1. International financial transactions are used for two purposes. First, there is the international trade of goods and services, such as food or insurance that people buy or sell for money. Second there is the international exchange of financial assets, such as real estate, stocks, or bonds that people also buy or sell with money. International trade between nations or the international exchange or assets differs from domestic trade or asset exchanges because the nations use different currencies. This problem is resolved by the existence of foreign exchange markets, in which the currency used by one nation can be purchased and paid for with the currency of the other nation.
2. The balance of payments for a nation is a summary of all the financial transactions with foreign nations; it records all the money payments received from and made to foreign nations. Most of the payments in the balance of payments accounts are for exports or imports of goods and services or for the purchase or sale of real and financial assets. The accounts show the inflows of money to the United States and the outflows of money from the United States. For convenience, both the inflows and outflows are stated in terms of U.S. dollars so they can be easily and consistently measured.
a. The current account section of a nation’s balance of payments records the imports and exports of goods and services. Within this section
(1) the balance on goods of the nation is equal to its exports of goods minus its imports of goods;
(2) the balance on services of the nation is equal to its exports of services minus its imports of services;
(3) the balance on goods and services is equal to its exports of goods and services minus its imports of goods and services (if the balance is positive there is a trade surplus and if it is negative there is a trade deficit); and
(4) the balance on the current account is equal to its balance on goods and services and two other “net” items (which can be positive or negative)/ First there is net investment income (such as dividends and interest) which is the difference in investment income received from other nations minus any investment income paid to foreigners. Second, there are net private and public transfers, which is the difference between such transfers to other nations minus any transfers from other nations. This balance on the current account may be positive, zero, or negative.
b. International asset transactions are shown in the capital and financial account of a nation’s balance of payments.
(1) The capital account primarily measures debt forgiveness and is a “net” account. If Americans forgave more debt owed to them by foreigners than foreigners forgave debt owed to them by Americans, then the capital account would be entered as a negative.
(2) The financial account shows foreign purchases of real and financial assets in the United States. This item brings a flow of money into the United States, so it is entered as a plus in the capital account. U.S. purchases of real and financial assets abroad result in a flow of money from the United States to other nations, so this item is entered as a minus in the capital account. The nation has a surplus in its financial account if foreign purchases of U.S assets (and its inflow of money) are greater than U.S. purchases of assets abroad (and its outflow of money). The nation has a deficit in its financial account if foreign purchases of U.S. assets are less than U.S. purchases of assets abroad. The balance on the capital and financial account is the difference between the value of the capital account and the value of the financial account.
c. The balance of payments must always sum to zero. For example, any deficit in the current account would be offset by a surplus in the capital and financial account. The reason that the accounts balance is that people trade currently produced goods and services or preexisting assets. If a nation imports more goods and services than it exports, then the deficit in the current account (and outflow of money) must be offset by sales of real and financial assets to foreigners (and inflow of money).
d. Sometimes economists and government officials refer to balance-of-payments deficits or surpluses. Whether a nation has a balance-of-payments deficit or surplus depends on what happens to its official reserves. These reserves are central bank holdings of foreign currencies, reserves at the International Monetary Fund, and stocks of gold.
(1) A nation has a balance-of-payments deficit when an imbalance in the combined current account and capital and financial account leads to a decrease in official reserves. These official reserves are an in-payment to the capital and financial account.
(2) A balance-of-payments surplus arises when an imbalance in the combined current account and capital and financial account results in an increase in official reserves. These official reserves become an out-payment from the capital and financial account.
(3) Deficits in the balance-of-payments will happen over time and they are not necessarily bad. What is of concern, however, for any nation is whether the deficits are persistent over time because in that case they require that a nation continually draw down its official reserves. Such official reserves are limited and if they are depleted, a nation will have to adopt tough macroeonomic policies. In the case of the United States, there are ample official reserves and their depletion is not a major concern.
3. There are two basic types of exchange-rate systems that nations use to correct imbalances in the balance of payments. The first is a flexible- or floating-exchange-rate system. The second is a fixed-exchange-rate system. If nations use a flexible- or floating-exchange-rate system, the demand for an the supply of foreign currencies determine foreign exchange rates. The exchange rate for any foreign currency is the rate at which the quantity of that currency demanded is equal to the quantity of it supplied.
a. A change in the demand for or the supply of a foreign currency will cause a change in the exchange rate for that currency. When there is an increase in the price paid in dollars for a foreign currency, the dollar has depreciated and the foreign currency has appreciated in value. Conversely, when there is a decrease in the price paid in dollars for a foreign currency, the dollar has appreciated and the foreign currency has depreciated in value.
b. Changes in the demand for or supply of a foreign currency are largely the result of changes in the determinants of exchange rates such as tastes, relative incomes, relative price levels, relative interest rates, expected returns, and speculation.
c. Flexible exchange rates can be used to eliminate a balance-of-payments deficit or surplus.
