Chapter 29

A. The Balance of International Payments 1. The balance of international payments is the set of accounts that measures all the economic transactions between a nation and the rest of the world. It includes exports and imports of goods, services, and financial instruments. Exports are credit items, while imports are debits. More generally, a country's credit items are transactions that make foreign currencies available to it; debit items are ones that reduce its holdings of foreign currencies. 2. The major components of the balance of payments are: I. Current account (merchandise trade, services, investment income, transfers) II. Financial account (private, government, and official-reserve changes) The fundamental rule of balance-of-payments accounting is that the sum of all items must equal zero: I + II = 0. 3. Historically, countries tend to go through stages of the balance of payments: from the young debtor borrowing for economic development, through mature debtor and young creditor, to mature creditor nation living off earnings from past investments. In the 1980s, the United States moved to a different stage where low domestic saving and attractive investment opportunities again led it to borrow heavily abroad and become a debtor nation. B. The Determination of Foreign Exchange Rates 4. International trade involves the new element of different national currencies, which are linked by relative prices called foreign exchange rates. When Americans import Japanese goods, they ultimately need to pay in Japanese yen. In the foreign exchange market, Japanese yen might trade at ¥100/$ (or reciprocally, ¥1 would trade for $0.01). This price is called the foreign exchange rate. 5. In a foreign exchange market involving only two countries, the supply of U.S. dollars comes from Americans who want to purchase goods, services, and investments from Japan; the demand for U.S. dollars comes from Japanese who want to import commodities or financial assets from America. The interaction of these supplies and demands determines the foreign exchange rate. More generally, foreign exchange rates are determined by the complex interplay of many countries buying and selling among themselves. When trade or financial flows change, supply and demand shift and the equilibrium exchange rate changes. 6. A fall in the market price of a currency is a depreciation; a rise in a currency's value is called an appreciation. In a system where governments announce official foreign exchange rates, a decrease in the official exchange rate is called a devaluation, while an increase is a revaluation. 7. According to the purchasing-power parity (PPP) theory of exchange rates, exchange rates tend to move with changes in relative price levels of different countries. The PPP theory applies better to the long run than the short run. When this theory is applied to measure the purchasing power of incomes in different countries, it raises the per capita outputs of low-income countries. C. The International Monetary System 8. A well-functioning international economy requires a smoothly operating exchange-rate system, which denotes the institutions that govern financial transactions among nations. Three important exchange-rate systems are (a) the flexible exchange rates, in which a country's foreign exchange rate is determined by market forces of supply and demand; (b) fixed exchange rates, such as the gold standard or the Bretton Woods system, in which countries set and defend a given structure of exchange rates; and (c) managed exchange rates, in which government interventions and market forces interact to determine the level of exchange rates. 9. Classical economists like David Hume explained international adjustments to trade imbalances by the gold-flow mechanism. Under this process, gold movements would change the money supply and the price level. For example, a trade deficit would lead to a gold outflow and a decline in domestic prices that would (a) raise exports and (b) curb imports of the gold-losing country while (c) reducing exports and (d) raising imports of the gold-gaining country. This mechanism shows that under fixed exchange rates, countries which have balance-of-payments problems must adjust through changes in domestic price and output levels. 10. After World War II, countries created a group of international economic institutions to organize international trade and finance. Under the Bretton Woods system, countries "pegged" their currencies to the dollar and to gold, providing fixed but adjustable exchange rates. When official parities deviated too far from fundamentals, countries could adjust parities and achieve a new equilibrium without incurring the hardships of inflation or recession. 11. When the Bretton Woods system broke down in 1971, it was replaced by today's hybrid system. Today, the major economic regions (the U.S., Euroland, and Japan) have currencies that float relative to each other. Most small countries peg their currencies to the dollar or to other currencies.