1. THE ROLE AND NATURE OF INVESTMENT

Learning Objectives1. Discuss the main arguments economists make in support

of free trade.2. Explain the determinants of net exports and tell how each

affects aggregate demand.

• International finance is the field that examines the macroeconomic consequences of the financial flows associated with international trade.

1.1 The Case for Trade

• A tariff is a tax imposed on imported goods and services.

• A quota is a ceiling on the quantity of specific goods and services that can be imported, which reduces world living standards.

1.2 The Rising Importance of International Trade

1.3 Net Exports and the Economy

• Determinants of net exports– Income– Relative prices– The exchange rate– Trade policies– Preferences and technology– Net exports and aggregate demand

1.3 Net Exports and the Economy

Changes in Net Exports and Aggregate Demand

Effect of initial increase in net exports without

multiplier

Effect of initial increase in net exports without

multiplier

Multiplier times the initial

increase in net exports

Multiplier times the initial

increase in net exports

Effect of initial decrease in net exports without

multiplier

Effect of initial decrease in net exports without

multiplier

Multiplier times the initial

decrease in net exports

Multiplier times the initial

decrease in net exports

AD2AD2 AD1AD1

2. INTERNATIONAL FINANCE

Learning Objectives

1. Define a country’s balance of payments, and explain what is included on the current and capital accounts.

2. Assuming that the market for a country’s currency is in equilibrium, explain why the current account balance will always be the negative of the capital account balance.

3. Summarize the economic arguments per se against public opposition to a current account deficit and a capital account surplus.

• Balance of payments is the balance between spending flowing into a country and spending flowing out.

2. INTERNATIONAL FINANCE

EQUATION 2.1

• Quantity of currency demanded is from two sources– Exports– Rest of world purchases of domestic assets

• Quantity of currency supplied is from two sources– Imports– Domestic purchases of rest of world assets

EQUATION 2.2

suppliedcurrency ofquantity demandedcurrency ofQuantity

assets) worldofrest of purchases (domesticImportsassets) domestic of purchases worldof(restExports

2.1 Accounting for International Payments

• The current account is an accounting statement that includes all spending flows across a nation’s border except those that represent purchases of assets.

• The balance on current account refers to spending flowing into an economy from the rest of the world on current account less spending flowing from the nation to the rest of the world on current account.

• A current account surplus is a situation that occurs when spending flowing in for the purchase of goods and services exceeds spending that flows out.

• A current account deficit is a situation that occurs when spending for goods and services that flows out of the country exceeds spending that flows in.

2.1 Accounting for International Payments

• The capital account is an accounting statement of spending flows into and out of the country during a particular period for purchases of assets.

• The balance on capital account refers to the balance between rest of world purchases of domestic assets and domestic purchases of rest of world assets.

• A capital account surplus is a positive balance on capital account.• A capital account deficit is a negative balance on capital account.

2.1 Accounting for International Payments

EQUATION 2.3

EQUATION 2.4

assets)] world-of-rest of purchases (domestic-assets) domestic of purches world-of-[(rest Imports - Exports

balance)account (capitalbalanceaccount Current

2.2 Deficits and Surpluses: Good or Bad?

• For consumers neither surplus nor deficit seem to pose a problem.

• Public opinion appears to regard surpluses and deficits as undesirable.

– Foreign income from U.S. assets– Loss of sovereignty

• There is no economic justification for viewing any particular current account balance as a good or bad thing.

3. EXCHANGE RATE SYSTEMS

Learning Objectives1. Define the various types of exchange rate systems.2. Discuss some of the pros and cons of different exchange

rate systems.

3.1 Free-Floating Systems

• A free floating exchange rate system is a system in which governments and central banks do not participate in the market for foreign exchange.

3.2 Managed Float Systems

• A managed float involves government or central bank participation in a floating exchange rate system.

3.3 Fixed Exchange Rates

• A fixed exchange rate system is a system in which the exchange rate between two currencies is set by government policy.

• A commodity standard system is a system in which countries fix the value of their respective currencies relative to a certain commodity or group of commodities.

• Currency board arrangements are fixed exchange rate systems in which there is an explicit legislative commitment to exchange domestic currency for a specified foreign currency at a fixed rate.

Maintaining a Fixed Exchange Rate Through Intervention

S1

D1D2

S2

Fixed rate

3

$4

Anatomy of a Currency Collapse: Thai Baht

$0.04

$0.02

S2S1

D2 D1

Weakness in the Japan economy causes the baht demand to fall

Weakness in the Japan economy causes the baht demand to fall

Thailand’s central bank buys baht, increasing

demand

Thailand’s central bank buys baht, increasing

demand

Thai asset holders sell baht fearing the central bank might give up its

efforts

Thai asset holders sell baht fearing the central bank might give up its

efforts

In July 1997 the central bank gave up efforts to prop the

currency. By the end of the year the value of the baht had fallen to about $0.02

In July 1997 the central bank gave up efforts to prop the

currency. By the end of the year the value of the baht had fallen to about $0.02