A.      Foreign exchange markets enable international transactions to take place by providing markets for the exchange of national currencies.

B.   An American export transaction is explained below.

1. U.S. firm is selling $300,000 worth of computers to British firm.

2. Imagine the exchange rate is $2 = 1 Br. pound, so the British firm must pay 150,000 pounds.

3. The British firm will draw a check on its deposit at a London bank for 150,000 pounds, and will send it to the U.S. exporter.

4. The exporter sells the British check to an American bank for $300,000 in exchange for the British check, and the exporter’s account is credited.

5. The American bank will deposit the 150,000 pounds in a correspondent London bank for future sale.

6. Note the major points here.

a. Exports create a demand for dollars and a supply of foreign money, in this case British pounds.

b. The financing of an American export reduces the supply of money (demand deposits) in Britain and increases it in the U.S.

C.   An American import transaction example illustrates how a British exporter is paid in pounds while the importer pays dollars.

1. A U.S. firm is buying 150,000 pounds worth of compact discs from Britain.

2. The exchange rate remains at $2 = 1 Br. pound, so the American purchaser must exchange its $300,000 for 150,000 Br. pounds at an American bank—perhaps the same one as in the export example.

3. The American bank will give up its 150,000 pounds in the London bank to the importer, who will pay the British compact discs exporter, who will deposit the money in the exporter’s bank.

4. Again note the major points.

a. The financing of American imports reduces the supply of money (demand deposits) in the U.S. and increases it in the exporting country, Britain.

b. Imports create a demand for foreign currency (pounds in this case) and a supply of U.S. currency.

A.  A nation’s balance of payments is the sum of all transactions that take place between its residents and the residents of all foreign nations.  These transactions include merchandise exports and imports, tourist expenditures, and interest plus dividends from the sale and purchases of financial assets abroad.  The balance of payments account is subdivided into three components:  the current account, the capital account, and the official reserves account.

B.      Current Accounts is shown in top portion of Table 38.1.  The main entries are:

1. The current account summarizes U.S. trade in currently produced goods and services.

2. The merchandise trade balance is the difference between its exports and imports of goods.

3. The balance on goods and services, shown in (line 7) Table 38.1 is the difference between U.S. exports of goods and services (items 1 and 4) and U.S. imports of goods and services (items 2 and 5).

4. Balance on the current account is found by adding all transactions in the current account (item 10, Table 38.1).

5. Global Perspective 38.1 gives trade balance for other nations.

C.      Capital Account:

1. The capital account summarizes the flows of payments (money “capital”) from the purchase or sale of real or financial assets.

2. For example, a foreign firm may buy a real asset, say an office tower in the U.S., or a U.S. government bond.  Both kinds of transactions involve the “export” of the ownership of U.S. assets from the United States in return for payments of foreign currency (money “capital”) inflows.

3. The balance in the capital account was $322 billion in 1999.  (Line 12, Table 38-1)

D.      Official Reserves Account:

      The third account in the overall balance of payments is the official reserves account.  The central banks of nations hold quantities of foreign currencies called official reserves.  These reserves can be drawn on to make up any net deficit in the combined current and capital accounts (much as you would draw on your savings to pay for a special purchase).  In 1999 this was $9 billion (Line 10 minus Line 13).

E.      Payments Deficits and Surpluses:  (See Lines 10 minus Line 13 in Table 38.1)

1. A drawing down of official reserves measures a nation’s balance of payments deficit; a building up of official reserves measures its balance of payments surpluses.  Adding to foreign reserves would occur if there is a surplus.

2. A balance of payments deficit is not necessarily bad, nor is a balance of payments surplus necessarily good.  However, persistent payments deficits would ultimately deplete the foreign exchange reserves.

3. To correct its balance of payments deficit, a nation might implement a major depreciation of its currency or other policies to encourage exports.

A.      Freely floating exchange rates are determined by the forces of demand and supply.  Figure
38.1 (Key Graph) illustrates the exchange rate (price) for British pounds in American dollars.

1. The demand for any currency is downsloping because as the currency becomes less expensive, people will be able to buy more of that nation’s goods and, therefore, want larger quantities of the currency.

2. The supply of any currency is upsloping because as its price rises, holders of that currency can obtain other currencies more cheaply and will want to buy more imported goods and, therefore, will give up more of their currency to obtain other currencies.

3. As with other commodities, the intersection of the supply and demand curves for a currency (pounds in Figure 38.1) will determine the price or exchange rate.  In the example it is $2 to 1 pound.

B.      Depreciation means the value of a currency has fallen; it takes more units of that country’s currency to buy another country’s currency.  $3 for 1 pound would be a depreciation of the dollar, compared to the original example of $2 per pound.

C.      Appreciation means the value of a currency or its purchasing power has risen; it takes less of that currency to buy another country’s currency.  $1 = 1 pound would be an appreciation of the dollar relative to the pound.