(1) When a nation has a payment deficit, foreign exchange rates will increase, thus making foreign goods and services more expensive and decreasing imports. These events will make a nation’s goods and services less expensive for foreigners to buy, thus increasing exports.
(2) With a payment surplus, the exchange rates will increase, thus making foreign goods and services less expensive and increasing imports. This situation makes a nation’s goods and services more expensive for foreigners to buy, thus decreasing exports.
d. Flexible exchange rates have three disadvantages.
(1) Flexible rates can change often so they increase the uncertainties exporters, importers, and investors face when exchanging one nation’s currency for another, thus reducing international trade and international purchase and sale of real and financial assets.
(2) This system also changes the terms of trade. A depreciation of the U.S. dollar means that the Untied States must supply more dollars to the foreign exchange market to obtain the same amount of goods and services it previously obtained. Other nations will be able to purchase more U.S. goods or services because their currencies have appreciated relative to the dollar.
(3) The changes in the value of imports and exports can change the demand for goods and services in export and import industries, thus creating more instability in industrial production and in implementing macroeconomic policy.
4. If nations use a fixed-exchange-rate system, the nations fix (or peg) a specific exchange rate. To maintain this fixed exchange rate, the governments of these nations must intervene in the foreign exchange markets to prevent shortages and surpluses of currencies caused by shifts in demand and supply.
a. One way a nation can stabilize foreign exchange rates is though currency interventions. In this case, its government sells its reserves of a foreign currency in exchange for its own currency (or gold) when there is a shortage of the foreign currency. Conversely, a government would buy a foreign currency in exchange for its own currency (or gold) when there is a surplus of the foreign currency. The problem with this policy is that it only works when the currency needs are relatively minor and the intervention is of short duration. If there are persistent deficits, currency reserves may be inadequate for sustaining an intervention, so nations may need to use other means to maintain fixed exchange rates.
b. A Nation might adopt trade policies that discourage imports and encourage exports. The problem with such policies is that they decrease the volume of international trade and make it less efficient, so that the economic benefits of free trade are diminished.
c. A nation might impose exchange controls so that all foreign currency is controlled by the government, and then rationed to individuals or businesses in the domestic economy who say they need it for international trade purposes. This policy too has several problems because it distorts trade, leads to government favoritism of specific individuals or businesses, restricts consumer choice of goods and services they can buy, and creates a black market in foreign currencies.
d. Another way a nation can stabilize foreign exchange rates is to use monetary and fiscal policy to reduce its national output and price level and raise its interest rates relative to those in other nations. These events would lead to a decrease in demand for an increase in the supply of different foreign currencies. But such macroeconomic policies would be harsh because they could lead to recession and deflation, and cause civil unrest.
5. In the past, some type of fixed-exchange-rate system was used such as the gold standard or the Bretton Woods system. The exchange-rate system used today is a more flexible one. Under the system of managed floating exchange rates, exchange rates are allowed to float in the long term to correct balance-of-payments deficits and surpluses, but if necessary there can be short-term interventions by government to stabilize and manage currencies so they do not cause severe disruptions in international trade and finance. For example, the G8nations regularly discuss economic issues and evaluate exchange rates, and at times have coordinated currency interventions to strengthen a nation’s currency. This “almost” flexible system is favored by some and criticized by others.
a. Its proponents contend that this system has not led to any decrease in world trade, and has enabled the world to adjust to severe economic shocks throughout its history
b. Its critics argue that it has resulted in volatile exchange rates that can hurt those developing nations that are dependent on exports, has not reduced balance-of-payments deficits and surpluses, and is a “nonsystem” that a nation may use to achieve its own domestic economic goals.
6. The United States had large and persistent trade deficits in the past decade and they are likely to continue.
a. These trade deficits were the result of several factors:
(1) More rapid growth in the domestic economy than in the economies of several major trading partners, which caused imports to rise more than exports.
(2) The emergence of large trade deficits with China and the use of a relatively fixed exchange rate by the Chinese
(3) A rapid rise in the price of oil that must be imported from oil-producing nations
(4) A decline in the rate of saving and a capital account surplus, which allowed U.S. citizens to consume more imported goods
b. The trade deficits of the United States have had two principal effects
(1) They increased current domestic consumption beyond what is being produced domestically, which allows the nation to operate outside its production possibilities frontier. This increased current consumption, however, may come at the expense of future consumption.
(2) They increased the indebtedness of U.S. citizens to foreigners. A negative implication of these persistent trade deficits is that they will lead to permanent debt and more foreign ownership of domestic assets, or lead to large sacrifices of future domestic consumption. But if the foreign lending increases the U.S. capital stock, then it can contribute to long-term U.S. economic growth. Thus, trade deficits may be a mixed blessing.
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