In this section, we begin with a look at the balance of payments, followed by a discussion of exchange rate determination, and in the next section at policy implications.
The balance of payments is used to record the value of the transactions carried out between a country's residents and the rest of the world. The balance of payments is composed of two accounts:
(1) Since the large majority of the current account deals with trade of goods and services we will only discuss this component of the current account.
The balance of payments sums to zero because of the symmetry of the current and capital accounts.
Consider the purchase of a Japanese-made VCR by an American. This is considered an export from Japan and an import into the United States. When the U.S. consumer purchases the VCR, he pays in dollars (which increases the value of imports in the current account). However, the producer in Japan receives yen. The exchange of dollars for yen takes place in the foreign exchange markets. The important point is that the Japanese producers do not want dollars; instead they need yen to pay their employees, suppliers, and dividends to shareholders. The dollars return to the U.S. through the capital account.
We end up with a circular flow of currency. In the example given here, the dollars spent on a Japanese VCR will:
- increase the value of imports into the U.S.,
- reduce the value of the current account surplus ($exports -$ imports > 0) or increase the value of the current account deficit ($exports - $imports< 0).
- increase the supply of dollars in foreign exchange markets (we will soon see the effect on the yen/$ exchange rate), and
- eventually return to the U.S. through the capital account.
Consider an example. Assume that initially both the current account and capital account are in balance; NX = 0. Now you, rush out and buy a new $200 Toshiba VCR made in Japan and imported into the United States. The result is a $200 current account deficit (exports = 0, imports = $200). Back in Japan, Toshiba's bank statement shows a $200 credit, but Toshiba needs to withdraw yen to pay for manufacturing costs. As a result, Toshiba's bank uses the foreign exchange market to convert the dollars into yen, so Toshiba's bank credit is actually denominated in yen.
As a result of your purchase, the supply of dollars in the foreign exchange markets has increased by $200. Now let us assume that a Japanese saver wants to buy $200 worth of stock shares of a U.S. company, fast growing Sun Microsystems for example. She will deposit $200 worth of yen (2) in her brokerage account. Her investment bank will convert the yen into $200 and execute the stock purchase of Sun Microsystems shares. Consequently, your $200 has made its way back into the U.S. through the capital account.
(2) If we assume an initial exchange rate of ¥ 100/$1, the Japanese saver deposits ¥ 20,000 in her Tokyo account
Although this example is simplistic, it shows the basic linkage between the current and capital accounts. In general, deficits or surpluses in either account will show up as the opposite in the other account. Later in this topic we will show the linkage between changes in the capital account in Mexico and swings in the current account. Thus the linkages can work either way: from the current account to the capital account or the capital to current account.
There are exceptions to the one-to-one tradeoff. For example, the dollar is used throughout the world as an alternative to transactions in the domestic currency. As a result, some dollars may remain in Russia, as goods may be paid for in either rubles or dollars in the markets of Moscow. This is a relatively minor factor which will have no impact on our analysis.
When considering a nation's current account surplus or deficit, we need to consider some determinants of the level of its total imports and exports of goods and services. For now, let us assume that its trade is not influenced by trade barriers such as tariffs and quotas; we will look at these effects later.
There are four primary considerations when examining activity in a nation's current account:
- Changes in economic growth rates and national income will have a significant influence on the amount of goods and services that a country imports. As GDP growth and consumer incomes rise, purchases of goods and services also increase. Part of this increased consumption will be composed of foreign imports. For example, for every dollar that U.S. consumers spend on goods and services, about 10%, or 10 cents, is spent on imported goods. Thus we can expect a positive correlation between economic growth and the level of imports.
We also need to consider the GDP growth of a nation's trading partners. High growth rates abroad will lead to increases in the demand for another country's exports as foreign consumers increase their purchases of goods and services. Therefore, relative economic growth rates is the key variable. If a nation's economy is growing relatively faster than its trading partners, then the value of imports will increase faster than exports and net exports will decline.
