Unit 7 Part 2

Unit 7 Notes Continued....

Foreign Exchange (FOREX):

• The buying and selling of currency.
• Any transition that occurs in the Balance of Payments necessitates foreign exchange.
• The exchange rate (e) is determined in the foreign currency market. 

Changes in Exchange Rates:

·         Exchange rates (e) are a function of the supply and demand for currency.

• ⬆Supply of a currency à ⬇in exchange rate of a currency 
• ⬇Supply of a currency à ⬆in exchange rate of a currency
• ⬆Demand for a currency à ⬆in exchange rate of a currency
• ⬇Demand for a currency à ⬇in exchange rate of a currency 

Appreciation & Depreciation: 

• Appreciation: When the exchange rate of that currency ⬆ (e⬆) 
• Depreciation: When the exchange rate of that currency ⬇ (e⬇) 

Exchange Rate Determinants:

• Consumer Tastes
• Relative Income
• Relative Price Level
• Speculation 

Exports and Imports: 

• Appreciation: U.S. goods à more expensive
• Foreign goods à cheaper = Reduces exports and increasing imports

• Depreciation: U.S. goods à cheaper
• Foreign goods à more expensive = Increasing exports and reducing imports

Flexible Rates:

• It’s very sensitive to the business cycle and it provides options for investments 

Fixed Rates: 

• It is based on a countries willingness to contribute currency and control the amount. 

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: Exists when a country can produce more of a good/service than another country can 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.

Examples of Output Problems: 

1. Words per minute
2. Miles per gallons
3. Tons per acre
4. Apples per tree
5. Televisions produced per hour

Examples of Input Problems: 

1. # of hrs to do a job
2. # of acres to feed a horse
3. # of gallons of paint to paint a house

Specialization and Trade:

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

Help Links:

Comparative and Absolute Advantage

Comparative and Absolute Advantage

Unit 7 Part 1

Balance of Payments: 

·          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 of Payments is divided into 3 accounts:

o    Current Account

o    Capital/Financial Account

o    Official/Reserves Account

Current Account: 

·         Balance of Trade or Net Exports

o    Exports of Goods/Services

o    Exports create a credit to the balance
      of payments

·         Net Foreign Income 

o    Income earned by U.S. owned foreign assets - income paid to foreign held U.S assets

·         Net Transfers 

·         Foreign Aid:

o    a debit to the current account 

o    Ex: Mexican migrant worker sends money to Mexico

Capital/ Financial Account: 

• The balance of capital ownership
• Includes the purchase of both real and financial assets 
• Direct investment in the United States is a credit to the capital account
• Ex: The Toyota Factory in San Antonio

• Direct investment by U.S. firms/individuals in a foreign country are debits to the capital account
• Ex: The Intel Factory in San Jose, Costa Rica.

• Purchase of foreign financial assets represents a debit to the capital account
• Ex: Warren Buffet buys stock in Petrochina 

• Purchase of domestic financial assets by foreigners represents a credit to the capital account
• Ex: The UAE sovereign wealth fund purchases a large stake in the NASDAQ

Relationship between Current Account & Capital Account:

• The Current Account and the 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 U.S. Federal Reserve system
• Balance of payments surplus ---> Fed accumulates foreign currency and debits the balance of payments
• Balance of payments deficit ---> Fed depletes its reserves of foreign currency and credits the balance of payments
• Official reserves zero out balance of payments

Active v. Passive Official Reserves:

·         The U.S. is passive in its use of official reserves. If does not seek to manipulate the dollar exchange rate.

Formulas:

Balance of Trade

• Goods Exports + Goods Imports 

Balance of Goods & Services 

• Goods Exports + Service Exports + Goods Imports + Service Imports

Current Account: 

• Balance of goods & services + Net Investments + Net Transfers 

Capital Account:

• Foreign Purchases + Domestic Purchases

Helpful Links for Further Understanding:

Balance of Payments

Balance of Payments