05 per euro, the expected
depreciation rate of the dollar against the euro is (1 .05
1.00)/1.00 = 0.05; if the expected
future exchange rate now rises to $ I .06 per euro, the expected depreciation rate also rises,
to
(1.06
1.00)/1.00 = 0.06.
Because a rise in the expected depreciation rate of the dollar raises the expected dollar
return on euro deposits, the downward-sloping schedule shifts to the right, as in Figure 14-6.
At. the initial exchange rate E,, there is now an excess supply of dollar deposits:
Euro

344

PAIRT THREE

Exchange Ratcs and Opcn-Econorny Macrocconomics

clepos,ts olier a higher cxpccted rate of returo (measured in dollar tcrms) than do doliar de
posits. The doliar theretore depreciates againsi the curo unti! equiiihrium is reached at pomi 2.
Wc conclude that. ali cisc equal. a rise in the ex,)ec!(d future excIuinge mie canNes a
rate
rive in the curreni evcha,e rate. Similar/y, a /i// in the crpccted /i,tIm cxcha,,e
cauves a /i11 in the curreni exchange rate.

Case Study
What Explains the Carry Trade?
Over rnuch of the 20()Us, .Iapaiicse ycn intciest rates wcre dose tu iero (a Figure 14-2
shows i whiie Atisiralia\ intercst raies we e comkniah! positive, clirnhing Lo aver
7 percent per year bv the spring ai 2(HIX.
\/hiic i niight ihicieioie ha e appeaicd it
proceeds
m yen and n est
tractive lt
paritv
interesi
(hie
huIRis.
duilii
in Austraiian
lunIi
tritee\
ueh
a
cnditkn InpiIe thai
not be .%v.1cma1i(-a//v profitable: i )n a\cragc.
shouidn t Ik interest ad antage ai Australian
duilars [c iped out by relative appieciat
of 1w yen?
N nici heiss. narlset ra r ranging troni
pioa ecd hedge
housewives Lo
and driving
doiiars
Australian
hiak did in fact pursue this strategy. mnvesting billions in
generali).
Moic
that currencys value up. rather than down, against the yen.
internationai investors frequently borrow lowinterest currencies (calied funding cur
rencies) and buy high-iiterest currencies (called investment currencies), with results
that can be prottahie over long periods. This activity is caiJed the carrv ira1e, and
while it is generaliy impossible to docunient the extent of carry trade positions accu
rately. they can become very Jarge when sizable international interest differentials open
up. Is the prevalence of the carry trade evidence that interest parity is wrong?
The hoiiest answer is that while interest parity does not hold exactly in practicein
pan because of the risk and liquidity factors mentioned aboveeconornists are stili
working hard to understand if the carry trade requires additional explanation. Their
work Is likely to throw further light on the functioning of foreign exchange markets in
-

particular and financiai niarkets in generai.

One important hazard of the carry trade is that investment currencies (the high-inter
est currencies that carry traders target) may experience abrupt crashes. Figure 1-1-7
iilustrates this feature of foreign exchange markets, comparing the cumulative retum to
investing Y100 in yen bonds and in Australian doliar bonds over different investment
horizons, with the initial investment being made at the start of 2003. As you can see,
the yen investment yields next to nothing, whereas Austrailan dollars pay off hand
somely, not oniy because of a high interest rate but because the yen tended to fail
against the Australian dollar through the summer of 2008. But in 2OO the Australian
dollar crashed against the yen, failing in price from \t104 yen to oniy 66l yen between
July and Decernber. As Figure 14-7 shows, this crash did not wipe out the gains to the
carry trade strategy entirelyif the strategy had been initiated early enough! Ofcourse,
anyone who got into the business late, for exampie. in 2007, did very pooriy indeed.
Conversely, anyone savvy enough to unwind the strategy in June 2008 would have

trt:

1 4

yCl1;Iflc Rutcs

and the

Forciiii

Ixchanic Markct: Aii Assel JPP.iCI1

345

investment return

2003

2004

2005

2006

2007

2008

2009

2010

Figure 14-7
Cumulative Total Investment Return in Australian Doflar Compared to
Japaiwse Ven, 200 201 O
lhc Austrdhan Iull, yn ( arry trade h,is btin a iitinl on vcrage bui
is LIhLt In i,ddn larg r(v(rsb
j
as in 200t.
Soiir e:

raie5 and threv-niuiirh treasury yieids (rom Globai Fiiianci.ii Data.

