Unit 7

Formulas

• Balance of Trade:
  Goods Exports + Goods Imports
• Balance on goods and services:
  Goods Exports + Service Exports + Goods Imports + Service Imports
• Current Account:
  Balance on goods and services + Net Investment + Net Transfers
• Capital Account:
  Foreign Purchases + Domestic Purchases

The Balance of Payment

• Balance of Payment
• Measure of money inflows and outflows between the united States and the Rest of the World (ROW).
• Inflows are referred to as CREDITS.
• Outflows are referred to as DEBITS.
• The Balance Payments is divided into 3 accounts
• Current Account
• Capital/Financial Account
• Official Reserves Account
• Current Account
• Balance of Trade or Net Exports
• Exports of Goods/Services - Imports of Goods/Services
• Exports create a credit to the balance of payments.
• Imports create a debit to the balance of payments.
• Net Foreign Income
• Income earned by U.S. owned foreign assets - Income paid to foreign held U.S. assets
• Ex. Interest Payments on U.S. owned Brazilian bonds - Interest payments on German owned U.S.Treasury bonds.
• Net Transfers (tend to be unilateral)
• Foreign Aid → a debit to the current account
• Ex. Mexican migrant workers send money to family in Mexico.
• Capital/Financial Account
• The balance of capital ownership
• Includes the purchase of both real and financial assets.
• Direct investment by U.S. firms/individuals in a foreign country are debits to the capital account.
• Purchase of foreign financial assets represents a debit to the capital account.
• Purchase of domestic financial assets by foreigners represents a credit to the capital account.
• Relationship between Current and Capital Account
• The Current Account and Capital Account should zero each other out.
• That is...If the Current Account has a negative balance (deficit), then the Capital Account should then have a positive balance (surplus)
• Official Reserves
• The foreign currency holdings of the United StatesFederal Reserve System.
• When there is a balance of payments surplus, the Fed accumulates foreign currency and debits the balance of payments.
• When there is a balance of payments deficit the Fed depletes its reserves of foreign currency and credits the balance of payments.
• Where there's a balance of payments the Fed depletes
• Active v. Passive Official Reserves
• The United States is passive in its use of official reserves. It does not seek to manipulate the dollar exchange rate.

  Mechanics of Foreign Exchange (FOREX)

  • Foreign Exchange (FOREX)
  • The buying and selling of currency
  • Ex. In order to purchase souvenirs in France, it is first necessary for Americans to sell their Dollars and buy Euros.
  • Any transaction that occurs in the balance of Payments necessitates foreign exchange.
  • The exchange rate (e) is determined in theforiegn currency market.
  • Changes in Exchange Rates
  • Exchange rates (e) are a function of the supply and demand for currency.
  • An increase in the supply of a currency will decrease the exchange rate of a currency.
  • An decrease in the supply of a currency will increasethe exchange rate of a currency.
  • An increase in the demand of a currency will increasethe exchange rate of a currency.
  • An decrease in the demand of a currency willdecrease the exchange rate of a currency.
  • Appreciation and Depreciation
  • Appreciation of a currency occurs when the exchange rate of that currency increase (e↑)
  • Depreciation of a currency occurs when the exchange rate of that currency decrease (e↓)
  • Exchange Rate Determinants
  • Consumer Tastes
  • Relative Income
  • Relative Price Level
  • Speculation
  • Exports and Imports
  • The exchange rate is a determinants of both exports and imports.
  • Appreciation of the dollar causes American goods to be relatively more expensive and foreign goods to be relativelycheaper thus reducing exports and increasing imports.
  • Depreciation of the dollar causes American goods to be relatively cheaper and foreign goods to be relatively more expensive thus increasing exports and reducing imports.
  • Floating/Flexible Rates
  • Depends on demand and supply of that currency vs. other currencies.
  • It is very sensitive to the business cycle
  • Provide options for investment
  • Fixed Rates
  • Based upon a country's willingness to distribute currency and the ability to control the amounts.

    Absolute Advantage

    • Individual: exists when a person can produce more of a certain good/service than someone else in the same amount of time (or can produce a good using the least amount of resources.)
    • National: exist when a country can produce more of a good/service than another country in the same time period.

    Comparative Advantage

    • A person or a nation has a comparative advantage in the production of a product when it can produce the product at a lower domestic opportunity cost than can a trading partner.
    • Ex. for input: number of hours to do a job, number of acres to feed a horse, number of gallons of paint to paint a house.
    • Ex. for output:

    Specialization and Trade

    • Gains from trade are based on comparative advantage, not absolute or advantage.