The Balance of Payments

1. Do all international financial transactions necessarily involve exchanging one nation’s distinct currency for another? Explain. Could a nation that neither imports goods and services nor exports goods and services still engage in international financial transactions?

Answer: The answer is almost certainly a yes. Only in rare cases would you find barter exchanges (goods and services for other goods and services). Yes, they could engage in financial transactions (the exchange of assets across countries).

2. Explain: “U.S. exports earn supplies of foreign currencies that Americans can use to finance imports.

” Indicate whether each of the following creates a demand for or a supply of European euros in foreign exchange markets: a. A U.S. airline firm purchases several Airbus planes assembled in France. b. A German automobile firm decides to build an assembly plant in South Carolina. c. A U.S. college student decides to spend a year studying at the Sorbonne in Paris. d. An Italian manufacturer ships machinery from one Italian port to another on a Liberian freighter.

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e. The U.S. economy grows faster than the French economy.

f. A U.S. government bond held by a Spanish citizen matures, and the loan amount is paid back to that person. g. It is widely expected that the euro will depreciate in the near future.

Answer: American exports lead to an increase in the foreigncurrency bank deposit holdings of Americans. These holdings will be decreased through American purchases of imports. Hence, the foreigncurrency assets earned through exports can be used to finance imports. (a) A demand for euros: The U.S. airline must purchase euros before purchasing the Airbus planes. (b) A supply of euros: The German automobile firm must purchase U.S. dollars, or supply euros, before building the plant. (c) A demand for euros: The U.S. college student must purchase euros before studying in France. (d) A supply of euros: The Italian manufacturer must purchase U.S. dollars, or supply euros, to pay the Liberian freighter (which requires payment in U.S. dollars).

(e) A demand for euros: Since the U.S. economy grows faster than the French economy, U.S. imports from France will grow faster than France's imports from the U.S. holding everything else constant. To buy these additional French goods the U.S. will purchase more (net) euros. (f) A demand for euros: The U.S. pays the Spanish citizen in U.S. dollars. The Spanish citizen then purchases euros so she has currency she can use in her home country. (g) A supply of euros: Since individuals holding euros expect the currency to depreciate in the near future they sell (supply) the euros today in an attempt to avoid the loss in the future.

3. What do the plus signs and negative signs signify in the U.S. balance of payments statement? Which of the following items appear in the current account and which appear in the capital and financial account? U.S. purchases of assets abroad; U.S. services imports; foreign purchases of assets in the United States; U.S. good exports, U.S. net investment income. Why must the current account and the capital and financial account sum to zero?

Answer: The plus sign (+) indicates a credit to the U.S. balance of payments. The negative sign (-) indicates a debit the U.S balance of payments. U.S. purchases of assets abroad: current account

U.S. services imports: current account
Foreign purchases of assets in the United States: capital and financial account U.S. good exports: current account
U.S. net investment income: current account

The balance on the current account and the balance on the capital and financial account must always sum to zero because any deficit or surplus in the current account automatically creates an offsetting entry in the capital and financial account. People can only trade one of two things with each other: currently produced goods and services or preexisting assets. Therefore, if trading partners have an imbalance in their trade of currently produced goods and services, the only way to make up for that imbalance is with a net transfer of assets from one party to the other.

4. What are official reserves? How do net sales of official reserves to foreigners and net purchases of official reserves from foreigners relate to U.S. balance-of-payment deficits and surpluses? Explain why these deficits and surpluses are not actual deficits and surpluses in the overall balance of payments statement.

Answer: Official reserves consist of foreign currencies, certain reserves held with the International Monetary Fund, and stocks of gold. These reserves are owned by governments or their central banks. Although the balance of payments must always sum to zero, in some years a net sale of official reserves by a nation’s treasury or central bank occurs in the process of bringing the capital and financial account into balance with the current account. In such years, a balance-of-payments deficit is said to occur. This deficit is in a subset of the overall balance statement and is not a deficit in the overall account. Remember, the overall balance of payments is always in balance. But in this case the balancing of the overall account includes sales of official reserves to create an inflow of dollars to the United States.

These net sales of official reserves in the foreign exchange market show up as a plus (+) item on the U.S. balance of payments statement, specifically as foreign purchases of U.S. assets. In other years, the capital and financial account balances the current account because of government purchases of official reserves from foreigners. The treasury or central bank engineers this balance by selling dollars to obtain foreign currency, and then adding the newly acquired foreign currency to its stock of official reserves. In these years, a balance-of-payments surplus is said to exist. This payments surplus therefore can be thought of as either net purchases of official reserves in the balance of payments or, alternatively, as the resulting increase in the stock of official reserves held by the government.

Again, the balance of payments must always sum to zero. The net sale or purchase of official reserves by a nation’s treasury or central bank occurs in the process of bringing the capital and financial account into balance with the current account. The deficit or surplus prior to the sale or purchase of reserves is a subset of the overall balance statement and is not a deficit or surplus in the overall account.