dnuhled his or It money in tive and a hiIt

The c;nt\ trade is ohviousI a very

risky husiness.
\Ve can gain some isih: into this pattern h imagining tho Investors expect
a grad
tial I peeLnt annual appreciation ol the Ausiralian dollar to occur with
hgh pmhahility
(say. 90 percent) aiid a big 40 percent depreciation to occur with a 10 percen
t prohahil
ity. Then the expected .ipp t; nt rate of the \uli tIian dollar is:

hxpeciedappreciation

0.)

X I

--

((LI

X 40

3.1 pcrcent per vear.

The negative expected appreciation rate means that the yen is actuail
y expected to
appreciate on average against the Australian dollar. Moreover, the probab
ility of a
occurring in the first five years of the investment is only i (0.9 =
)
10.59 = 41
percent, less than 9
ffty-fifty. The resulting pattem of cumula
tive returns could easily look
much Iike the one shown in Figure 14-7. Calculations hke these are
suggestive, and
although they are unlikely to explain the fuJI magnittide ofcarry trade returns
, researchers
have found that investrnent currencies are particularly subject to abrupt crashe
s, and fund
ing currencies to abrupt 0
appreciations.

1f crashes aic independent events over time, the probabilit that a crash does
9
not occur over Ove ye,lrs is
Thereiore. the robabihty that a crash docs occur in the fivc-year period
is i (0.9)

See Markus K. l3runnermeier. SteIin Nagel, and Lasse Il. Pedersen,

Carry Trades and Currency Crashes.
NBER Mac,occo,io,nics Annua! 23 (2008).
pp. 313347. Thcse Ondings are consistena with the apparentl grealer
empirical success of the interest parity condition over rclatively long periods, as
docuinented by Men7ie Chino.
The (Panini) Rehabditation of lnterest Rate Panity in the Fioating Rate
Era: Longer Honizons, Alternative
Expectations. and Emerging Markt.t. bui-no! afl,uernatio,iu! Mantv
nnd Financt 25 (Fehruary 2006). pp. 721.

346

PART TH REE

Exchiigc IZ.ilcs ind Opeii-Lconomy Macroccononiics

cxplaitations IlaSe(l L)iI iisk aI)LI lltjtlidity eoiideiatiuiis Ikl\e alN(

i;,jkl, I Lrir\. whidi
bern advaiiccd. (.)tten. ahiupt eurrency Ilio clnelIts urelli durine
il. I.rI\ valu
l
l.ash
iktnd
iiic1
luI
tcin
all. situations iii whiuii 0111cr \4raldl is
paia! III and
is
CX(ELI
are
ju.itlti
trade
abie. In such eirCuiisi ner. Iaie losscs l)l eilrry
moie ahoui
inuch
say
wiiI
We
may torce tradcrs Il) seil other asscts iley ov. a ai a Ius.
o! Lt.
pe
tt
clolIr
cri.es in later rhapteis. but WC note br IiOW tIlII IR AL1S(ratliln
20(18 oucurred in the iuidst o! a cvere gloh.I Iiiancial u-a
sibie br in
Vvhen hig carry iride posiiins emerge, the governtnent o! til_iaIs respon
Icrnatiilial ccononic p iieies ofien lose 1cep. In Iheir rarlv phase. carry iride dynam
ucr
iii aol hiiild up r\er
iCs viii (Irive investment eurrencies hihei is iiivesiors pile
erish
the
makes
This
eurreiicy.
nent
investi
cxposurcs io a sudden depreciation of the
buiding
bigger when it occurs. as wrongIooted investois all scramhe iii rrp iheii
i Iitv
pussib
tlw
I
\el
as
al.
as
gran
y
iotns. lite result is ueLer exchange rate olatiiii In
.
ad
s
rknis
bond
of hig trader usses with negative repercnssions in sioL narkni
(oinpIeicntaiv