D.      Determinants of exchange rates are the forces that cause the demand or supply curves to shift.

1. Changes in tastes or preferences for a country’s products would shift the demand for the currency as well.

2. Relative income changes will cause changes in the demand and supply of currencies.  Rising incomes increase the demand for imports, which increases the supply of that country’s currency and the demand for other country’s currencies.

3. Relative price changes will cause changes in the demand and supply of currencies.  If American prices rise relative to British prices, this will increase the demand for British goods and pounds; conversely, it will reduce the supply of pounds as British purchase fewer American goods.  The theory of purchasing power parity asserts that exchange rates will change to maintain a uniform price in one currency, e.g., dollars, for each product across countries.

4. Changes in relative real interest rates will affect the demand and supply of currencies.  Higher U.S. interest rates attract foreign savings; hence, they raise the demand for dollars and reduce the supply of dollars as U.S. investment dollars may remain in this country.

5. Speculation is another determinant.  If one believes the value of a currency is about to fall, it will increase the supply of that currency and reduce its demand.  Likewise, if one believes the value of a currency is about to rise, it will increase its demand and reduce its supply as people want to hold that currency.  Note that such predictions can be self‑fulfilling prophecies, since the change in demand is in the direction of the prediction.  (Table 38.2)

E.      Theoretically, flexible rates have the virtue of automatically correcting any imbalance in the balance of payments.  If there is a deficit in the balance of payments, this means that there will be a surplus of that currency and its value will depreciate.  As depreciation occurs, prices for goods and services from that country become more attractive and the demand for them will rise.  At the same time, imports become more costly as it takes more currency to buy foreign goods and services.  With rising exports and falling imports, the deficit is eventually corrected (Figure 38.2 illustrates this).

F.      There are some disadvantages to flexible exchange rates.

1. Uncertainty and diminished trade may result if traders cannot count on future prices of exchange rates, which affect the value of their planned transactions.  (However, see Last Word for this chapter for ways in which traders can avoid risk.)

2. Terms of trade may be worsened by a decline in the value of a nation’s currency.

3. Unstable exchange rates can destabilize a nation’s economy.  This is especially true for nations whose exports and imports are a substantial part of their GDPs.

A.      Fixed exchange rates are those that are pegged to some set value, such as gold or the U.S. dollar.

B.      Official reserves are used to correct an imbalance in the balance of payments, since exchange rates cannot fluctuate to bring about automatic balance.  This is called currency intervention.

C.      Trade policies directly controlling the amount of trade and finance might be used to avoid imbalance in trade and payments.

D.      Exchange controls and rationing of currency have been used in the past but are objectionable for several reasons.

1. Controls distort efficient patterns of trade.

2. Rationing involves favoritism among importers.

3. Rationing reduces freedom of consumer choice.

4. Enforcement problems are likely as “black market” rates develop.

E.      Domestic macroeconomic adjustments may be more difficult under fixed rates.  For example, a persistent deficit of trade may call for tight monetary and fiscal policies to reduce prices, which raises exports and reduces imports.  Such contractionary policies can also cause recessions and unemployment, however.

A.  The gold standard was the international system used during the 1879‑1934 period.  It provided for fixed exchange rates in terms of a certain amount of currency for an ounce of gold.  Under this system, each nation must:

1. Maintain a fixed relationship between the stock of gold and the money supply.

2. Gold flows would maintain the fixed rate.  If the dollar appreciated, gold would flow into the U.S.; if it depreciated, gold would flow out.  These flows would keep the value of the currencies at their fixed rates.

3. Figure 38.2 helps explain the domestic macroeconomic adjustments that would occur.  If gold flowed into a country, its money supply would increase because the gold/money ratio is fixed.  Therefore, when the dollar appreciated, the U.S. money supply would increase proportionately to the gold increase.  A rise in the money supply would cause U.S. incomes and prices to rise and would increase our demand for foreign goods, while the demand for U.S. exports declined.  Such a change in the balance of trade would cause the dollar to depreciate again.  In other word, a gold standard causes domestic adjustments.  This is its major disadvantage.

4. The advantages are stable exchange rate and automatic adjustments in balance of payments.

5. The worldwide Depression of the 1930s ended the gold standard, because improving economic conditions became the main goal of national policies.

B.   The Bretton Woods system was enacted following World War II by the leading industrialized western nations.  It had two main features.

1. The International Monetary Fund (IMF) was created to hold and lend official reserves.  Included in official reserves was a new kind of international governmental currency called Special Drawing Rights (SDRs).

2. Pegged exchange rates were initiated, which were adjustable when a fundamental imbalance was recognized.  The rates were maintained by government intervention in the supply and demand of currencies.

a. Governments could spend or purchase currencies directly.

b. Gold could be bought or sold by governments.

c. IMF borrowing could take place from the required accounts that nations had at the International Monetary Fund.

