Chapter 19 Quiz

International Finance and Exchange Rates

Balance of Payments Accounts

The balance of payments is a record of all economic transactions between residents of a country and the rest of the world during a specific period. It is divided into several main accounts:

• Current Account: Records transactions involving goods, services, income, and current transfers. The largest category is typically imports.

• Capital and Financial Account: Records transactions involving financial assets, such as foreign investment in the United States. The largest category is usually foreign investment.

• Official Settlements Account: Tracks changes in official reserves held by the central bank.

Example: If Toyota purchases a truck factory in San Antonio, Texas, this is recorded in the capital and financial account as a foreign investment in the United States.

Current Account Deficits and Surpluses

A current account deficit occurs when a country imports more goods, services, and income than it exports. The United States has had a current account deficit for most years since 1981.

• Fluctuations in the current account balance are mainly the result of changes in net exports.

• A nation that has invested more in the rest of the world than other countries have invested in it is called a creditor nation.

• The U.S. switched from being a net lender to a net borrower in the early 1980s, running large current account deficits.

Exchange Rates and Foreign Exchange Market

The exchange rate is the price of one currency in terms of another. It is determined by the supply and demand for currencies in the foreign exchange market.

• If the exchange rate rises, the quantity of dollars demanded decreases, and there is a movement up along the demand curve for dollars.

• If the exchange rate appreciates, the quantity of dollars demanded decreases.

• If the exchange rate changes from 1.00 euro per dollar to 1.10 euro per dollar, the dollar has appreciated against the euro.

Example: To appreciate the U.S. dollar against the Mexican peso, the Fed could buy dollars and sell pesos in the foreign exchange market.

Determinants of Exchange Rates

Several factors influence exchange rates, including interest rates, inflation, and government intervention.

• An increase in the U.K. interest rate decreases the demand for U.S. dollars and depreciates the exchange rate.

• When the U.S. interest rate differential rises, the demand for dollars increases, shifting the demand curve for dollars rightward.

• The U.S. interest rate has an effect on the demand for dollars but not on the supply of dollars.

Purchasing Power Parity (PPP)

Purchasing power parity is the theory that in the long run, exchange rates adjust so that identical goods cost the same in different countries. If prices for the same goods and services differ between two nations, the exchange rate will adjust over time to achieve PPP.

Government Intervention in Exchange Rates

Central banks can intervene in the foreign exchange market to influence the value of their currency.

• If the U.S. dollar depreciates against the euro, the Fed can sell dollars in the foreign exchange market to keep the exchange rate stable.

• Government holdings of foreign currency are recorded in the capital and financial account.

Supply and Demand for Dollars

The supply and demand for dollars in the foreign exchange market are influenced by trade and financial flows.

• If U.S. imports increase (with a constant exchange rate), the supply of U.S. dollars increases in the foreign exchange market.

• As the U.S. exchange rate rises, the price of U.S. imports increases and the quantity supplied of dollars increases.

Summary Table: Key Balance of Payments Accounts

Account	Main Transactions	Largest Category
Current Account	Goods, services, income, current transfers	Imports
Capital and Financial Account	Foreign investment, loans, reserves	Foreign investment in the U.S.
Official Settlements Account	Central bank transactions	Official reserves

Key Formulas and Concepts

• Exchange Rate (E): The price of one currency in terms of another.

• Purchasing Power Parity (PPP): $E = \frac{P_{\text{foreign}}}{P_{\text{domestic}}}$ where $P_{\text{foreign}}$ and $P_{\text{domestic}}$ are the price levels in the foreign and domestic countries, respectively.

• Current Account Balance: $\text{Current Account Balance} = \text{Exports} - \text{Imports} + \text{Net Income} + \text{Net Transfers}$

Additional info: These notes expand on the quiz questions by providing definitions, examples, and formulas relevant to international finance and exchange rates, as covered in Macroeconomics courses (Chapters 18 and 19).