International Trade , Balance of

Payments and Exchange Rates

 International Trade
• All economies, regardless of their
size, depend to some extent on other
economies and are affected by
events outside their borders.
• The “internationalization” or
“globalization” of any economy will
occur in the private and public
sectors, in input and output markets,
and in business firms and
households.

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 Trade Surpluses and Deficits

• When a country exports more than it

imports, it runs a trade surplus.

• A trade deficit is the situation when

a country imports more than it
exports.

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 Terms of Trade

• The ratio at which a country can

trade domestic products for imported
products is the terms of trade.

• The terms of trade determine how

the gains from trade are distributed
among trading partners.

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 Trade Barriers : Tariffs,
Export Subsidies, and Quotas
• Protection is the practice of shielding a
sector of the economy from foreign
competition.
• A tariff is a tax on imports.
• A quota is a limit on the quantity of
imports.
• Export subsidies are government
payments made to domestic firms to
encourage exports.
• Dumping refers to a firm or industry that
sells products on the world market at prices
below the cost of production.

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 The Balance of Payments

• Foreign exchange is simply all

currencies other than the domestic
currency of a given country

• The balance of payments is the

record of a country’s transactions in
goods, services, and assets with the
rest of the world; also the record of a
country’s sources (supply) and uses
(demand) of foreign exchange.

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 The Current Account

• Exports earn foreign exchange and

are a credit (+) item on the current
account. Imports use up foreign
exchange and are a debit (–) item.

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 The Current Account

• A country’s current account is the

sum of its:
• net exports (exports minus imports),
• net income received from investments
abroad, and
• net transfer payments from abroad.

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 The Current Account
• The balance of trade is the
difference between a country’s
exports of goods and services and
its imports of goods and services.
• A trade deficit occurs when a
country’s exports are less than its
imports.
• Net exports of goods and services
(EX – IM), is the difference between
a country’s total exports and total
imports.

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 The Current Account

• Investment income consists of

holdings of foreign assets that yield
dividends, interest, rent, and profits
paid to U.S. asset holders (a source
of foreign exchange).

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 The Current Account

• Net transfer payments are the

difference between payments from
the United States to foreigners and
payments from foreigners to the
United States.

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 The Current Account

• The balance on current account

consists of net exports of goods, plus
net exports of services, plus net
investment income, plus net transfer
payments. It shows how much a
nation has spent relative to how
much it has earned.

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 The Capital Account

• For each transaction recorded in the

current account, there is an offsetting
transaction recorded in the capital
account.
• The capital account records the
changes in assets and liabilities.

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 The Capital Account

• The balance on capital account in the United

States is the sum of the following (measured in a
given period):
• the change in private U.S. assets abroad
• the change in foreign private assets in the United
States
• the change in U.S. government assets abroad, and

• the change in foreign government assets in the United

States

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 The Capital Account

• In the absence of errors, the balance on

capital account would equal the negative
of the balance on current account.

• If the capital account is positive, the

change in foreign assets in the country is
greater than the change in the country’s
assets abroad, which is a decrease in the
net wealth of the country.

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The Balance of Payment Account - Example
United States Balance of Payments, 2002
CURRENT ACCOUNT
Goods exports 682.6
Goods imports – 1,166.9
(1) Net export of goods – 484.3
Export of services 289.3
Import of services – 240.5
(2) Net export of services 48.8
Income received on investments 244.6
Income payments on investments – 256.5
(3) Net investment income – 11.9
(4) Net transfer payments – 56.0
(5) Balance on current account (1 + 2 + 3 + 4) – 503.4
CAPITAL ACCOUNT
(6) Change in private U.S. assets abroad (increase is –) – 152.9
(7) Change in foreign private assets in the United States 533.7
(8) Change in U.S. government assets abroad (increase is –) – 3.3
(9) Change in foreign government assets in the United States 46.6
(10) Balance on capital account (6 + 7 + 8 + 9) 474.1
(11) Statistical discrepancy 29.3
(12) Balance of payments (5 + 10 + 11) 0

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The Balance of Payments Account

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 Exchange Rates
• The main difference between an international
transaction and a domestic transaction concerns
currency exchange.

• International exchange must be managed in a

way that allows each partner in the transaction to
wind up with his or her own currency.

• The exchange rate is the price of one country’s

currency in terms of another country’s currency;
the ratio at which two currencies are traded for
each other.

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 The Open Economy with
Flexible Exchange Rates

• Floating, or market-determined,
exchange rates are exchange rates
determined by the unregulated
forces of supply and demand.

• Exchange rate movements have

important impacts on imports,
exports, and movement of capital
between countries.

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The Market for Foreign Exchange

• In a world where there are only two

countries, the United States and
Britain, the demand for pounds is
comprised of holders of dollars
wishing to acquire pounds. The
supply of pounds is comprised of
holders of pounds seeking to
exchange them for dollars.