5. Generally speaking, how is the dollar price of euros determined? Cite a factor that might increase the dollar price of euros. Cite a different factor that might decrease the dollar price of euros. Explain: “A rise in the dollar price of euros necessarily means a fall in the euro price of dollars.” Illustrate and elaborate: “The dollar-euro exchange rate provides a direct link between the prices of goods and services produced in the Euro Zone and in the United States.” Explain the purchasing-power-parity theory of exchange rates, using the euro-dollar exchange rate as an illustration.

Answer: The dollar price of the euro is determined in a currency exchange market that equates the supply euros with the demand for euros. A factor that might increase the dollar price of the euro could be the result of an increase in the demand for the euro or a decrease in the supply of the euro. (Examples) Increase in Demand: More Airbus aircraft purchased by U.S. airlines. Decrease in supply: Less Boeing aircraft purchased by European airlines. A factor that might decrease the dollar price of the euro could be the result of an decrease in the demand for the euro or an increase in the supply of the euro. (Examples) Decrease in Demand: Less Airbus aircraft purchased by U.S. airlines. Increase in supply: More Boeing aircraft purchased by European airlines. If the euro appreciates relative to the dollar, it takes more dollars to purchase one euro. At the same time, it takes fewer euros to buy a dollar, meaning that the euro price of dollars has fallen.

Through exchange rates, residents of all trading nations can express the prices of goods and services in other trading nations in terms of their domestic currencies. A change in the exchange rate between any two countries will automatically lead to an adjustment in the prices of all goods and services in both countries in terms of the other’s currency. The determination of these price conversions represents the most basic and visible function of exchange rates. The purchasing power parity theory of exchange rates holds that exchange rates change to equal the ratios of the nations’ price levels. If a certain item costs $100 in the U.S. and 50 euros in Germany, then the exchange rate should be $1 = 0.5 euros. It should take the same amount of dollars to buy the item anywhere in the world if exchange rates adjust to maintain purchasing power parity.

6. Suppose that a Swiss watchmaker imports watch components from Sweden and exports watches to the United States. Also suppose the dollar depreciates, and the Swedish krona appreciates, relative to the Swiss franc. Speculate as to how each would hurt the Swiss watchmaker.

Answer: If the dollar depreciated relative to the franc, this means that it took more dollars to get the francs necessary to buy a watch. In other words, the watch becomes more expensive in dollar terms which would cause a decline in imported watches purchased in the United States. Second, if the krona appreciated relative to the Swiss franc, this is the same thing as saying that the franc depreciated relative to the krona. In other words, it took more Swiss francs to buy parts in Sweden than it did previously. As a result, the imported components for the watches became more expensive to the Swiss company. The Swiss watchmaker was hurt twice. Its costs rose while its export sales declined.

7. Explain why the U.S. demand for Mexican pesos is downsloping and the supply of pesos to Americans is upsloping. Assuming a system of flexible exchange rates between Mexico and the United States, indicate whether each of the following would cause the Mexican peso to appreciate or depreciate, other things equal: a. The United States unilaterally reduces tariffs on Mexican products. b. Mexico encounters severe inflation.

c. Deteriorating political relations reduce American tourism in Mexico. d. The U.S. economy moves into a severe recession. e. The United States engages in a high-interest-rate monetary policy. f. Mexican products become more fashionable to U.S. consumers. g. The Mexican government encourages U.S. firms to invest in Mexican oil fields. h. The rate of productivity growth in the United States diminishes sharply.

Answer: The U.S. demand for pesos is downward-sloping: When the peso depreciates in value (relative to the dollar) the United States finds that Mexican goods and services are less expensive in dollar terms and purchases more of them, demanding a greater quantity of pesos in the process. The supply of pesos to the United States is upward-sloping: As the peso appreciates in value (relative to the dollar), US. goods and services become cheaper to Mexicans in peso terms. Mexicans buy more dollars to obtain more U.S. goods, supplying a larger quantity of pesos.

(a) The peso will appreciate. Mexican goods will become cheaper, so U.S. demand for pesos for will increase. (b) The peso will depreciate. The high rate of inflation in Mexico (relative the U.S.) will cause the price Mexican goods and services to increase (relative the U.S.). The U.S. demand for pesos will fall. The supply of pesos will also increase because U.S. goods are relatively cheaper. This will reinforce the depreciation of the peso. (c) The peso will depreciate. The reduction in U.S. tourism in Mexico reduces the demand for pesos.

(d) The peso will depreciate. The recession in the U.S. economy will reduce imports from Mexico. This, in turn, will decrease the demand for the peso. (e) The peso will depreciate. The high interest rate in the U.S. will attract investors from Mexico. This will increase the demand for U.S. dollars or the supply of pesos. (f) The peso will appreciate. U.S. consumers purchase more goods from Mexico. This increases the demand for the peso. (g) The peso appreciates. The U.S. firms must purchase pesos to invest in Mexico. This increases the demand for pesos. (h) The peso appreciates. The sharp decline in U.S. productivity reduces investment in the U.S. by firms in Mexico. This decreases the supply of pesos.

8. Explain why you agree or disagree with the following statements: a. A country that grows faster than its major trading partners can expect the international value of its currency to depreciate. b. A nation whose interest rate is rising more rapidly than interest rates in other nations can expect the international value of its currency to appreciate. c. A country’s currency will appreciate if its inflation rate is less than that of the rest of the world.