Eco 200 – Principles of

Macroeconomics

Chapter 7: Foreign Exchange

Markets and the Balance of
Payments
Foreign exchange market
 Foreign exchange = money
denominated in foreign currency
 Foreign exchange market = global
market in which currencies are
exchanged for each other
 Most foreign exchange transactions
involve purchase and sale of bank
deposits
Exchange rate
 Exchange rate = price of one currency
in terms of another
 Reciprocal exchange rates – If $1 is

worth 2 British pounds, each British

pound is worth ½ of a dollar.
 Domestic currency price

= foreign currency price x exchange rate

Appreciation and depreciation
 If the domestic currency appreciates,
 Imports become less expensive
 Imports rise
 Exports become more expensive in the rest of the
world.
 Exports decline
 If the domestic currency depreciates,
 Imports become more expensive
 Imports decline
 Exports become less expensive in the rest of the
world.
 Exports rise
Balance of payments
 Double-entry bookkeeping
 Two sides to each transaction
 Dollar value of money flowing into the country
must equal the dollar value of the money flowing
out (two sides of the same transaction)
 Credits
 activities that brings payments into the country
 Debits
 activities that involve payments to the rest of the
world
Current and capital accounts
 Current account = trade in goods and
services
 Capital account = trade in financial
assets
 Net balance on current account + net
balance on capital account + statistical
discrepancy = 0 (overall balance of
payments = 0)
Current account
 Merchandise – trade in goods
 Services – trade in services
 Investment income = payment for
capital services (interest payments)
 Unilateral transfers – payments for
which no goods or services are provided
in return
Current account
 Balance of payment accounts
– 2000 (in millions)
Account Credit Debit Net balance
Merchandise $183,728 $289,566 $105,838
Services $71,309 $51,647 $19,662
Investment income $79,749 $83,949 -$4,200
Unilateral transfers -$11,925
Current Account -$102,301
Capital Account $215,008 $143,283 $71,725
Statistical discrepancy -$30,410
Overall BOP $0