- Changes in relative prices or inflation rates will determine the comparative prices of imports and exports for a nation. A country that is experiencing higher inflation rates than its trading partners will see the relative prices of exports increase and the relative prices of imports decline. In general:
- With an increase in domestic inflation, the prices of goods that are exported also rise. As foreign consumers pay a higher price for imported goods from the country with higher inflation rates, they are likely to switch to lower-priced substitute goods produced by domestic firms or imported from other countries.
For example, if inflation rates in Japan rise, the prices of Japanese exports throughout the world also increase in tandem (we assume). American consumers now must pay a higher price for goods imported from Japan, such as VCRs, automobiles, and televisions. As the relative price of Japanese imports increases (assume U.S. and all other inflation rates remain steady), U.S. consumers look for substitutes in consumption, such as American-made cars or Korean VCRs.
- The opposite holds true when domestic inflation rates decline relative to the inflation rates of trading partners. When a country's inflation rate falls, the relative prices of its exports decline and the prices of imported goods rise in comparison.
The basic rule is higher domestic inflation rates relative to other trading countries lead to a decrease in net exports. Higher inflation rates increase the relative prices of exports and decrease the relative prices of imports.
Lower domestic inflation rates relative to other trading countries lead to an increase in net exports. They decrease the relative prices of exports and increase the relative prices of imports.
- Changes in tastes will influence net exports. Consumer preferences change for a number of reasons and may affect their purchases of goods. Domestic governments and producers may appeal to patriotism and support of local jobs in attempts to increase consumption of domestically made goods and services relative to imports. However, over time with the increasing globalization of the world economy and methods of production, it has become increasingly difficult to find goods which are truly domestically made. Increasingly, manufacturers import parts and components from all over the world to produce a consumer good.
- Factors that determine comparative advantage such as production costs, technology, and worker skills all are important considerations when considering a country's current account trade balance. For example, increases in technology improve worker productivity and lower production costs. As the firm passes these savings on in the form of lower prices for consumer goods, exports increase as the relative price of the good falls in world markets. A nation that promotes education, worker skills, and technical research should see an expansion of its export markets over time as product quality improves and cost decreases.
The capital account deals with monetary flows into and out of a nation's financial markets. The most important determinant of financial flows are interest rates, which determine the rate of return on savings. In addition to interest rates, we should consider:
- The potential return on direct investment. Foreign firms will consider direct investment in a country the greater the potential return. By direct investment, a foreign firm may make a financial agreement with a domestic firm to provide money for capital expansion and research and development. Or the foreign firm may produce goods and services abroad, bringing in the money to build productive capacity.
- The potential return on financial assets such as real estate and equities will have important effects in the capital market. The combination of a developing country and volatile stock markets can lead to sudden and dramatic changes in capital account currency flows. Later in this topic we will examine events in Mexico during 1994 and 1995 as an example of how hot money flows in the capital account can seriously disrupt a country.
Returning to interest rates, the higher a country's interest rates, the more attractive its financial markets are to both domestic and foreign savers.
As domestic interest rates increase relative to rates in other countries, the relative rate of return in that country's financial markets rises, which attracts savings and financial capital. This leads to an increased inflow of money through the capital account and less money leaving a country in search of higher foreign interest rates, also through the capital account.
Throughout this course we have examined how equilibrium is determined in various markets. We began with the product market, looking at the supply and demand for a good. When supply equaled demand, the market price was decided. As we progressed, we saw how the equilibrium of the supply of labor and labor demand set the wage rate and how equilibrium in the market for loanable funds (the capital market) determined the rate of interest. Next we examined macroeconomic markets where the interaction of aggregate demand and aggregate supply changed macroeconomic prices (inflation) and output (GDP). Using the same basic analysis of supply and demand, we will now see how exchange rates are determined.
Exchange rates give us the price of one currency in relation to another. As with any good, the relative price of two currencies is determined by the supply and demand of the currencies in exchange rate markets. We can use basic fundamentals to explain how a domestic currency's price changes in relation to another. For a floating currency, its price in relation to another currency is determined by conditions of supply and demand for the currency.
