appreciation

.: lur- _ _ --::sed . : _-rotn

: .-:f unt .: JOr_

;.iS than f ^ -I uI€]gn - fs n-tost ..-; OeS ::

from holding foreign assets, and from unilateral transfers falls short of the amount needed to pay for imports, pay foreigners for their U.S. assets, and make unilateral transfers. If the current account is in deficit, the necessary foreign exchange must come from a net inflow in the financial account. Such an inflow in the financial account could stem from bor- rowing from foreigners, selling domestic stocks and bonds to foreigners, selling a steel plant in Pittsburgh or a ski lodge in Aspen to foreigners, and so forth.

If a country runs a current account surplus, the foreign exchange received from exports, from hold- ing assets abroad, and from unilateral transfers exceeds the amount needed to pay for imports, to pay foreign hoiders for U.S. assets, and to make uni- laterai transfers. If the current account is in surplus, this excess foreign exchange results in a net outflow in the financial account through lending abroad, buy- ing foreign stocks and bonds, buying a shoe plant in Italy or a vil1a on the French Riviera, and so forth.

When all transactions are considered, accounts must always balance, though specific accounts usu- aliy don't. A deficit in a particular account should not necessarily be viewed as a source of concern, nor should a surplus be a source of satisfaction. The deficit in the U.S. current account in recent years has been offset by a financial account surplus. As a result, foreigners are acquiring more ciaims on U.S. assets.

'.:lli lil -:

U.S. Balance of Payments lor 20A7 (billions of dollars)

Current Aecounts

i. Merchandise exports

2. Merchandise imports

3. Merchandise trade balance (1 + 2) 4. Service exports

5. Service imports

6. Goods and services balance {3 + 4 + 5} 7. Net investment income from abroad

L Net unilateral transfers

9. Cunent account balance {6 + 7 + B)

Financial Accounts

1 0. Change in U.S.-owned assets abroad

1 1. Change in foreign-owned assets in U.S.

1 2. Financial account balance {1 0 + 1 1 } 1 3. Statistical discrepancy

T0TAI (9 + 12 + 13l

LOz F*:"migre Hxa&:arage Reg*s and fufarkets Now that you have some idea about interna- tional ?lows, we can iite a ilose, iook at tna forces that determine the underlying value of the currencies involved. Let's begin by look- ing at exchange rates and the market for foreign exchange.

ForeEgn Exehemge Foreign exchange, recalI, is foreign money needed to carry out international transactions. The exchange rate is the price measured in one country's curency of buying one unit of another country's currency. Exchange rates are determined by the interaction of the households, firms, private financial institu- tions, governments, and central banks that buy and sell foreign exchange. The exchange rate fluc- tuates to equate the quantity of foreign exchange demanded with the quantity supplied. Tirpically, for- eign exchange is made up of bank deposits denomi- nated in the foreign currency. When foreign travel is involved, foreign exchange often consists of foreign paper money.

The foreign exchange market incorporates ali the arrangements used to buy and seli foreign exchange. This market is not so much a physicai place as a network of telephones and computers connecting financial centers all over the world. Perhaps you have seen pictures of foreign exchange traders in New York, Frankfurt, London, or Tokyo in front of computer screens amid a tangie of phone lines. The foreign exchange market is like an ali-night diner-it never cioses. A trading center is always open some- where in the world.

We will consider the market for the euro in terms of the dollar. But first, a little more about the euro. For decades the nations of Western Europe have tried to increase their economic cooperation and trade. These countries believed they wouid be more pro- ductive and more competitive with the United States if they acted less like many separate economies and more like the 5o United States, with a single set of trade regulations and one currency. Imagine the has- sle involved if each of the 5o states had its own currency.

In zooz, euro notes and coins entered circulation in the rz European countries adopting the common cur- rency. The big advantage of a

exchange raie the Frice fisasilieci in {}tie {:*,rilqay'ii ** rtEJriey cf pilr*h*s,ng '1 *nit *f egr':thel couilt.y's dilrrencv

-t

h l

+ 1,148.5

- i,967.9

-819.4 +491.7

- 378. 1

- 700.3

+81.7

-112.7

-731.3

* 1,289.9

+2,057.1

+767.8

- 36.5

0.0

S0URCE: "U.S. lnternational Transacti0ns Acc0unts Data," Bureau of Economic Analysis, U.S. Department of C0mmerce, Table 1. 15 December 2008, at htto:i/ www.bea.qov/international/xls/table 1.xls,

CHAPTER l9 iitictr;,irora l'l:ii 277

common currency is that Europeans no longer have to change money every time they cross a border or trade with another country in the group. Again, the inspiration for this is the United States, arguably the most successful economy in world history'

So the euro is the common currency of the euro areq, or euro zone, as the now r 6-country region is usu- ally calied. The price, or exchange rate, of the euro in terms of the dollar is the number of dollars required to purchase one euro. An increase in the number of dollars needed to purchase a euro indicates weak- ening, or depreciation, of the dollar. A decrease in the number of dollars needed to purchase a euro indicates strengthening, or appreciation, of the dol- lar. Put another way, a decrease in the number of euros needed to purchase a dollar is a depreciation of the dollar, and an increase in the number of euros needed to purchase a doliar is an appreciation ofthe do11ar.

Because the exchange rate is usually a market price, it is determined by demand and supply: The equilibrium price is the one that equates quan- tity demanded with quantitY supplied.To simpiify the anal- ysis, suppose that the United States and the euro area make up the entire world, so the demand and suPPlY for euros in international finance is the demand and supply for foreign exchange from the U.S. perspective.