in i rkct s h r in terha ik i

i in

SUMMARY
ys
i. An e.vchange rate is the price o! one countrys currency in terins of another countr
us
to
enable
they
e
becaus
ns
ng
decisio
currency. Exchange rates plav a mie in spendi
ia
deprec
a
equa!,
else
All
translate differeni countries prices into comparabie terms.
tion of a countrys currency against foreign currencies (a rise in the home cuency
i e.
prices of foreign currencies) makes its exports cheaper and its imports more expens
curren
An appreciatiol? of i(s currency (a fai! in the home cunency pnces of foreign
cies) makes its exports more expensive and its imports cheaper.
pants
2. Exchange rates are deterrnined in theJoreign eschange ,narket. The major partici
in
ai
financi
k
nonban
ations,
corpor
tionai
interna
in that rnarket are commercia! banks,
the
mar
l
in
roie
pivota
a
play
banks
erciai
stitutions. and nationai central banks. Comm
make
ket because they facilitate the exchange of interest-bearing hank deposits. which
takes
ge
trading
exchan
up the bulk of foreign exchange trading. Even though foreign
logy
n
techno
nicatio
piace in many linancial centers around the world, modem commu
impor
iinks thosc centers together mio a singie market that is open 24 hours a day. An
which parties agree to
,
tant category of foreign exchange trading is/orward tradiig in
t,
exchange currencies 00 some future date at a prenegotiated exchange rate. In contras
opot trades are settled immcdiately.
riately
3. Because the exchange rate is the relative price of two assets, it is most approp
an
is
that
pricing
asset
le
of
princip
thought of as being an asset price itself. The basie
all
ting
evalua
In
power.
sing
assets current value depends on its expected future purcha
the
which
at
rate
the
assei. savers look ai the expected rate of rcturn it offers, that is,
is possible to incas
value of ai investinent in the asset is expected to rise over time. lt
in
tire an assets expected rate of return in differeni ways. each depending on the units
which the assers value is measured. Savers care about an assets expected rea! rate f
tsaac Kieshchelski. and
11 Bruunernieier et li.. iind.. as well as A. Crair Bui-nside, Madia Iiichenbaum.
See
Paper 1-1054. Nalional
Workinr
Tide?
Returis
the
Carry
tu
the
Expbain
Scozia T. Rebebo. Do Peso Prohlens
ttureau of Leonome Research. June 200i.

C HAPTER i -i

Exchange IZatcs and the Forciin Exchangc i..larkct: An Asset Appio

ach

347

i-elio-a, the rate al which ils value expressed in terms oI a represe

ntative output basket
ix expeeted io rise.
4. When relative assei returns are relevant. as in the foreign
exchange market, il ix
appropriale (o compare expected changes in assets curren
cy values. provided those
alues are expressed in the sante currency. lf uiskand Iiquidi
tv fuctors do noi strongly
influence the demands for foreign currency asscts,
PirticiIJaIts in the Ioreign
exehange market always prefer to holcf those assets yielding the highes
t expected rate
of rettin.
5. The returns on deposits traded in the foicign exchange market depenci
on 1111 LresI rates
and expected exchange rate changes. To compare the expected rates
of return otlercd
by dollar and euro deposits. tor example, the return on euro deposits
rnust be expressed
in dollar terms hy adding to the euro interest rate the expected rate
c/d(pre(-ui!ioi1 ot
the dollar againsi the euro (or rate ofappreciation of the curo agains
t the dollar) over
the deposits holding period.
6. Equilihrium in the foreign exchange market requires miei-est paril\;
that ix, deposils of
al I currencies must offer the same expected rate of return when returns
are measured in
coniparable terms.
7. For given interest rates and a given expectation of the future exchan
ge rate, the interest
parity condition tells us the current equilibrium exchange rate. When
the expected
dollar return on euro deposils exceeds that on dollar cleposits. for exarnp
le, the dollar
immediately depreciates against the euro. Other things equal. a dollar
depreciation
today reduces the expected doliar return on euro deposits by reducin
g the depreciation
rate of the dollar against the euro expected for the future. Simiiarly,
when the expected
return on euro dcposits ix below that 011 dollar deposits. the doliar must
immediatelv
appreciate against the euro. Other things equal, a current apprec
iation of the dollar
makes euro deposits more attractive hy increasing the doliars expect
ed future depreci
ation against the Furopean currency.
8. All cisc equa]. a rise in dollar intercst rates causes the dollar to apprec
iate against the
curo while a rise in euro interest rates causes the doilar to depreciate
against the euro.
Todays exchange rate is also altered by changes in its expected
future Ievel. If thcre
is a rise in the expected future le\el of the dollar/euro rate, tor
example. then at
unchanged interest rates. todays dollar/euro exchange rate xviiI also rise.