Before we begin with our analysis of floating exchange rates, consider two other ways in which a currency's value can be determined.
Figure 12-1 shows the demand and supply of dollars in foreign exchange markets. We label the horizontal axis with the quantity of dollars in the foreign exchange markets. We will measure the value of the dollar in relation to the Japanese yen, so we label the vertical axis as the yen/$ ratio, or the price of the dollar in relation to the yen. The dollar's value is determined by the equilibrium of the demand for the dollar in foreign exchange markets with the supply of dollars in the same markets. In this case one dollar is worth 100 yen (¥ 100/$1). Or equivalently, it takes 100 yen to buy one dollar.
Now that we see how the demand and supply of dollars in foreign exchange markets determine its value relative to other currencies, let us consider changes in the dollar's value. We will first examine how current account conditions impact the U.S. dollar, and then we will examine the capital account.
First, let's examine how a change in economic growth affects the current account. Throughout this section it will be important to emphasize the ceteris paribus condition, or holding everything else constant. In this case let us assume that a tax cut increases U.S. GDP growth. Importantly, we hold everything else constant such as inflation rates and the rate of Japanese GDP growth.
Accelerating economic growth in the U.S. increases incomes and consumption. As U.S. consumers increase their consumption, part of this will include additional spending on imports. Over 10 cents out of every dollar spent by U.S. consumers is on imported goods. As economic growth increases in the U.S., so does spending on imports, reducing the value of net exports.
Remember what happens when a U.S. consumer buys an import. In Baltimore, the consumer pays for a Japanese good in dollars. The dollars make their way over to Japan through the foreign exchange markets where they are converted to yen. The result is to increase the supply of dollars in foreign exchange markets, which we will show below, and also increase the demand for yen (which we will not show).
As U.S. consumers increase their consumption of imports, the supply of dollars in foreign exchange markets rises. Figure 12-2 shows a rightward shift in the supply of dollars from S$0 to S$1 as U.S. consumers increase their purchases of imports. As a result, the price or value of the dollar falls from P$0 to P$1in relation to the yen. This is also known as a depreciation of the dollar.
This also means that the yen has appreciated, which could also be shown by looking at the demand for yen using the demand and supply for yen and the $/yen ratio.
The depreciation of the dollar could be expressed numerically. For example, the original yen/dollar ratio was ¥ 100/$1, and after the dollar depreciates let us say the new yen/dollar ratio is ¥ 90/$1. Originally, one dollar would buy the equivalent of ¥ 100 worth of Japanese goods and services. At the new value, the purchasing power of one dollar has fallen to ¥ 90 worth of Japanese goods and services.
Now consider the capital account. Let us construct a scenario where the U.S. Federal Reserve uses restrictive monetary policy to raise U.S. interest rates. Importantly, we hold all other economic variables constant, such as foreign interest rates.
In the previous example, changes in the level of imports affected the amount of dollars in the foreign exchange market through the current account, which measures trade in goods and services. Movements in interest rates impact the number of dollars in foreign exchange markets through the capital account. The capital account measures currency flows of savings and financial capital (or the supply of loanable funds). In the current account, dollars end up in the foreign exchange markets as a result of a purchase or sale of a tangible good or service. Money moves in the capital account seeking more favorable rates of return (e.g., higher interest return) or greater stability. No transactions of goods and services occur in this case; only the movement of money. Money that moves either through the capital or the current account still ends up in the same foreign exchange market; it just takes a different route (via accounting definitions) getting there.
With an increase in U.S. interest rates (holding all foreign interest rates constant), money from foreign savers enters the U.S. seeking a higher relative return. Consider the Japanese saver in Yokosuka making a purchase of U.S. Treasury Bills because he seeks a higher rate of return than he can earn domestically. The saver deposits his money with his brokerage in Japan and the broker takes the yen deposit and exchanges the yen for dollars in the foreign exchange market. The dollars are then used to buy a U.S. T-bill in America. The Japanese saver becomes the owner of the U.S. T-bill. Importantly, this transaction has increased the demand for dollars in the foreign exchange market. The demand for dollars increases as yen are exchanged for dollars in the foreign exchange market in order to make the T-bill purchase.
