International Finance

1
International Finance

• International Finance -- measures of
  international transactions, and determination of
  exchange rates in the US.

2
Measures of International Finance

• Record of all transactions between Americans and
  residents of other countries over a flow
  interval.
• Current Account
• Capital Account
• Official Settlements Balance

3
The Current Account

• Current Account
• Exports Foreign Transfers to US
  Income earned from American holdings of
  investments abroad
• -- Imports US Transfers to Foreigners
  Income earned from foreign investments in US

4
The Current Account Interpretation

• Items in the first set of -- current account
  inflows, ways that dollars enter into the US from
  international current account transactions.
• Items in the second set of -- current account
  outflows, ways that dollars leave the US from
  international current account transactions.

5
The Current Account Characteristics

• Comprehensive measure of the Balance of Trade (NX
  is an approximation).
• Net income generated to Americans as a result of
  international transactions.

6
The Capital Account

• Capital Account
• New Foreign Purchases of
• US Assets
• - New US Purchases of
• Foreign Assets
• Capital Account
• Capital Inflows
• - Capital Outflows

7
The Official Settlements Balance

• Official Settlements Balance Current Account
  Capital Account
• Represents net total dollar inflows after all
  international transactions have been completed
  during a flow period.
• Recorded as change in official reserve assets at
  the International Monetary Fund (IMF)

8
The Recent US Record -- International Transactions

• Current Account
• Capital Account 0
• Official Settlements Balance ? 0
• Example -- 2000 (Billions of )
• -- Current Account -435
• -- Capital Account 399
• -- Settlements Balance -36

9
A Quick review About Exchange Rates

• Exchange Rate (e) -- the amount of foreign
  currency needed to be exchanged for one (US)
  dollar.
• Also known as the value of the dollar.
• Conversion Ratio, in units of (foreign
  currency)/(US dollar)

10
Exchange Rate Changes

• e? ? price of American goods and
• services to foreigners?
• ? price of foreign goods and
• services to Americans?
• e? ? price of American goods and
• services to foreigners?
• ? price of foreign goods and
• services to Americans?

11
Exchange Rate Regimes

• Fixed (Pegged) Exchange Rates -- exchange rates
  are fixed by the government, unless changed by
  economic policy.
• Floating Exchange Rates -- exchanged rates
  determined by natural forces in the foreign
  exchange market.

12
The Foreign Exchange Market the Exchange Rate

• The Foreign Exchange Market -- the demand and
  supply for dollars for use in international
  transactions.

13
Concepts to Understand Foreign Exchange
Behavior

• Items (goods, services, financial assets) are
  priced in a countrys home currency.
• If one wishes to buy from another country, he/she
  must convert from their own currency to the
  currency of the country selling the item.

14
More Important Foreign Exchange Concepts

• The exchange rate (e) specifies the ratio of
  conversion.
• The same exchange rate holds for all transactions
  purchases or sales of goods, services and
  financial assets.

15
The Demand for Dollars

• The Demand for Dollars -- foreigners demand for
  US dollars, to buy American goods, services, or
  financial assets.
• Inversely related to the exchange rate (e), with
  other causes (shift variables) as well.

16
The Supply of Dollars

• The Supply of Dollars -- Americans supplying
  dollars to the foreign exchange market, in order
  to buy foreign goods, services, or financial
  assets.
• Positively related to the exchange rate (e), with
  other causes (shift variables) as well.

17
Foreign Exchange Market Equilibrium

• Equilibrium exchange rate (foreign
  currency)/(US) -- price of
  dollars.
• At equilibrium, total dollar inflows equal total
  dollar outflows.
• Therefore, at equilibrium, the
  Official Settlements Balance 0 automatically
  without any need for policy.

18
Major Causes of Exchange Rate Movements

• US Interest Rates (r)
• Interest Rates of Other Nations (rW)
• Speculation -- Expectations of future exchange
  rate changes.

19
US Interest Rates and Exchange Rate Movements

• Suppose r?.
• This causes substitution away from foreign assets
  into US assets.
• The demand for dollars increases (D curve shifts
  rightward) and the supply of dollars decreases
  (S curve shifts leftward).
• As a result e?.

20
Foreign Interest Rates and Exchange Rate Movements

• Suppose rW?.
• This causes substitution away from US assets into
  foreign assets.
• The demand for dollars decreases (D curve shifts
  leftward) and the supply of dollars increases
  (S curve shifts rightward).
• As a result e?.

21
Speculation and Exchange Rate Movements

• Constantly fluctuating exchange rate creates
  opportunities to make capital gains from timed
  purchases or sales of currency.
• Incentive to buy dollars when exchange rate is
  low, then sell dollars when exchange rate rises.
• Creates speculative bubble behavior -- like
  stock market.

22
Floating Exchange Rates

• Advantages
• -- No loss of official reserves at the IMF,
  market equilibrium ? current account capital
  account 0.
• -- Federal Reserve does not need to participate
  in foreign exchange market, can focus solely on
  domestic policy.

23
Floating Exchange Rates (Continued)

• Disadvantages
• -- Fluctuating exchange rate is disruptive to
  International Trade.
• -- Exchange rates can fluctuate a great deal,
  especially due to speculation (speculative
  bubbles).

24
Fixed Exchange Rates

• Advantages
• -- exchange rate is constant, stability in
  International Trade.

25
Fixed Exchange Rates (Continued)

• Disadvantages
• -- Federal Reserve must intervene constantly in
  the foreign exchange market ? money supply
  decreases or loss of official reserves.
• -- Fed might be forced into contractionary
  monetary policy to raise US interest rates and
  increase e to the target fixed rate.

26
Exchange Rate Regimes -- Overall

• Ideal system floating exchange rates which do
  not exhibit much movement.
• Actual system (US) Managed Float --
  floating exchange rates with occasional Federal
  Reserve intervention, to stop large movement in
  e.