The Demand fon Forelgn Exchange Whenever U.S. residents need euros, they must buy them in the foreign exchange market, which could include theirlocalbanks, payingfor them with dollars- Exhibit 4 depicts a market for foreign exchange-in this case, euros. The horizontal axis shows the quan- tiqy of foreign exchange, measured here in millions of euros. The verticai axis shows the price per unit of foreign exchange, measured here in dollars per euro. The demand curve D for foreign exchange shows the inverse relationship between the dollar price of the euro and the quantity of euros demanded, other ,- things assumed constant. Assumed constant along ! the demand curye are the incomes and preferences

-i of U.S. consumers, expected inflation in the United fi States and in the euro area, the euro price ofgoods in I the euro area, and interest rates in the United States p and in the euro area. People have many reasons for H demanding foreign exchange, but in the aggregate,' the lower the dollar price of foreign exchange, other things constant, the greater the quantity of foreign exchange demanded.

A drop in the doliar price of foreign exchange, in this case the euro, means that fewer doilars are needed to purchase each euro, so the dollar prices of euro area products (iike German cars, Italian shoes, tickets to Euro Disney, and euro area securi- ties), which list prices in euros, become cheaper. The cheaper it is to buy euros, the lower the dollar price of euro area products to U.S. residents, so the greater the quantity of euros demanded by U.S. residents, other things constant. For example, a cheap enough euro might persuade you to tour Rome, climb the Austrian Alps, wander the museums of Paris, or crawl the pubs of Dublin.

Exliil:it 4 The Foreign Exchange Market

currel1cv depreci6tion with tespect to the dsllar. an increase in the number of dallars needed tc !:urchase 1 unit of icreign exchange in a flexible rate systerTl

currency. apprecrattan with resFect to th* dollar, a decrease in the number af dollavs needed to purchase 1 unit of {ereign exehange in a flexible rat€ system

a f o

oq

* $1.30 I o E 1.25 o o) C

"E 1.2oO X U

Foreign exchange {millions of euros)

27A PART + irtientaiional Mactoeconontlc:;

I i" r^ ar',-hr-.raa a.,rac fnr,4nllryc Fl:r^.y^. yacirlantc

I want doilars to brrv {i.S. soocls ancl ser-vice.q accllit:e F IT Q rc.ar- .--,-L6'l^Dnc in /-l^11.yo ..?.6h; ,]nllcro rn

$ their U.S. friends and relatives. Euros are supplied 5 in the foreign exchange market to acquire the dol- ! tars peopte vr'ant. An increase in the doilar-per-euro I exchange rate, other things constant, makes U.S. F products cheaper for foreigners because foreign resi-L o< dents need fewer euros to get the same number of p doilars. For example, suppose a Dell computer selis ? for $Ooo. If the exchange rate is $r.zo per euro, that f computer costs 5oo euros; if the exchange rate is $ $t.rS per euro, it costs only 48o euros. The number of { Oett computers demanded in the euro area increases f; as the dollar-per-euro exchange rate increases, other o things constant, so more euros will be supplied on

the foreign exchange market to buy doliars. The positive relationship between the dollar-per-

euro exchange rate and the quantity of euros sup- plied on the foreign exchange market is expressed in Exhibit 4 by the upward-sloping supply curve for foreign exchange (again, euros in our example). The supply curve assumes that other things remain constant, including euro area incomes and tastes, expectations about inflation in the euro area and in the United States, and interest rates in the euro area and in the United States.

Setermining the Hxe$:ange Rate Exhibit 4 brings together the demand and supply for foreign exchange to determine the exchange rate. At a rate of $r.25 per euro, the quantity of euros demanded equals the quantity supplied-in our example, 8oo miilion euros. Once achieved, this equiiibrium rate will remain constant until a change occurs in one of the factors that affect supply or demand. If the exchange rate is allowed to adjust freely, or to float, in response to market forces, the market will clear continually, as the quantities of for- eign exchange demanded and supplied are equated.

What if the initial equilibrium is upset by a change in one of the underiying forces that affect demand or supplyi For example, suppose higher U.S. incomes increase American demand for all normal goods, including those from the euro area. This shifts the U.S. demand curve for foreign exchange to the right, as Americans buy more Itaiian marble, Dutch

$ iffi ,ffi " 'liliftlii. t ii laj!l1,{-$:Yffi ,ffiffii#4r3:. i;i*.i €:i::,:' il:rii!,,iliF;iiijiaiiiiiir{i:-lt+ir'i*ffiffiE

chocolate, German machines, Parisian vacations, anC euro area securities.

This increased demand for euros is shown in Exhibit 5 on the next page by a rightward shift of the demand curve for foreign exchange. The demari increase from D to D' leads to an increase in i:-= exchange rate per euro from $r.25 to $r.z7.Th'::. the euro increases in value, or appreciates, whiie -: doliar falls in value, or depreciates. An increas= -:- U.S. income should not affect the euro supply c'.il-:ii. though it does increase the quantity of euros sutr'.';i The higher exchange value of the euro prompts -'-:i.:st in the euro area to buy more American producls al: assets, which are now cheaper in terms of the e.:r,:,

To review: Any increase in the demand for icr::= exchange or any decrease in its supply, other -;-:gs constant, i.ncreases the number of dollars req'i::3: :l purchase one unit of foreign exchange, which is a :3::e- ciation of the doliar. On the other hand, any d<:ease in tJle demand for foreigrr exchange or any ::--clease in its supply, other things constant, reduces th= ::u=- ber of dollars required to purchase one unii c: i:eig'n exchange, which is an appreciation of the doiia;.

Arbltrages;rs ft ffi d Speca*l at*rs Exchange rates between two currencies are nearly identical at any given time in markets around the world. For example, the doliar price of a euro is the same in New York, Frankfurt, Tokyo, London, Zuich, Hong Kong, Istanbul, and other financial centers.

CHAFT'EF. :g jr ti:r;:it:rrra; i:lirari:t 279