Ch. 18: International Finance

–Financing international trade–Balance of payments accounts–International borrowing and lending–Explanations for U.S. change from lender to

borrower. –Exchange rate determination. – Interest rate differentials

Financing International Trade

• Balance of Payments Accounts– Records international trading, borrowing and

lending. – Three accounts:

• Current account• Capital account• Official settlements account• + in balance of payments = inflows of currency• - In balance of payments = outflows of currency

Financing International Trade

Current account: net exports + net investment income + net transfers

Capital account (financial account):

Foreign investment in U.S. - U.S. investment in foreign co.’s

Official settlements: – net change in U.S. official holdings of foreign currency

Current + Capital + official settlements = 0 (approx.)

Financing International Trade– The balance of payments (as a % of GDP)

over the period 1983 to 2003.

Borrowers and Lenders, Debtors and Creditors

• A country that is borrowing more from the rest of the world than it is lending to it – is a net borrower.– has a current account deficit and a capital account

surplus (assume official settlements acc=0)• A country that is lending more to the rest of

the world than it is borrowing from it – is a net lender.– has a current account surplus, and capital account

deficit (assume official settlements=0)• The U.S. is currently a net borrower (but as late

as the 1970s it was a net lender.)

Borrowers and Lenders, Debtors and Creditors

• Debtor nation– during its entire history has borrowed more

from the rest of the world than it has lent to it.

• Creditor nation– invested more in the rest of the world than

other countries have invested in it over its entire history

• Difference between borrower/lender nation & creditor/ debtor – difference between stocks and flows of financial capital.

– Being a net borrower is not a problem provided the borrowed funds are used to finance capital accumulation that increases income.

– Being a net borrower is a problem if the borrowed funds are used to finance consumption.

Borrowers and Lenders, Debtors and Creditors

Borrowers and Lenders, Debtors and Creditors

• Current Account Balance• NX + Net int. income + Net transfers• NX is largest item in current account.• The other two items are much smaller and

don’t fluctuate much.

• NX = (T – G) + (S – I )• (T-G): govt surplus/deficit.• (S-I): private sector saving

(surplus/deficit).

Financing International Trade

• Net exports for the U.S. for 2003

–$506 billion = +$42 b (priv sector surplus)

- 548 b (govt sector deficit)

Borrowers and Lenders, Debtors and Creditors

• S-I has moved in the opposite direction of (T-G)

• No strong relationship between NX and the other two balances individually.

Borrowers and Lenders, Debtors and Creditors

• Is U.S. Borrowing for Consumption or Investment?– U.S. borrowing from abroad finances

investment. – It is much less than private investment and

almost equal to government investment in public infrastructure capital.

The Exchange Rate

Foreign exchange market– currency of one country is exchanged for the

currency of another.• Foreign exchange rate

• The price at which one currency exchanges for another

• Currency depreciation/appreciation– fall/rise in the value of the currency in terms

of another currency.

The Exchange Rate

More recent currency trends at http://finance.yahoo.com/currency

The Exchange Rate

The Exchange Rate

• Demand for $ in the Foreign Exchange Market– Quantity of dollars that traders plan to buy in

the foreign exchange market during a given period:

– Depends on • The exchange rate• Interest rates in the U.S. and other countries• Expected future exchange rate

The Exchange Rate

• Law of Demand for Foreign Exchange– The demand for dollars is a derived demand.– People in foreign countries buy $ so that they

can buy U.S.-made goods and services or U.S. assets.

– As the exchange rate rises (f.c. per $), U.S. exports become more expensive for foreigners and the quantity of $ demanded falls.

The Exchange Rate

The Exchange Rate

• Changes in the Demand for Dollars – Interest rates in the U.S. and in other countries – Changes in the expected future exchange rate– U.S. prices relative to foreign prices– Changes in expected relative profitability of

investments in U.S.– Changes in income in foreign countries

The Exchange Rate

• Supply in the Foreign Exchange Market– Ceteris paribus, the higher the exchange rate

(f.c. per $), the greater is the quantity of dollars supplied in the foreign exchange market.

– As f.c. per $ increases, imports from foreign countries become cheaper to U.S., and U.S. wants to sell more $ to purchase imports.

The Exchange Rate

• Changes in the Supply of Dollars– Shift in the supply curve.– Interest rates in the U.S. and in other countries – Changes in the expected future exchange rate– U.S. prices relative to foreign prices– Changes in expected relative profitability of

investments in U.S.

The Equilibrium

The Exchange Rate

• Changes in the Exchange Rate– Changes in demand and supply in the foreign

exchange market change the exchange rate (just like they change the price in any market).

– interest rates. – inflation rates– investment opportunities– expected future exchange rates

Movements in exchange rates

• Increase in U.S. interest rates relative to rest of world.

• Increase in expected investment returns relative to rest of world.

• Increase in U.S. inflation relative to rest of world.

• Expected increase in value of $ in future.

Other Exchange Rate Considerations.– Purchasing power parity:

• A currency should buy the same amount of goods and services in every country.

• If PPP does not hold, there may be an opportunity for profit-making through arbitrage.

• Example– Gold costs $300 per ounce in U.S.; 200 Euros

in Europe. PPP exchange rate should be $300=200 Euros (i.e. .67 Euros per dollar).

– If exchange rate is 1 Euro per dollar, » how can profits be made?» how will this affect exchange rate?

The Exchange Rate

• If PPP holds, e = P in f.c./ P in $% ch in e = inflation in f.c. – inflation in U.S.

The Exchange Rate

• Interest rate parity – The return on a currency is the interest rate

on that currency plus the expected rate of appreciation over a given period.

– When the returns on two currencies are equal, interest rate parity prevails.

– Market forces achieve interest rate parity very quickly.

The Exchange Rate• Return in $ = return in f.c. - % change in P of $

– If a German bond pays 10% over next year and value of $ increases 10%, what’s return in $?

– If a German bond pays 10% over next year and value of $ decreases 10%, what’s return in $?

• Interest differentials across countries reflect expected movements in exchange rates.

• If German bonds pay 10% and U.S. bonds pay 4%, what is

– expected movement in exchange rate? – Expected difference in inflation rate?

The Exchange Rate

• The Fed in the Foreign Exchange Market– Through its influence on the interest rate, the

Fed can influence the exchange rate. – The Fed can also intervene directly

• By buying $ in foreign exch. market (selling f.c.) – Fed can increase demand for $– Strengthen $– Incur net loss of official reserves.

• By selling $ in foreign exch. Market (buying f.c.) – Fed can increase supply of $– Weaken $– Incur net gain of official reserves.