KEY TERMS
appreciation. p. 322
arbitrage. p. 326
deprecialion, p. 322
exchange rate. p. 320
fore[gn exchange rnarket. p. 324
trward exchange rate. p. 327

PROBLEMS

inierhank trading, p. 324

inieresi parlty
condition, p. 337
mlerest rate, p. 332
liquidit3, p. 332
rate of appreciation. p. 336

rate of depreciatiori, p334

rate ol return, p. 329
reat rate of return, p. 329
risk, p. 332
spot exchange rate, p. 326
vehicte currency. p. 326

Du9econIab
1. In Munich a bratwurst costs 5 euros: a hot dog costs S4at Boston
s Fenway Park. At
aii exchange rate of $ 1.05/per euro, what ix the price of a bratwurst in
terrns of a hot
dog? All else equa!, how does this relative price change if the dollar
depreciates to
l.25 ier euro? Compared with the initial situation, has a hot dog becom
e more or
less expertsive relative to a bratwurst?

348

PAT 1

-i

Exchii-ige IZ.itcs iiitl ()peii-Ccoiiomy lIacroccononiics

lor
2. A U.S. dollar costs 7.5 Norweg,an kruner, htit the same dollar can he pLirchased
rate?
ge
exehan
frane
Swiss
krone/
gian
I .25 Swiss trancs. What is the Norwe
dullars. The
3. Peiroleum is soli! in a world market .ind iends lo he prieed in U.S.
iuanufaekir
in
tise
tu
Nippon Steel Chemical Group ol Japan must impuri iietroleuin
clepreciates
the
yen
i1s1 and other juodtiets. l1o are its pn)tits afteeted when
ilgai nst lite dullar?
4. Caleulate the dollar rates of relurn un the following asscls:
a. A painhing whose PIee rises lrom $200.000 to $250.000 in a year.
price
b. A bottie of a rare Burgundy. Domaine de la RomaneConti 1978, whose
2014.
and
2013
n
riscs from $255 lo $275 betwee
s is
e. A 10.000 depusil in a London bank in a year when the inlerest rate un pound
per
1.38
tu
pound
$
per
1.50
IO percent and the $IE exchange rate moves from $
pound.
ri if the
5. What would be the real rates of return on the assets in the preceding questio
e in
price chLmges deseribed were accompanicd hy a simtiltanem,s IO pcrcent increas
all dollar priees?
the same,
6. Suppose the dollar interest rate and the pound sterling inlerest rate are
exchange
rium
$/
t
equilih
curren
the
n
n
betwee
5 percent per year. What is the relatio
ge rate,
$/1
exchan
future
ed
expect
the
se
rate and its expected future levei? Suppo
t per
percen
10
tu
rises
t
rate
$ 1.52 per pound, rcmains cunstani as Britains interes
$/
rium
new
equilib
year. lf the U.S. interest rate also remains constant. what is the
exchange rate?
decline in
7. Traders in assel rnarkets suddenly Ieaii that the interesi rate un dollars iil
effect
the near ftiture. Use the diagrammatic analysis of this chapter tu determine the
and
dollar
un
t
rates
inleres
i
curren
ing
assum
rate.
ge
un the curreni dollar/euro exchan
curo deposits do not chaif!e.
foreign cx
8. We noted that we could have developed our diagrarnrnatic analysis of
euro/dollar
the
with
,
Europe
change market equilibrium from the perspeclive of
l
at
vertica
le
R IO indicate
exchange rate Ec,s(= 1/Es,) un the vertical axis. a schedu
g how the
showin
the euro return un curo deposits. and a downwardsloping schedule
of equi
euro return un doliar deposits varies with Ec,s. Derive this alternative picture
ed
libriurn and use it to exarnine the effeet of changes in interest rates and the expect
future exchange rate. Do your answers agree with those we found earlier?
ars
9. The following report appeared in the Neu York Tinies on August 7, 1989 (Doll
Strength a Surprise. j). Dl):
But now the senirnent is that the ecunorny Is heading lor a soft landing. with
the econumy slowing significantly and inflation suhsiding. but without a i-ecession.
This outlook is good for the dollar for two reasons. A soft Janding is not as dis
ruptive as a recession. so the foreign investments that suppuri the dollar are more
likely to continue.
Also, a soft landing would noi force the Federal Reserve tu push interesi rates
re
sharply 1oser io stimulate growth. Falling nterest rates can put downward pressu
Iess
ies
un the dollar hecause they make investmems in dollar-denominated securit
sm
attractive tu lreigners, prompting the selling uf dollars. In addition, the optmi
re
sparked by the expectation of a soft landing can esen offset some of the pressu on
the dollar from lower interest rates.
chaptefs
a. Show how you xould interpret the third paragraph of this report using this
mode! of exchange rate determination.
the
h. What additional factors in exchange rate determination rnight help you explain
second paragraph?

