| 1. |
Trade between two nations differs
from domestic trade because the nations use different currencies. This problem is resolved
by the existence of foreign exchange markets
in which the currency used by one nation can
be purchased and paid for with the currency of the other nation.
- United States exports create a foreign demand for
dollars
and the satisfaction of this demand increases the supply of foreign currencies in
the foreign exchange market.
- United States imports create a domestic demand
for foreign currencies
and meeting this demand decreases the supplies of foreign
currencies in the foreign exchange market.
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| 2. |
The international balance of payments for a
nation is an annual record of all its transactions with the other nations in the world; it
records all the payments received from and made to the rest of the world.
- The current account section of a nation’s
international balance of payments records its trade in currently produced goods and
services. Within this section
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- the trade balance of the nation is equal to its
exports of goods (merchandise) less its imports of goods (merchandise);
- the balance on goods and services is equal to its
exports of goods and services less its imports of goods and services; and
- the balance on the current account is equal to
its balance on goods and services plus its net investment income (dividends and interest)
from other nations and its net private and public transfers to other nations
and minus
this balance may be either a surplus or a deficit.
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- The capital account section of a nation’s
international balance of payments records its sales of real and financial assets (which
earn it foreign currencies) and its purchases of real and financial assets (which use up
foreign currencies). The nation has a capital account surplus (deficit) if its sales are
greater (less) than its purchases of real and financial assets.
- The official reserves account consists of the
foreign currencies owned by the central bank. These reserves decrease when they are used
to finance a net deficit on the combined current and capital accounts. The reserves
increase when a nation has a net surplus on its current and capital account. The three
components of the balance of payments — the current account
the capital account
and
the official reserves account — must equal zero.
- A nation has a balance of payments deficit when
imbalances in the combined current and capital accounts lead to a decrease in official
reserves. A balance of payments surplus arises when imbalances in the combined current and
capital accounts result in an increase in official reserves.
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| 3. |
There are flexible (floating) and fixed
exchange-rate systems that nations use to correct imbalances in the balance of payments.
If the foreign exchange rate floats freely
the demand for and the supply of foreign
exchange determine foreign exchange rates. The exchange rate for any foreign currency is
the rate at which the quantity of that currency demanded is equal to the quantity of it
supplied.
- A change in the demand for or the supply of a
foreign currency will cause a change in the exchange rate for that currency. When there is
an increase in the price paid in dollars for a foreign currency
the dollar has
depreciated and the foreign currency has appreciated in value. Conversely
when there is
an decrease in the price paid in dollars for a foreign currency
the dollar has
appreciated and the foreign currency has depreciated in value.
- Changes in the demand for or supply of a foreign
currency are largely the result of changes in tastes
relative incomes
relative price
levels
relative interest rates
and speculation.
- Flexible exchange rates can be used to eliminate
a balance of payments deficit or surplus.
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- When a nation has a payment deficit
foreign
exchange rates will increase
thus making foreign goods and services more expensive and
decreasing imports. These events will make a nation’s goods and services less
expensive for foreigners to buy
thus increasing exports.
- With a payment surplus
the exchange rates will
increase
thus making foreign goods and services less expensive and increasing imports.
This situation makes a nation’s goods and services more expensive for foreigners to
buy
thus decreasing exports.
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- But a flexible exchange-rate system increases the
uncertainties exporters
importers
and investors face
thus reducing international trade.
This system also changes the terms of trade and creates instability in domestic economies.
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| 4. |
When nations fix (or peg) foreign exchange
rates
the governments of these nations must intervene in the foreign exchange markets to
prevent shortages and surpluses caused by shifts in demand and supply.
- One way a nation can stabilize foreign exchange
is for its government to sell its reserves of a foreign currency in exchange for its own
currency (or gold) when there is a shortage of the foreign currency. Conversely
a
government would buy a foreign currency in exchange for its own currency (or gold) when
there is a surplus of the foreign currency; however
currency reserves may be limited and
inadequate for handling large and persistent deficits or surpluses
so it may use other
means to maintain fixed exchange rates.