Figure 12-3 shows the impact of higher U.S. interest rates. As foreign savers send their money over to the U.S. to purchase American financial assets, the demand for dollars increases from D$0 to D$1. This raises the price or value of the dollar relative to the yen from P$0 to P$1. This is known as an appreciation of the dollar.
Subsequent Effects of a Currency Revaluation
We conclude this section with a Table that shows how changes in exchange rates affect the relative prices of goods. Assume the initial yen/dollar exchange rate is ¥ 100/$1 and the dollar depreciates to ¥ 90/$1. We now look at the impact on a U.S.-made mountain bicycle and a Japanese-made television. The price of the mountain bike to U.S. consumers remains fixed at $500, while in Japan, Japanese consumers pay ¥ 36,000, regardless of the exchange rate. As the table below shows, at the initial exchange rate of ¥ 100/$1, Japanese consumers pay ¥ 50,000 for the imported U.S.-made bike. U.S. consumers pay $360 to purchase the imported T.V. from Japan. For simplicity, assume the price paid for imports only reflects the market price that foreign consumers pay.
|Comparative Prices of Goods in Japan and the United States|
|¥ 36,000 Japanese-made TV||$500 U.S.-made bike|
|Exchange Rate||Price in Japan||Price in U.S.||Price in U.S.||Price in Japan|
|¥ 100 = $1||¥ 36,000||$360||$500||¥ 50,000|
|¥ 90 = $1||¥ 36,000||$400||$500||¥ 45,000|
Now consider the change in the relative price that consumers pay for imports when the dollar depreciates to ¥ 90/$1. While the price of the bike does not change for U.S. consumers, the increased purchasing power of the yen reduces the price that Japanese consumers pay for the imported bike to ¥ 45,000. Likewise the price of a Japanese-made television purchased by U.S. consumers rises to $400. From the table we can see that a depreciation of a country's currency (the dollar depreciates in this example) increases the price of imports and lower the price of its exports. An appreciation of a nation's currency (e.g., the yen), increases the relative prices of its exports, while making imports cheaper to buy for domestic consumers.
Extending this concept to net exports, we see that a depreciating currency will eventually increase exports and decrease imports, improving net exports. In contrast, an appreciating currency reduces exports and increases imports, reducing net exports. Of course, we are isolating the impact of changes in the exchange rate only. There are many other factors at work that could work opposite or complementary to the exchange rate effect. For a more realistic appraisal of overall trade, refer to the earlier part of this section that looks at factors determining the current and capital accounts. However, we can conclude that changes in exchange rates do alter the relative prices of imports and exports.
One of the strengths of the US economic system (and for many other countries as well) is the independence of the Federal Reserve (central bank) from the political process (executive and legislative). While the Chair of the Federal Reserve is a political appointee as are several members of the Federal Open Market Committee, once in place, they can practice monetary policy independent of political pressures from the White House and Congress. For the most part, Presidents and Congress have been wise in making Federal Reserve appointments based on the qualifications of the appointee and not on a litmus test of potential obedience to political causes.
The central bank such as the Federal Reserve performs the critical role of printing and controlling the domestic money supply. If the central bank lacks independence from a nation's political rulers, often inflation is the result. To gain the favor of voters, politicians like to spend and distribute money. Since taxes are unpopular, the easiest source for money to spend excessively is to order the central bank simply to print the money for the government to distribute. The result is increasing amounts of money to purchase a given amount of goods and inflation quickly takes off.
In an attempt to break the close connection between the central bank and the politicians, a few countries have taken extreme measures to control the money supply and thus the inflation rate. Perhaps the strongest remedy was recently undertaken by Ecuador. Ecuador abandoned its domestic currency, the sucre, in favor of making the US dollar the national currency. This is a process known as dollarization. To be clear, Ecuador now uses the same dollars that Americans use in the United States.
