Chapter Seven: Foreign Exchange and the Balance of Payments

• Foreign Exchange and Exchange Rates
  • Changes in Exchange Rates
• Determination of the Exchange Rate
  • Demand for Foreign Exchange
  • Supply of Foreign Exchange
  • The Equilibrium Exchange Rate
• Exports, Imports and Trade Deficits
• International Capital Flows
• The Balance of Payments
  • Current Account
  • Capital Account
  • Statistical Discrepancy Account
• Useful Web Resources

Foreign Exchange and Exchange Rates

The exchange rate (e) is the amount of domestic currency that it takes to purchase one unit of foreign currency. We will view everything from the U.S. perspective. For example, if US$1 purchases 5 pesos, then it takes US$0.20 to purchase 1 peso, so the exchange rate is 0.2 or 1/5. Alternatively, if US$1 purchases 0.50 pounds, then it takes US$2 to purchase one pound so the exchange rate is 2.0. Confused?

TABLE 1 Exchange Rates
Country	Currency	U.S.$ Equivalent	Currency per U.S. $
Brazil	Real	0.369	2.71
Britain	Pound	1.87	0.535
Canada	Dollar	0.812	1.23
E.M.U.	Euro	1.30	0.766
India	Rupee	0.023	43.76
Japan	Yen	0.010	104.84
Mexico	Peso	0.089	11.28
Taiwan	Dollar	0.031	32.01
Note: Many exchange listings use the Currency per U.S. $ method except when quoting the British pound. The British pound is almost always quoted as the U.S. $ Equivalent.

To confuse things even more, exchange rates are often quoted as the inverse of the above definition. A table of exchange rates can be read daily from any major newspaper such as the New York Times or the Wall Street Journal. The Board of Governors of the Federal Reserve also posts comprehensive exchange rate data on a weekly and monthly basis. Table 1 lists exchange rates as would be seen in many business newspapers as of January 7, 2005. Notice that exchange rates are defined two ways, either as the U.S. $ Equivalent, or Currency per U.S. $. The U.S. $ Equivalent tells us how much one unit of foreign currency is worth in U.S. dollars while the Currency per U.S. $ quotes foreign currency in terms of how much foreign currency one U.S. dollar can purchase. For example, for the U.S.-euro exchange rate, the U.S. $ Equivalent is 1.30, meaning that it takes about US$1.30 to purchase one euro. Conversely, the Currency per US $ is 0.766, such that one U.S. dollar can purchase about 0.77 euros. The way we define exchange rates in this chapter is the U.S. $ Equivalent.

Changes in exchange rates

U.S. exchange rates have fluctuated widely over time. The figure titled "Exchange Rates" plots the average value of the inverse of the U.S. exchange rate against the currencies of its major trading partners between 1980 and 2006. Because of the inverse scaling, rising values indicate a stronger U.S. dollar. Notice the strong U.S. dollar in the mid-1980s. As we explain below, the mid-1980s was a period when U.S. exporters had a difficult time competing in international markets and U.S. consumers enjoyed cheap prices of imports. The dollar rose again in the mid- to late 1990s as foreigners rushed to invest their wealth in U.S. assets to take part in the booming economy. The dollar began to slide in 2002 and continued its slide through 2004.

Demand for foreign exchange is domestic demand for foreign currency. As described above, import demand is simultaneously a demand for foreign exchange. The figure titled "Demand for Foreign Exchange" plots the exchange rate on the vertical axis against the quantity of foreign exchange on the horizontal axis.

Given the exchange rate e_A, the quantity demanded of foreign exchange is FE_A. As the exchange rate rises to e_B, the quantity demanded of foreign exchange falls to FE_B. Therefore, the demand curve for foreign exchange is negatively sloped; as the exchange rate rises, quantity demanded of foreign exchange falls.

The reasoning for the negative slope of the demand curve is the following. Suppose that one U.S. dollar initially purchases one euro such that e=1. Simplifying, a flashlight that costs 10 euros to produce in Germany will sell for US$10 in the U.S. Now the U.S. dollar depreciates or weakens relative to the euro such that the exchange rate, e, rises to 1.5. At this exchange rate, it takes US$1.50 to purchase 1 euro. The same flashlight that costs 10 euros to produce in Germany will sell for US$15 in the U.S. Because the U.S. dollar weakened relative to the euro, it takes more U.S. dollars to purchase the same amount of euros; consequently, the prices of imports rise. When import prices rise, demand for imports fall and, hence, the demand for foreign exchange falls.

The opposite side of the coin is the supply of foreign exchange. The U.S. supplies foreign exchange when it makes the U.S. dollar available for purchase by a foreign entity. For example, suppose that someone from Mexico wishes to purchase a Chevy Blazer produced in Detroit, Michigan. The Mexican citizen purchases the Blazer from the Mexican automobile dealer and pays in pesos. The Mexican dealer then exchanges pesos for U.S. dollars and pays the automobile producer in U.S. dollars. In this example, the U.S. supplied dollars to Mexico. Just as the demand for foreign exchange comes from imports, the supply of foreign exchange comes from exports.

Given the exchange rate e_A in the figure titled "Supply of Foreign Exchange", the quantity supplied of foreign exchange is FE_A. As the exchange rate rises to e_B, the quantity supplied of foreign exchange rises to FE_B. Therefore, the supply curve for foreign exchange is positively sloped; as the exchange rate rises supply of foreign exchange also rises.

Again, let us assume that one U.S. dollar purchases one euro, so e=1. A flashlight that costs US$10 to produce in the U.S. sells for 10 euros in Germany. Now the exchange rate rises (remember, always from the U.S. perspective) to 1.5 so that one euro can purchase US$1.50. With the higher exchange rate, it takes just 6.67 (10/1.5) euros to purchase the US$10 flashlight. Instead of selling for 10 euros, the flashlight sells for just 6.67 euros. With U.S. export prices cheaper in Germany, Germany's demand for U.S. exports will rise; therefore, the U.S. supply of foreign exchange will rise.

