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International Finance
When you have completed your study of this chapter, you will be able to
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CHAPTER CHECKLIST
1 Describe a countrys balance of payments accounts and explain what determines the amount of international borrowing and lending.
2 Explain how the exchange rate is determined and why it fluctuates.
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Table 34.1 on the next slide shows the U.S. balance of payments in 2010.
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Net Exports
Private sector balance is saving minus investment. Government sector balance is equal to net taxes minus
government expenditure on goods and services. Table 34.2 on the next slide shows what determines net exports.
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The foreign exchange rate is a price and, like all prices, demand and supply in the foreign exchange market determine its value.
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The exchange rate influences the quantity of dollars demanded for two reasons:
Exports effect Expected profit effect
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rises, the quantity of dollars demanded decreases along the demand curve for dollars.
2. If the exchange rate falls,
the quantity of dollars demanded increases along the demand curve for dollars.
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Other things remaining the same, the larger the U.S. interest rate differential, the greater is the demand for U.S. assets and the greater is the demand for dollars on the foreign exchange market.
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Other things remaining the same, the higher the exchange rate, the larger is the expected profit from selling dollars and the greater is the quantity of dollars supplied in the foreign exchange market.
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rises, the quantity of dollars supplied increases along the supply curve for dollars.
2. If the exchange rate
falls, the quantity of dollars supplied decreases along the supply curve for dollars.
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Market Equilibrium
Demand and supply in the foreign exchange market determines the exchange rate.
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The net return on the Canadian dollar deposit is 3 percent (5 percent minus 2 percent) a year.
Interest rate parity holds.
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If the U.S. interest rate rises relative to those in other countries, the value of the U.S. dollar rises on the foreign exchange market.
If foreign interest rate rises relative to U.S. interest rate, the value of the U.S. dollar falls on the foreign exchange market. So the exchange rate responds to monetary policy.
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The Fed can try to smooth out fluctuations in the exchange rate by changing the supply of U.S. dollars.
The Fed changes the supply of U.S. dollars on the foreign exchange market by buying or selling U.S. dollars.
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Why Has Our Dollar Been Sinking? Our dollar has been on a falling trend since the early 2000s but it hasnt always been sinking. A Rising Dollar: 19992000 Between 1999 and 2000, the dollar appreciated against the euro. It rose from 0.86 euros to 1.17 euros per dollar. Figure 1 on the next slide explains why this happened.
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Why Has Our Dollar Been Sinking? In 1999, the demand and supply curves were those labeled D99 and S99. The equilibrium exchange rate was 0.86 euros per dollarwhere the quantity of dollars supplied equaled the quantity of dollars demanded.
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Why Has Our Dollar Been Sinking? During 2000, the U.S. economy expanded faster than the European economy. The interest rate in Europe was 2 percentage points lower than the U.S. interest rate. The euro was expected to depreciate against the dollarthe dollar was expected to appreciate against the euro.
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Why Has Our Dollar Been Sinking? With a positive U.S. interest rate differential and the dollar expected to appreciate, the demand for dollars increased from D99 to D00 and the supply of dollars decreased from S99 to S00. The exchange rate rose to 1.17 euros per dollar.
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Why Has Our Dollar Been Sinking? A Falling Dollar: 20012008 Between 2001 and 2008, the dollar fell from 1.17 euros to 0.63 euros per dollar. After 2001, U.S. economic growth slipped below the European growth rate, European inflation fell, interest rates in Europe exceeded those in the United States, and the U.S. current account deficit continued to increase.
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currency traders expected the exchange rate to fallthe dollar to depreciate against the euro.
The demand for dollars decreased to D08 and the supply of dollars increased to S08. The exchange rate fell to 0.63 euros per dollar.
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