Here are some of the considerations of the dollarization in Ecuador:
· The government of Ecuador cannot print dollars - this would be counterfeiting.
· The major source of dollars comes from exports and tourism.
· The government of Ecuador gives up a tremendous amount of power in monetary policy. Unless the government collects ample dollar reserves, it will have trouble increasing the supply of money to lower domestic interest rates.
· For the purposes of foreign trade, Ecuador is now tied to the value of the dollar. If the dollar appreciates against other currencies such as the euro or yen, the prices of exports from Ecuador will rise to foreign consumers, just as they do in the United States.
· For the reasons discussed above, the money supply of Ecuador is very limited and the government has no ability to print money to finance its activities. If the government runs a budget deficit, it must either borrow the money in financial markets by issuing debt and/or raise taxes to increase revenues. As a result, inflation due to excessive monetary stimulus is no longer a problem.
Is dollarization a long run solution for Ecuador? Certainly giving up the domestic currency and adopting a foreign currency is an extreme measure, both economically and socially.
A step short of dollarization is to use what is known as a currency board. A country that implements a currency board still uses the domestic currency but is required to hold a major foreign currency at a one-to-one ratio. For example, in the 1990s Argentina started a currency board to limit the supply of pesos and control inflation - the source of the inflation was the same as with Ecuador, too many pesos printed by the government. Argentina's currency board required the government of Argentina to hold a dollar in reserve for every peso in circulation. The only way for the government to increase the number of pesos was to acquire additional dollars - primarily from exports and tourism. Furthermore, the currency board required Argentina to fix the exchange rate of the peso at a rate of one peso per dollar.
Argentina's currency board created some severe problems for Argentina and was abandoned in 2002. A major source of Argentina's problem resulted from the appreciation of the dollar, and thus the peso that was fixed to the dollar at a one-to-one ratio. As the dollar, and thus the peso appreciated in the 1990s, Argentina's export prices increased. Argentina is very dependent on agricultural exports (such as beef) to neighbor countries. As the price of imports from Argentina increased for buyers in Brazil, cheaper substitutes from other countries were found (e.g. beef from Peru), further damaging Argentinas economy that had been suffering from a recession that started in 1998.
While a solution to Argentina's foreign exchange problems appeared to be obvious - allow the peso to devalue against the dollar - in reality things were more complicated. Once the currency board was established, the government of Argentina lacked the ability to print pesos to accommodate continued deficit spending - it turned to foreign debt markets instead. Argentina's government issued tremendous amounts of government debt, mostly sold to foreign lenders who liked the fact that payments were made in dollars. When Argentina's government sold debt, the interest payments and eventual reimbursement would be made in US dollars. With a currency board and a one-to-one exchange rate, it did not really matter to the government if it paid in dollars or pesos.
By early 2002, Argentina accounted for one-fourth (25%) of all debt sold by emerging country governments. Argentina's businesses were also large borrowers in foreign markets, typically making their debt payments in dollars as well. Consider the consequence of a peso devaluation, to 3 pesos to a dollar for example. Before the devaluation, the government of Argentina or a business would have to raise one peso in revenues (through taxes for the government, sales for the firm) to convert to a dollar in order to make a dollar in debt payments. After the devaluation of the peso to 3 pesos per dollar, the government or business would have to raise 3 pesos domestically to convert into a dollar to make a dollar in debt payments. The price of debt servicing would have tripled. In a practical sense, with the peso devaluation, the government would have to impose a significant and unpopular tax increase, and businesses would have to raise prices to collect the additional pesos to service the outstanding debt.
In 2002, as its financial situation deteriorated and foreign lenders stopped purchasing debt originating in Argentina in 2002, Argentina allowed the peso to devalue to a floating currency. Unable to raise the additional pesos to make dollar-denominated interest payments the government of Argentina defaulted on its foreign debt. The government of Argentina declared bankruptcy.