The Equilibrium Exchange Rate

As with other goods, factors that influence the supply or demand for foreign exchange can change, which will affect the equilibrium outcome. We deal with one of these forces below.

As large as these trade numbers are, they must be put into context. The U.S. nominal GDP in 2005 was approximately US$12.5 trillion; therefore, the ratio of exports to GDP (also charted in the figure) was just 10.2 percent. In other words, despite the enormous absolute size of the country's trade, most of the production in the U.S. is for domestic consumption.

TABLE 2 U.S. Trade Deficits
Year	Trade Deficit (US$ Billions)
1980	19.4
1985	121.9
1990	80.9
1995	96.3
2000	377.6
2003	494.9
2004	611.3
2005	716.7

Each year since 1980, the U.S. has imported more goods and services than it has exported. The excess of imports over exports is referred to as the trade deficit or the (negative) balance on goods and services. The Census Bureau reports the U.S. trade deficit on a monthly basis. Table 2 lists U.S. trade deficits for selected years. Trade deficits have increased substantially over the last few years because of the strong growth of the U.S. economy combined with a strong dollar. When American incomes rise relative to incomes of foreigners, purchases of imports increase as well, leading to the larger deficit. In 2005 the trade deficit was US$716.7 billion, nearly double the 2000 deficit.

Trade deficits suggest that the demand for foreign exchange exceeds the supply of foreign exchange. If the U.S. demands US$2.0 trillion in foreign exchange to purchase imports but it supplies just US$1.3 trillion to provide exports, does that not imply that the market is in disequilibrium? If imports and exports were the only reasons that we traded foreign exchange then the market would be in disequilibrium and the exchange rate would rise (the U.S. dollar would depreciate) until supply and demand for foreign exchange were equal. Recall that a depreciating U.S. dollar increases import prices and decreases export prices. However, another source of supply and demand for foreign exchange exists that potentially allows trade deficits or surpluses to persist year after year.

Besides imports, another source of demand for foreign currency comes from investing in foreign assets. A capital outflow is the purchase of a foreign asset by a domestic entity. For example, many U.S. employers offer savings plans to employees as part of their benefit package. Often, the employee has several choices of how to invest the savings, including an international equity account. In essence, the employer hires a fund manager to pool the funds from the employee savings plan and invest in foreign stocks. In this example, the employee who elects the international equity account is demanding foreign exchange. If the international equity fund purchases Japanese stocks then the U.S. dollars must be converted to yen before the stocks are purchased. Capital outflow may be more direct by way of foreign direct investment. If Coca-Cola Inc. builds a production plant in Singapore, then U.S. dollars must be converted to the Singapore currency to fund the plant.

A major reason that capital flows from one nation to another is to earn a higher interest rate return than the domestic return. For example, if a U.S. investor had US$10,000 to invest and she believed that U.S. stocks would yield 7 percent but British stocks would yield 9 percent, then she would likely purchase the British stocks. Capital outflows are typically high during a financial or national crisis as people protect their savings. When civil war was raging in Yugoslavia in the 1990s, for example, many people in Yugoslavia transferred their savings to the other European nations. Likewise, Russia experienced massive capital outflows at the beginning of its transition as people feared losing their savings to hyperinflation or government confiscation. Higher expected returns in other nations relative to the domestic nation increases capital outflows.

An increase in capital outflows simultaneously increases the demand for foreign exchange because the domestic investor must purchase the foreign currency while purchasing the foreign asset. As the figure titled "Increase in Capital Outflows" illustrates, an increase in capital outflows shifts the demand for foreign exchange to the right, increasing both the exchange rate and the quantity of foreign exchange traded in the market. Notice that because of the higher exchange rate and, hence, weaker U.S. dollar, imports decrease and exports increase relative to their levels before the change in the capital outflow.

We can now explain the paradox of persistent trade deficits. If foreigners are willing to invest more funds in U.S. assets than U.S. citizens are willing to invest in foreign assets, then the U.S. can run a persistent trade deficit year after year. In other words, the U.S. may demand more foreign exchange for imports than it supplies for exports, but the difference is made up in international capital flows. The U.S. demands less foreign exchange for capital outflows than it supplies in foreign exchange for capital inflows. Ultimately, the supply and demand for foreign exchange are equal.

The Balance of Payments is composed of two major accounts: the current and capital accounts. Due to the flexible exchange rate system, the value of the currency flowing out of the country equals the value of the currency flowing into the country. This implies that the current and capital accounts must sum to zero such that:

Balance of Payments = Current Account + Capital Account = 0

or, Current Account = - Capital Account.

Table 3 lists the 2005 U.S. balance of payments.

The current account includes more than just exports and imports of goods and services. It also includes net income that U.S. citizens earn from abroad on their investments and net unilateral transfers. The net income on investments includes foreign stock dividends and interest payments on foreign-held bonds. Unilateral transfers are gifts and grants sent abroad by U.S. residents. In sum, the U.S. current account deficit in 2005 was US$785.5 billion, 91 percent of which was due to the US$717 billion trade deficit.

Capital Account

• Strong Dollar, Weak Dollar: Foreign exchange rates and the U.S. economy, published by the Federal Reserve Bank of Chicago, explains the advantages and disadvantages os a strong and weak dollar, respectively.

• Visit the European Union’s website on the euro to obtain more information about the euro.

• Are capital controls--restrictions on financial flows into and out of a country--beneficial to developing nations? Find out by reading this Economic Letter from the San Francisco Fed.

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