Unit 10 - Foreign Exchange

Rates and Payment Balances

Macroeconomics
 Unit 10 - Foreign Exchange
Rates and Payment Balances
 Foreign Exchange Rates

When countries trade,

they exchange products
for currencies.
In a free market, the value
of the currencies is
determined by the demand and
supply of the currencies.

Macroeconomics
 Unit 10 - Foreign Exchange
Rates and Payment Balances
 Exchange Rate Systems

When currency values are allowed to fluctuate,

we speak of a flexible rate system.
When currency values are not allowed to
fluctuate for a period of time, we speak of a
fixed exchange rate system.

Macroeconomics
 Unit 10 - Foreign Exchange
Rates and Payment Balances
 Devaluation and Revaluation

In a fixed exchange rate system, when the

currency values change after a period of time,
we speak of devaluation if there is a decrease
in the currency’s value, and revaluation if
there is an increase in the currency’s value.

Macroeconomics
 Unit 10 - Foreign Exchange
Rates and Payment Balances
 Devaluation and Revaluation
Example
1 US Dollar = 3.64 Qatari Riyal
After governments agree to a new “fixed” level:
1 US Dollar = 3.50 Qatari Riyal (hypothetical example)

Has the dollar

revaluated or
devaluated relative
to the Qatari Riyal?

Macroeconomics
 Unit 10 - Foreign Exchange
Rates and Payment Balances
 Devaluation and Revaluation

If the dollar devaluates, it becomes cheaper for

Qatar to buy U.S. products.

US exports become cheaper, and Qatari exports

to the U.S. become more expensive.

Macroeconomics
 Unit 10 - Foreign Exchange
Rates and Payment Balances
 Depreciation and Appreciation
In a flexible exchange rate system, when the
currency values change after a period of time,
we speak of depreciation if there is a decrease
in the currency’s value, and appreciation if
there is an increase in the currency’s value.

Macroeconomics
 Unit 10 - Foreign Exchange
Rates and Payment Balances
 Depreciation and Appreciation

Example
$1 = 9.5 South African Rand
After currency change:
$1 = 10 South African Rand

Has the dollar depreciated

or appreciated?

Macroeconomics
 Unit 10 - Foreign Exchange
Rates and Payment Balances
 Depreciation and Appreciation

If the dollar appreciates, it becomes more

expensive for South Africa to purchase dollars.

So if South Africa buys a U.S. car, it will have to

pay more for the car (ceteris paribus). U.S.
products become more expensive for South
Africa. U.S. exports to South Africa become more
expensive if the dollar appreciates.

Macroeconomics
 Unit 10 - Foreign Exchange
Rates and Payment Balances
 Flexible Exchange Rate Systems

An advantage of a fixed exchange rate system

between two currencies is that the exchange rates
are constant for a period of time. Therefore, it
creates more certainty in international trading.

Macroeconomics
 Unit 10 - Foreign Exchange
Rates and Payment Balances
 Variable Exchange Rate Systems

Advantages of a variable exchange rate system are:

 the currency always has its true (market) value.
 no surpluses or shortages of a currency.
 no government (central bank) interference necessary
(and no central bank losses).
 Modern day futures markets can fix the exchange rate
via futures contracts.

Macroeconomics
 Unit 10 - Foreign Exchange
Rates and Payment Balances
 Balance of Payments

The Balance of Payment (BOP) is

an accounting record of a
country’s inflows and outflows of
money exchanged in international
trade.

Macroeconomics
 Unit 10 - Foreign Exchange
Rates and Payment Balances
 Balance of Payments

The BOP consists of two main accounts:

1. The current account
2. The capital account

Macroeconomics
 Unit 10 - Foreign Exchange
Rates and Payment Balances
 Balance of Payments

The current account includes transactions related

to international:
1. merchandise trade (cars, computers, food)
2. services trade (insurance, tourism, consulting)
3. investment income (earnings from stocks,
bonds)
4. transfer payments (gifts, pensions)

Macroeconomics
 Unit 10 - Foreign Exchange
Rates and Payment Balances
 Balance of Payments

The capital account includes transactions related to

international:
5. purchases of financial assets (stocks, bonds)
6. purchases of real assets (land, buildings,
businesses)
7. purchases of foreign currency (by banks or
speculators)

Macroeconomics
 Unit 10 - Foreign Exchange
Rates and Payment Balances
 Balance of Payments

By definition:
the balance on the current account +
the balance on the capital account +
statistical discrepancy = 0.

Macroeconomics
 Unit 10 - Foreign Exchange
Rates and Payment Balances
 Balance of Payments

For BOP statistics, visit:

http://www.bea.gov

Macroeconomics
 Unit 10 - Foreign Exchange
Rates and Payment Balances
 BOP Issues

Controversial BOP issues include:

1. Is a trade deficit bad for the economy?
2. Should countries protect their domestic
industries (through trade restrictions) to
improve their balance of payments?
3. Should countries discourage domestic
investments by foreigners?
Macroeconomics
 Unit 10 - Foreign Exchange
Rates and Payment Balances

BOP Issues

Is a trade deficit bad for the economy?

 A trade deficit can be a sign of strength. The
more purchasing power a country has, the
more it will import.
 Imports adds to a country’s wealth.
 Imports help foreign countries; this will
eventually benefit the importing country.

Macroeconomics
 Unit 10 - Foreign Exchange
Rates and Payment Balances
 BOP Issues

Should countries protect their domestic industries

(through trade restrictions) to improve their balance of
payments?
 If a country protects its industries, other countries will
protect theirs (retaliation).
 Protectionism results in less specialization, less
competition, less efficiency, lower production, and a
lower standard of living.

Macroeconomics
 Unit 10 - Foreign Exchange
Rates and Payment Balances
 BOP Issues
Should countries discourage domestic investments by
foreigners?
 Investments by foreign companies in our country
results in more capital and more employment in our
country.
 It is a sign of a strong economy that other countries
want to invest in our country.
 Foreign investors invest for economic, not political
reasons.
 Economic interdependency strengthens, not weakens,
political ties.

Macroeconomics