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 The Market for Foreign Exchange

• The demand for pounds in

the foreign exchange market
shows a negative relationship
between the price of pounds
(dollars per pound) ($/£) and
the quantity of pounds
demanded.

• When the price of pounds falls, British-made goods and services

appear less expensive to U.S. buyers. If British prices are
constant, U.S. buyers will buy more British goods and services,
and the quantity demanded of pounds will rise.
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 The Market for Foreign Exchange

• The supply of pounds in

the foreign exchange
market shows a positive
relationship between the
price of pounds (dollars per
pound) ($/£) and the
quantity of pounds
supplied.

• When the price of pounds rises, the British can obtain more dollars
for each pound. This means that U.S.-made goods and services
appear less expensive to British buyers. Thus, the quantity of
pounds supplied is likely to rise with the exchange rate.
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The Equilibrium Exchange Rate

• The equilibrium exchange

rate occurs at the point at
which the quantity
demanded of a foreign
currency equals the
quantity of that currency
supplied.

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The Equilibrium Exchange Rate

• An excess supply of pounds will

cause the price of pounds to fall—
the pound will depreciate (fall in
value) with respect to the dollar.
• An excess demand for pounds will
cause the price of pounds to rise—
the pound will appreciate (rise in
value) with respect to the dollar.

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Fixed vs. Flexible Exchange Rate (IMP)
BASIS FOR COMPARISON FIXED EXCHANGE RATE FLEXIBLE EXCHANGE RATE

Meaning Fixed exchange rate refers to a Flexible exchange rate is a rate

rate which the government sets that variate according to the
and maintains at the same level. market forces.

Determined by Government or central bank Demand and Supply forces

Changes in currency price Devaluation and Revaluation Depreciation and Appreciation

Speculation Takes place when there is rumor Very common

about change in government
policy.

Self-adjusting mechanism Operates through variation in Operates to remove external

supply of money, domestic instability by change in forex rate.
interest rate and price.

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BoT vs. BoP (IMP)

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Depreciation vs. Devaluation (IMP)

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 Exchange Rates and the
Balance of Trade: The J Curve

• Initially, the negative effect

on the price of imports may
dominate the positive effects
of an increase in exports
and a decrease in imports.
• But when imports and
exports have had a time to
respond to price changes,
the balance of trade
improves.

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The Mundell Fleming Model

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 The IS* curve : Goods market eq’m

Y  C (Y T )  I (r *)  G  NX (e )

The IS* curve is drawn e

for a given value of r*.

Intuition for the slope:

 e   NX  Y

IS*
Y
 The LM* curve: Money market eq’m
M P  L(r *,Y )
The LM* curve
e LM*
• is drawn for a given
value of r*.

• is vertical because:
given r*, there is
only one value of Y
that equates money
Y
demand with supply,
regardless of e.
Fiscal policy under floating exchange rates

Y  C (Y T )  I (r *)  G  NX (e )
M P  L(r *,Y )
e LM 1*
At any given value of e,
e2
a fiscal expansion
increases Y, e1
shifting IS* to the right.
IS 2*
Results:
IS 1*
e > 0, Y = 0 Y
Y1
Monetary policy under floating exchange rates

Y  C (Y T )  I (r *)  G  NX (e )
M P  L(r *,Y )
e LM 1*LM 2*
An increase in M
shifts LM* right
because Y must rise
to restore eq’m in
e1
the money market. e2
Results: IS 1*
Y
e < 0, Y > 0 Y1 Y2
 Fiscal policy under fixed exchange rates

Under
Under floating
floatingrates,
rates,
afiscal
fiscalpolicy
expansion
is ineffective
e LM 1*LM 2*
would raise e.
at changing output.
To keepfixed
Under e fromrates,
rising,
the central
fiscal bank
policy is must
very
sell domestic currency, e1
effective at changing
which
output.increases M IS 2*
and shifts LM* right.
IS 1*
Results: Y
Y1 Y2
e = 0, Y > 0
Monetary policy under fixed exchange rates

An increase
Under in M
floating would
rates,
shift LM* right
monetary policyandis reduce e.
very effective at changing e LM 1*LM 2*
To prevent the fall in e, the
output.bank must buy
central
domestic currency,
Under fixed rates,which
reduces
monetaryM and shifts
policy LM*be
cannot e1
back
usedleft.
to affect output.
Results: IS 1*
Y
e = 0, Y = 0 Y1
The Modified Mundell Fleming Model
(IS-LM-BP)

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IS-LM-BP Model (Capital Mobility)

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IS-LM-BP Model (Capital Mobility)

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IS-LM-BP Model (Imperfect Capital Mobility)

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