F HA PTL R

.--

-.

1 4

li in

Itt.%

md thI. I oi ir,n I xdi in M iii

.

it

An Asst Appi O i.h

IO. Suppose the dol lar exehange rales ol the euri and the yen are equally
variable. The
euro. however. tends io depreeiate unexpcctedly againsi the doliar when the
return un
the lesi of vour wealth is unexpectedly high. while the yen tends tu apprec
iate unex
pectedly in the sanie circumstances. As a U.S. resident, which curren
cy. the euro or
the yen. would yoii consider riskier?
11. Does any ol the diseussion in this chapter Iead you tu believe that dollar
deposits may
have Iiquidity charaeteristics different from those of other currency
deposits? If so,
Iiow wonld the ditThrences afict the inlerest diferential hetween,
say, dollar and
Mexican peso deposiis? I)o you have any guesses ahout how
the liquidity of euro
(Ieposits niay be ehanging over time?
12. In October 1979. the U.S. central hank (the Federal Reserve System
) announced it
would play a less aclive mie in limiting 1uctuations in dollar inteies
t rates. After this
new policy was put into effect. the doilars exchange rates against foreign curren
cies
became more volatile. Does our analysis of the foreign exchange rnarke
t suggest any
connection between thcse two events?
13. Imagine that everyone in the world pays a mx of T percent on interest earning
s and on
any capital gains due tu exchange rate changes. How would such a tax aiter the
analy
sis of the interest
condition? How does your answer change if the tax applies to
interest earnings hut no! tu capital gains, which are untaxed?
14. Suppose the one-year Corward $/ exchange rate is $ 1 26 per euro and
the spot
exchange rate is $ 1.2 per euro. What is the forward prernium on euros (the forwar
d
discount un dollars)? What is the difference hetween the interest rate on
one-year
dollar deposits and that oti one-year euro deposits (assuming no repayment
risk)?
15. Europes singie currency. the euro. was introduced in January 1999.
replacing the
currencies of Il European Union members, including France, Germa
ny, Italy, and Spain
(hut not Britain; sec Chapter 20). Do you think that. inimediateiy after the euros
intro
duction. the value of lreign exchange trading in euros was greater or less
than the euro
value of the pre 1999 irade in the 11 origina) national cuiTencies? Explain your
answer.
16. Multinationals generally bave production plants in a number of countries. Conse
quently,
they can move production from expensive locations tu cheaper ones in respon
se tu vari
ous economie developmentsa phenomenon called outsoinving when a domes
tically
based lrm moves part of its production abroad. If the dollar depreciates. what
would
you expect to happen lo outsourcing b American compames? Explain and provid
e an
example.