3. The pegged rates could be changed (adjusted) when there were persistent problems with the balance of payments using the existing rate.  A persistent deficit could lead to devaluation (depreciation).

4. The Bretton Woods system was abandoned as nations acquired more and more dollars, and the U.S. abandoned its pledge to convert dollars into gold in 1971.  This led to a flexible exchange rate for the dollar and, therefore, flexible rates for every other major currency that was related to the dollar.

C.   The current system is really a “managed float” exchange rate system in which governments attempt to prevent rates from changing too rapidly in the short term.  For example, in 1987, the G-7 nations—U.S., Germany, Japan, Britain, France, Italy, and Canada—agreed to stabilize the value of the dollar, which had declined rapidly in the previous two years.  They purchased large amounts of dollars to prop up the dollar’s value.  Since 1987 the G-7 has periodically intervened in foreign exchange markets to stabilize currency values.

1. In support of the managed float.

a. Trade has expanded and not diminished under this system as some predicted it might.

b. Flexible rates have allowed international adjustments to take place without domestic upheaval when there has been economic turbulence in some areas of the world.

2. Concerns with the managed float.

a. Much volatility occurs without the balance of payments adjustments  predicted.

b. There is no real system in the current system.  It is too unpredictable.

A.  In 1999 the current account deficit in U.S. was $331 billion.  (Figure 38.3)

B.      Causes of the trade deficit.

1. Since 1992 the U.S. economy has grown more rapidly than the economies of several major trading nations.  This growth of income has boosted U.S. purchases of foreign goods.  In contrast, Japan, some European nations, and Canada have suffered recessions or slow income growth during this period.

2. Also, a declining savings rate in the U.S. has contributed to U.S. trade deficits and an increase in foreign investment in U.S.

C.      Implications of U.S. trade deficits

1. A trade deficit means that the U.S. is receiving more goods and services as imports from abroad than it is sending out as exports.  The gain in present consumption may come at the expense of reduced future consumption.

2. A trade deficit is considered “unfavorable” because it must be financed by borrowing from the rest of the world, selling off assets or dipping into foreign currency reserves.  In 1999, foreigners owned $1.5 billion more assets in U.S. than Americans owned in foreign assets.

3. Therefore, the current consumption gains delivered by U.S. trade deficits mean permanent debt, permanent foreign ownership, or large sacrifices of future consumption.  But it could also mean higher economic growth as foreign investment expands our capital base.

A.  Are speculators a positive or a negative influence?  Speculators sometimes contribute to exchange rate volatility.  The expectation of currency appreciation or depreciation can be self-fulfilling.

1. If speculators expect the Japanese yen to appreciate, they sell other currencies to buy yen.  The increase in demand for yen and in supply of other currencies will boost its value, which may attract still other speculators to buy yen.  The rise in yen value is partly a result of expectations.

2. Eventually, the yen’s value may soar too high relative to economic realities, the speculative “bubble” bursts, and the yen can plummet for the same self-fulfilling reasons, as speculators sell yen to buy other currencies.

B.      Speculation can have positive effects in foreign exchange markets.

1. Speculators may be useful in smoothing out temporary fluctuations.  If there is a temporary decline in demand, speculators take advantage of the dip in value by buying the currency; this props up demand, strengthening the value again.  If there is a temporary strong demand, which artificially raises the value of a currency, speculators will sell to take advantage of the price hike, and this will reduce the inflated value.

2. Speculators also absorb risks that others do not want to bear.  International transactions in goods and services can be risky if exchange rates change.  Buyers and sellers in international trade can reduce the risk of exchange rate changes in foreign transactions by hedging or buying the needed currency with forward contracts.  This is where a buyer or seller protects against a change in future exchange rates in the futures market.  Foreign exchange is bought or sold at contract prices fixed now, for delivery at a specified future date.

3. The example given is of an American importer who agrees to buy 10,000 Swiss watches to be delivered and paid for in three months.  The price is 75 francs per watch, or $50 per watch at the exchange rate on the date of the sale.  If the franc were to appreciate from 1.5 francs per dollar to 1 franc per dollar in three months, the importer would have to pay $75 per watch instead of $50 per watch.

a. Hedging can reduce the importer’s risk of having the franc appreciate.

b. The importer can purchase the 750,000 francs needed by signing a futures contract, agreeing to pay a specified amount (maybe $500,000 plus some allowance for fees) for those francs in three months.

c.            Speculators accept such contracts.  In this case, the speculator would be betting that the value of the franc would fall vs. the dollar, and at the end of the three months, the speculator would take the $500,000 and obtain more than the 750,000 francs for it.  The importer will have the 750,000 francs, and the speculator will have profited by having excess francs.  Of course, if the franc appreciates, the speculator loses on this deal.  In other words, the speculator has assumed the risk from the importer—and as a result may profit or lose.