Unit 10 - Foreign Exchange

Rates and Payment Balances

Macroeconomics

Unit 10 - Foreign Exchange

Rates and Payment Balances
Foreign

Exchange Rates

When countries trade,

they exchange products
for currencies.
In a free market, the value
of the currencies is
determined by the demand and
supply of the currencies.
Macroeconomics

Unit 10 - Foreign Exchange

Rates and Payment Balances

Exchange Rate Systems

When currency values are allowed to fluctuate,
we speak of a flexible rate system.
When currency values are not allowed to
fluctuate for a period of time, we speak of a
fixed exchange rate system.

Macroeconomics

Unit 10 - Foreign Exchange

Rates and Payment Balances

Devaluation and Revaluation

In a fixed exchange rate system, when the
currency values change after a period of time,
we speak of devaluation if there is a decrease
in the currencys value, and revaluation if
there is an increase in the currencys value.

Macroeconomics

Unit 10 - Foreign Exchange

Rates and Payment Balances

Devaluation and Revaluation

Example
1 US Dollar = 3.64 Qatari Riyal
After governments agree to a new fixed level:
1 US Dollar = 3.50 Qatari Riyal (hypothetical example)
Has the dollar
revaluated or
devaluated relative
to the Qatari Riyal?
Macroeconomics

Unit 10 - Foreign Exchange

Rates and Payment Balances

Devaluation and Revaluation

If the dollar devaluates, it becomes cheaper for
Qatar to buy U.S. products.
US exports become cheaper, and Qatari exports
to the U.S. become more expensive.

Macroeconomics

Unit 10 - Foreign Exchange

Rates and Payment Balances

Depreciation and Appreciation

In a flexible exchange rate system, when the
currency values change after a period of time,
we speak of depreciation if there is a decrease
in the currencys value, and appreciation if
there is an increase in the currencys value.

Macroeconomics

Unit 10 - Foreign Exchange

Rates and Payment Balances

Depreciation and Appreciation

Example
$1 = 9.5 South African Rand
After currency change:
$1 = 10 South African Rand
Has the dollar depreciated
or appreciated?
Macroeconomics

Unit 10 - Foreign Exchange

Rates and Payment Balances

Depreciation and Appreciation

If the dollar appreciates, it becomes more
expensive for South Africa to purchase dollars.
So if South Africa buys a U.S. car, it will have
to pay more for the car (ceteris paribus). U.S.
products become more expensive for South
Africa. U.S. exports to South Africa become
more expensive if the dollar appreciates.
Macroeconomics

Unit 10 - Foreign Exchange

Rates and Payment Balances
Flexible

Exchange Rate Systems

An advantage of a fixed exchange rate system

between two currencies is that the exchange rates
are constant for a period of time. Therefore, it
creates more certainty in international trading.

Macroeconomics

Unit 10 - Foreign Exchange

Rates and Payment Balances
Variable

Exchange Rate Systems

Advantages of a variable exchange rate system are:

the currency always has its true (market) value.
no surpluses or shortages of a currency.
no government (central bank) interference necessary
(and no central bank losses).
Modern day futures markets can fix the exchange rate
via futures contracts.
Macroeconomics

Unit 10 - Foreign Exchange

Rates and Payment Balances

Balance of Payments
The Balance of Payment (BOP) is
an accounting record of a
countrys inflows and outflows of
money exchanged in international
trade.

Macroeconomics

Unit 10 - Foreign Exchange

Rates and Payment Balances

Balance of Payments
The BOP consists of two main accounts:
1. The current account
2. The capital account

Macroeconomics

Unit 10 - Foreign Exchange

Rates and Payment Balances

Balance of Payments
The current account includes transactions related
to international:
1. merchandise trade (cars, computers, food)
2. services trade (insurance, tourism, consulting)
3. investment income (earnings from stocks,
bonds)
4. transfer payments (gifts, pensions)
Macroeconomics

Unit 10 - Foreign Exchange

Rates and Payment Balances

Balance of Payments
The capital account includes transactions related
to international:
5. purchases of financial assets (stocks, bonds)
6. purchases of real assets (land, buildings,
businesses)
7. purchases of foreign currency (by banks or
speculators)
Macroeconomics

Unit 10 - Foreign Exchange

Rates and Payment Balances

Balance of Payments
By definition:
the balance on the current account +
the balance on the capital account +
statistical discrepancy = 0.

Macroeconomics

Unit 10 - Foreign Exchange

Rates and Payment Balances

Balance of Payments
For BOP statistics, visit:
http://www.bea.gov

Macroeconomics

Unit 10 - Foreign Exchange

Rates and Payment Balances

BOP Issues
Controversial BOP issues include:
1. Is a trade deficit bad for the economy?
2. Should countries protect their domestic
industries (through trade restrictions) to
improve their balance of payments?
3. Should countries discourage domestic
investments by foreigners?
Macroeconomics

Unit 10 - Foreign Exchange

Rates and Payment Balances
BOP Issues
Is a trade deficit bad for the economy?
A trade deficit can be a sign of strength. The
more purchasing power a country has, the
more it will import.
Imports adds to a countrys wealth.
Imports help foreign countries; this will
eventually benefit the importing country.
Macroeconomics

Unit 10 - Foreign Exchange

Rates and Payment Balances

BOP Issues
Should countries protect their domestic
industries (through trade restrictions) to improve
their balance of payments?
If a country protects its industries, other
countries will protect theirs (retaliation).
Protectionism results in less specialization,
less competition, less efficiency, lower
production, and a lower standard of living.
Macroeconomics

Unit 10 - Foreign Exchange

Rates and Payment Balances

BOP Issues
Should countries discourage domestic investments by
foreigners?
Investments by foreign companies in our country
results in more capital and more employment in our
country.
It is a sign of a strong economy that other countries
want to invest in our country.
Foreign investors invest for economic, not political
reasons.
Economic interdependency strengthens, not weakens,
political ties.
Macroeconomics