FURTHER READINGS
Sani Y. Cross. Ali ilboiti 1/le Foreign E.vc/;an. Mai*et in the United Staws. New York:
Fedcral
Reserve Bank of New York. 1998. Prinier on the niarkct.
Fcderat Reserve Bank of New York. The iasic-s 0/ Foreign Tiutie and
Exchwo,1. ai http://www
.ny.frb.org/education/fx/index.html. Broad-ranging but highly accessible accoun
t ot exchange
markets and their rote. Also supplies many uselul Web links.

Philipp I-lartniann. Currenr Competinon and Forcign EcIiangc ,Wa*eis: The Do/im;
the Yen md the
Euro. Cambridee: Cambridge University Press, 1999. Thcoreticai and empirical micro-orienie
d
study of the tole of internationai currencies in ;ortd trade and assct markets.
John Maynard Keynes. A Traci on Moneta;) Reftrin, Chapter 3. London: MacMillan,
1923. Ciassic
anaiysis of the forward exchange markei. and covered interest parity.
Paui R. Kmgman. The Intemational Role ol the Doliar: Thcory arai Prospect, in
John E O. Bilson and
RichardC. Marston. eds. Evehwi,c Rate Theorv and Practku. Chicago: University ot
Chicago Press.
1984, pp. 26 1278. Theoretical and empiricai anaiysis of the doilars position asanin
ternationai
money.

350

Exc1iingc Ratcs aiicl Opcn-[coriomy Macrocconornics

PAPT TH REE

I v ich Infrrmiti,nul Jimuic 1(11 Mu,leis: Prh c.t miti Pulii ics. 2nd ed i ion Boston: I rwi n
I uens oli i Ie li min eXcli;ine
McGraw I-i 1. 201)1 Chapieis 35 (ti this Ci tiuprchensive

Richaid M

iriarket
Press, 2001
Rielard K. Lyons. The Mhms!,uciu,e Appiom li io Lxeiu,,,t,e R.uh. Cambridge: Mli
cxcliange
ktreign
0w
m:irkets
oF
nie
struci
ti
the
ne
un
ise
trcat
\dvanced
Ronaid I Me Kinnon Minie in hiuj,iniicnujl E.vchn,,t: un (o,iie,iihle ( urri,ii .StNh,,,. New
the
Yoik: Oxtrd Universiiy Press, l91) Theureticat and nsiiiiitktiial aiialysis ol the piace (ti
ions.
Ioreign exehange markct ti inLernal ional monetary relai
Foieign
Michael Mussa. Empirica! Regu Lirii ies in the I3eliavior of Ixchaiige Rates and I heories o! the
cmd
Pritev
,
iet
Eniiovnieii
/r
eds.
Pulii
Meltier.
lan
i-I.
Exehange Markei. n Karl Brunner and AI
North
Amsterdam:
Il.
Policy
Publie
on
Series
Conierenee
ochester
L.v(ha,l,i,( Raies, CarnegieR
rate
I-lotiand, )79. pp. 9_57. Fxamines the empirica! basis oF the assct price approaeh io exchange

determinaI mn

Risk.
David Sawyer. Continuous Linked Seitlemeni (CLS) ami Foreign Exchange Settietueni
and
of
functioning
the
Descrihes
Finiineiul Siohilitv RLiico 17 ( December 2004), p 5692.
exehange
loreign
of
settlement
rapid
0w
rationale 0w the Coniinuous Linked Seitlement system
transactions.

2nd edition. New York: John Wiley

the Iieiun exch;inge narket.
ol
instltutions
ami
tcrminology
the
on
1,asie
text
and Sons, 2000. A