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- A nation might adopt trade policies that
discourage imports and encourage exports.
- A nation might impose exchange rate controls and
rationing
but these policies tend to distort trade
lead to government favoritism
restrict consumer choice
and create black markets.
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- Another way a nation can stabilize foreign
exchange rates is to use monetary and fiscal policy to reduce its national income and
price level and raise interest rates relative to those in other nations. These events
would lead to a decrease in demand for and increase in the supply of different foreign
currencies.
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| 5. |
In their recent history
the nations of the
world have used three different exchange-rate systems.
- Under the gold standard
each nation must define
its currency in terms of a quantity of gold
maintain a fixed relationship between its
gold and its money supply
and allow gold to be imported or exported without restrictions.
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- The potential gold flows between nations would
ensure that exchange rates remained fixed.
- Payment deficits and surpluses would be
eliminated through macroeconomic adjustments. For example
if a nation has a balance of
payments deficit and gold flowing out of the country
its money supply would decrease.
This event would increase interest rates and decrease total spending
output
employment
and the price level. The opposite would happen in the other country because it has a
payments surplus. The changes in both nations would eliminate any payments deficit or
surplus.
- During the worldwide depression of the 1930s
nations felt that remaining on the gold standard threatened their recoveries
and the
policy of devaluating their currencies to boost exports led to the breakdown and
abandonment of the gold standard.
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- From the end of World War II until 1971 the
Bretton Woods system
committed to the adjustable-peg system of exchange rates and managed
by the International Monetary Fund (IMF)
kept foreign exchange rates relatively stable.
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- The adjustable-peg system required the United
States to sell gold to other member nations at a fixed price and the other members of the
IMF to define their monetary units in terms of either gold or dollars (which established
fixed exchange rates among the currencies of all member nations) and required the other
member nations to keep the exchange rates for their currencies from rising by selling
foreign currencies
selling gold
or borrowing on a short-term basis from the IMF.
- The system also provided for orderly changes in
exchange rates to correct a fundamental imbalance (persistent and sizable balance of
payments deficits) by allowing a nation to devalue its currency (increase its defined gold
or dollar equivalent).
- The other nations of the world used gold and
dollars as their international monetary reserves in the Bretton Woods system. For these
reserves to grow
the United States had to continue to have balance of payments deficits
but to continue the convertibility of dollars into gold it had to reduce the deficits
and
faced with this dilemma
in 1971 the United States suspended the convertibility of
the dollar
brought an end to the Bretton Woods system of fixed exchange rates
and
allowed the exchange rates for the dollar and the other currencies to float.
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- Exchange rates today are managed by individual
nations to avoid short-term fluctuations and allowed to float in the long term to correct
balance of payments deficits and surpluses. This new system of managed floating exchange
rates is favored by some and criticized by others.
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- Its proponents contend that this system has not
led to any decrease in world trade and has enabled the world to adjust to severe economic
shocks.
- Its critics argue that it has resulted in
volatile exchange rates
has not reduced balance of payments deficits and surpluses
and
is a “nonsystem” that a
- nation may use to achieve its own domestic
economic goals.
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| 6. |
During the 1990s
the United States has had
large and persistent trade deficits.
- These trade deficits were the result of several
factors:
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- more rapid growth in the domestic economy than in
the economies of several major trading partners
which caused imports to rise more than
exports;
- recent large deficits in the Federal budget which
drove up real interest rates
increased the international value of the dollar
and
increased imports and decreased exports; and
- a decline in the rate of saving and a capital
account surplus
which allowed U.S. citizens to consume more imported goods.
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- The trade deficits of the United States have had
two principal effects: They increased current domestic consumption and allowed the nation
to operate outside its production possibilities frontier
and they increased the
indebtedness of U.S. citizens to foreigners. A possible implication of these persistent
trade deficits is that they will lead to permanent debt and foreign ownership of domestic
assets
or large sacrifices of future domestic consumption.
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