Ch. 18: International Finance

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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

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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

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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.)
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Financing International Trade

• The balance of payments (as a of GDP) over the
  period 1983 to 2003.

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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
  acc0)
• 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 settlements0)
• The U.S. is currently a net borrower (but as late
  as the 1970s it was a net lender.)

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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.

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Borrowers and Lenders, Debtors and Creditors

• 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.

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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 dont
  fluctuate much.
• NX (T G) (S I )
• (T-G) govt surplus/deficit.
• (S-I) private sector saving (surplus/deficit).

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Financing International Trade

• Net exports for the U.S. for 2003
• 506 billion 42 b (priv sector surplus)
• - 548 b (govt sector deficit)

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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.

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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.

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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.

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The Exchange Rate
More recent currency trends at http//finance.yaho
o.com/currency
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The Exchange Rate
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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

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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.

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The Exchange Rate
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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

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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.

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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.

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The Equilibrium
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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

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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.

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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 300200
  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?

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The Exchange Rate

• If PPP holds,
• ? e P in f.c./ P in
• ch in e inflation in f.c. inflation in U.S.

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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.

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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, whats return in ?
• If a German bond pays 10 over next year and
  value of decreases 10, whats 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?

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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.

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