Julian Walmsley. The Fonigii EvcIuo,e tiiid Monev Markeis Gnu/e,

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yoln tudy tinie, and

Io

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APPENDIX

T1J

14

CHAPTER

Forward Exchange Rates and Covered

Interest Parity
This appendix explains hov Iorvard exehange rates ave deermined.
Under the assumplion
that the interesi parity condition aways holds, a torward exchan
ge rate equals the SI)Ot
exchange rate expecled to prevail ori the forward contracts value date.
As the lirsi step in the discussion, we pomi ora the dose connection
among the lorward
exchange tale between two currencies. theii spot exchange rate. and the
interest rates on
deposits denominated in those currencies. The conncction ix descrih
ed by the co iered
interesi paritV coridition. which is similai io the (nonco
vered) interest parity condition
detining foreign exchange markct equilihrium hut involves the forwar
d exchange rate
rather than the expected future spoi exchange rate.
To be concrete, ve again consider dollar and euro deposits. Suppose you
want to huy a
euro deposit with dollars hut would like io be (ertain about the numhe
r of clollars it will be
worth ai the end of a year. You can avoid exchange rate risk by buying
a euro deposit and,
at the same time, sei iing the proceeds of your invextment forward. When
you huy a euro
deposit with doiiars and at the same time seil the principal and interes
t forward for doliars,
we say you have covered yoursclf, that is. avoided the possih
ility of an unexpected
depreciation of the euro.
The coered interest parity condition slates that the rates oC return
on dollar deposits
and covered foreign deposits musi be the same. Ari cxample wiH clarify
the meaning of
the condition and illustrate why it musi alway.s hoid. Lei
F,c stand for the oneyear
forward pice of curos in terms of dollars. and suppose F
1 = $ 1.113 per euro. Assume
that at the same time, the spot exchange rate E = $1.05 per
euro, R = 0.10, and
0.04. The (dollar) rate of return un a dollar deposit ix ciearly 0.10, or
Rc
10 perceni. per
year. What is the rate of returri ori a covered euro deposit?
We answer Lhis question as we clid in the chapter. A i deposit costs
5 1 .05 today. and
it ix worth 1.04 after a year. Jf you seli 1.04 forward today at
the forward exchange
rate of $1.113 per euro, the dollar value of your in estment at the
end of a year ix
($1.113 pereuro) X (1,04)
$1.158. The rate of return on a covered purchase of a
eurodeposit is therefore (1.158
1.05)J1.05
0.103. This 10.3 percent per year rate of
return exceeds the iO percent offered by dollar deposits. so covered interes
t parity does noi
hold. In this situation, no one would be willing io hold dollar deposi
ts: eeryone would
prefer covered euro deposits.
More formally. e can express the covered return on euro deposits as
(
5
F
1 I + R)

which ix approximately equa! io

351

352

FAi1 THREE

Exchangc Ratcs

and Opcii-Econorny Macrocconornics

Eic )/IZ, is a smali number. The covcreil interesi panly

1
when the produci I?( >< (F,
condition can therelore be viitLen
R,

514
I? (E

The quantily

Eq )/Es,:

dis
is cal]ecl the fnirard premino? on euros against doliars. (lt is aiso calicd the flirnard
interest
eovered
the
state
colli?! on dollars against euros.) Using this terrninology, ve can
ivte O??
parity condition as lollows: Thc interest la/e on dal/ar depovits equals I/le i Uerest
on
di,vcounl
(1111 tonlard
CUPO dIdpoviIs p/u.c the fornard prenulini on eiiro.s aiunv1 cloI/arv
clollars againsi CIIPOS).
for
There is strong empirical evidence that the covered interest parity condition holds
currency
Indeed,
center.
financial
singie
a
within
issued
dilYerent foreign currency dcposits
interest nites
traders often set the torward exchange rates they quote by iooking al current
12
from
Deviations
formula.
prity
and spot exchange rates and using the coveied interest
in
iocated
are
compared
covered interest parity can occur. however, if the deposits being
may
governments
different countries. These deviations occur when asset hoiders fear that
nationai
impose reguiations that wili prevent the free movement of foreign funds across
there
borders. Our derivation of the covered interest parity condition imp]icitiy assumed
banks
that
fears
oF
because
also
occur
can
Deviations
kind.
was no politica! risk of this
wiil fai!. making them unable lo pay off large deposits.
By comparing the (noncovered) i nterest parity cond ition.
5
R