Starting in 2002, many European countries gave up their sovereign currency to form the European Monetary Union (EMU) and create a joint currency known as the euro. Members of the currency union include economic powers like Germany and smaller nations including Ireland and Portugal. The monetary union is directed by the European Central Bank (ECB) that acts as does any central bank - prints the money, controls the money supply and interest rates, regulates banks and other activities. The ECB is headquartered in Brussels, Belgium.
In practice, EMU countries are undertaking an economic integration. Rather than considering multiple currencies and exchange rates, there is now a single currency the all member nations will use for transactions and a single exchange rate with other major currencies. Furthermore, monetary policy is focused on overall economic conditions in the euro-zone, not one country. Although remaining independent, fiscal policy is restricted for each member country by the stability criteria. As a condition for membership, the stability criteria requires that when a country has a fiscal budget deficit, the deficit exceeds no more than 3% of total domestic GDP. As a result of the stability criteria, countries are limited in the fiscal stimulus they can give the domestic economy through government spending and tax policies.
An additional consideration of the EMU is the establishment of more transparent borders between member countries. The movement of goods and workers between nations is much more open and tariffs are abolished between member countries. Aside from improving the transport of goods between countries, workers have the increased flexibility of moving to a country that offers better employment and wage opportunities when necessary.
The economic benefits to the EMU appear substantial and member countries have a good incentive to participate. However, while the EMU makes huge strides in economically integrating EMU countries, each retains its political sovereignty. However, domestic politicians have lost much of their economic power to the EMU authority and the ECB. Majors tests of the EMU's longevity will come when there are asymmetric shocks. For an example of an asymmetric shock, assume that Germany and most of the other EMU countries are facing inflationary pressures. At the same time, assume that France has a weak domestic economy and the French unemployment rate is rising. Since the overall economic condition of the EMC is one of a rising likelihood of inflation, the prudent policy for the ECB is to raise interest rates to slow economic growth across the EMU and dampen inflationary pressures. However, this will only increase the already troubled unemployment rate in France to a higher level.
A good analogy is found in the United States where it is common for a state or a region to have different economic circumstances than the country as a whole. For example, in the 1980s when oil prices collapsed, oil producing states like Oklahoma and Texas were hurt, while much of the rest of America was helped by lower gasoline prices. The term "rust belt" described some of the Midwestern states that produced much of the nation's automobiles and steel. These states were devastated by the 1982 recession, while other parts of the country felt only minimal impacts. Another example looks at the "peace dividend" realized in the early 1990s when the Soviet Union disintegrated. California, a state very dependent on the defense industry, experienced a local recession as the US government slashed defense expenditures after the Gulf War. However, the Federal Reserve did not respond by lowering interest rates to help California, in fact, the Fed raised interest rates through much of 1994 to respond to overall macroeconomic conditions in the United States. With diminished job opportunities in the local economy, there was an exodus of residents to states like Colorado where the local economy was booming and jobs were plentiful.
Returning to our example in Europe, if France is suffering from a "local" recession and the ECB is raising interest rates to reduce inflationary pressures in the overall European macroeconomy, French workers may have to consider migrating to another European country when the job opportunities are better. Workers who move from California to Colorado need to adjust to the lack of ocean access and some other minor changes. In contrast, a French citizen who migrates to Spain needs to learn a new language and adopt a very different culture.
Another consideration is in the area of income transfers. In the United States, Europe and for many countries, unemployed workers receive assistance from the government until they can find a new job. This represents an income transfer from those who are currently working and paying taxes, to the unemployed who receive benefits. The problem could become interesting in the EMU when a country suffers from chronically high unemployment rates. In this case, countries with high unemployment would be a net recipient of income transfers from other EMU countries that have managed their economy's better. There could be some resentment of this fact between countries with a long history of grievances.
Historically, no currency union between different countries has ever succeeded in the long run. At any time, a member nation can vote to drop out of the EMU and there are many popular politicians in Europe who include quitting the EMU as part of their platform. The major test of the euro will come when economic times become very difficult for some of the member nations.
Copyright © 2002, Jay Kaplan
All rights reserved