1
R + (E

true at
with the covei-ec interesi parity condition, you wilI lnd that hoth conditions can be
exchange
the sarne time only if the one-vear forward $/ rate quoted today equals the spot
rate ieople expect Lo matenalize a year from today:
F

a date in
This makes intuitive sense. When two parties agree to trade foreign exchange un
on that
prevali
to
expect
the
rate
the future, the exchange rate they agree on is the spot
be
should
transactions
date. The irnportant dilference between covered and noncovered
whereas
risk,
rate
kept in mmd. however. Covered Lransactions do not involve exchange
14
noncovered transactions do.
is pro ided b Frank McCormick in
12 evdence supportin1 the covered intere? parlly condition
Empirical
PoIitcal Econoon 87 (Aprii 1979).
o/
.hurnul
Commcnt,
Prolits
Unexpioited
Arbitragc-:
Interest
Covered
Interesi Arbitra_ce: Theor and
Covered
md
Costs
pp. 411417. and 1y Kevin Clinton in Transaction
358370.
i9$8.
pp.
96
(Aprii
Lconono
ical
1i idence. Juurnal of Poli
rarket, sec Rohert Z .Aliber,
For a more detaiied diseussion ot the mie ol politicai risk in the forward exchange
13
eceniber 1973).
81
(November/D
Lio,u;n
oJPolil,ccil
Jounial
tion,
The interesi Parity Theorem: A Reintcrpret:i
inovenient can uso cause
er
mone)
cio.shord
00
retnction
iovemment
uclual
coerse.
01
.
14511459

deviiitions troni cosered interest panty.

cos ered interest panty des ialions. On the feai of bank tiiilure as a cause br
interest Parity Dudni the Financiai
Coscred
from
Deviations
interpretiniz
incker.
ank
r
2
sec Naohiko Baba mci t
Settlements. December 2008. The
Maiket Turmod of 20072008. Workin Paper No. 267, Bank for intcmationai
21
Chapler
in
cvents unclerlying lhis msI paper are discussed
hile a useful siniplificution. inay noI
We indicated in the text that the (noncovcred) mterest parity condition.
14
forcgn exchange market. Thereforc.
the
in
dcrnands
aiways luold exactly if the riskiness o? currencies iniluences
even if coicd irilerest p:irir hoJdnsk
Iuctor
hy
a
Cute
spot
future
expccted
the
fiorn
the ftwward rate may difiir
more fully in Cbapter 8.
discussed
is
true. As noted earlicr. the role of risk in exchange rate detcrrmnation

C IAPTER

1 4

Exchame R.ites

atRi

the ioieitn Exciiange Mar ket: An Assct 1

Ap
r
oach

353

The theorv of covered inieresi par)Iy helps expiai the eluse correla
tiun helween the
mo\emenis in spoi and IorwnL1 exchange rates shown iii Figure 141
a correlation typical
ol all major cLirrencies. The unexpccwd economie events (hai afTect expcc(
e(l aSse( returns
ohcn have a rciatively sinai) efFeci on internatiotial interest rate di tTeren
ces between
deposits with short malurities (for example. three nonths). Tu nainta
in covercd interesi
parity, lherelore. spot and forward nitcs br the corresponding maturi
tics musi change
roughIy in proportion tu each other.
Wc conclude this appendix viili one luriher application o) the covere
d inicresi parity
condition. To illustrate the role ol borward exchange rales, the chapte
r used the example of
an Arnerican importer ol .lapanese radios anxious about the $N exchan
ge rate it wouid
lice in 30 days when the time carne to pay the supplier. In the examp
ie, Radio

Shack
solved the prohlem by seliing forward for yen enough dollars tu cover
the cost of the
radios. But Radio Shack could have solved the prohlem in a different,
more compiieated
way. It could have (1) borrowed dollars from a hank; (2) sold those dollars
immediately
for yen ai the spot exehangc rate and piacerI the ycn in a 30day yen hank
deposit; (3) then,
afier 30 days, used the proceeds ol the maturing yen deposii to pay the Japane
se supplier;
and (41 used the realized proceeds of the U.S. radio sa)es. less prolts. io repav
the origina)
dollar loan.
Which course of actionthe forward ruiciiase o! yen or the sequence of
four transac
tions described in the preceding paragraphis more profitable for the import
er? We leave
it to you. as an exercise, tu show that the two strategies yield the same prott
when the
covered interest parity condition ho]ds.