The Global Financial System: Brief Chapter Summary

Chapter 4
The Global Financial System

Brief Chapter Summary
4.1 The Balance of Payments (pages 109–114)
Learning Objective 1
Explain how to calculate the balance of payments.
• The balance of payments is a system of accounting for economic interactions between
countries. The balance of payments consists of the current account, the financial account, and
the capital account.
4.2 Exchange Rates and Exchange Rate Policy (pages 115–

123)
Understand the advantages and disadvantages of different exchange rate
policies.
• The nominal exchange rate is the price of one currency in terms of another country's
currency. The real exchange rate is the rate at which goods and services in one country can be
exchanged for goods and services in another country.
4.3 What Factors Determine Exchanges Rates? (pages 124–

130)
Discuss what factors determine exchange rates.
• In the long run, nominal exchange rates tend to adjust to equalize the purchasing power of
different currencies. Complete equalization of purchasing power will not hold exactly
because not all goods are traded internationally, countries impose barriers to trade, and tastes
for goods differ across countries.
4.4 The Loanable Funds Model and the International Capital

Market (pages 130–139)
Use the loanable funds model to analyze the international capital market.
• The loanable funds model is used to analyze the determinants of the long-run real interest
rate.
60
©2014 Pearson Education
CHAPTER 4 | The Global Financial System 61
List of Key Terms

Balance of payments, p. 111. A record of a country's trade with other countries in goods, services,
and assets.
Capital account, p. 112. The part of the balance of payments that records (generally) minor
transactions, such as migrants’ transfers, and sales and purchases of non-produced, non-financial
assets.
Closed economy, p. 110. An economy in which households, firms, and governments do not
borrow, lend, or trade internationally.
Crowding out, p. 134. The reduction in private investment that results from an increase in
government purchases.
Currency appreciation, p. 117. An increase in the market value of one country’s currency relative
to another country’s currency.
Currency depreciation, p. 117. A decrease in the market value of one country’s currency relative
to another country’s currency.
Current account, p. 112. The part of the balance of payments that records a country’s net exports,
net investment income, and net transfers.
Exchange rate system, p. 119. An agreement among countries about how exchange rates should
be determined.
Financial account, p. 112. The part of the balance of payments that records purchases of assets a
country has made abroad and foreign purchases of assets in the country.
Fixed exchange rate system, p. 119. A system in which exchange rates are set at levels determined
and maintained by governments.
Floating exchange rate system, p. 120. A system in which the foreign-exchange value of currency
is determined in the foreign exchange market.
Interest parity condition, p. 127. The proposition that differences in interest rates on similar
bonds in different countries reflect investors' expectations of future changes in exchange rates.
Managed float exchange rate system, p. 120. A system in which private buyers and sellers in the
foreign exchange market determine the value of currencies most of the time, with occasional
government intervention.
Net capital outflows, p. 114. Capital outflows minus capital inflows.
Nominal exchange rate, p. 115. The price of one country's currency in terms of another country's
currency.
Open economy, p. 110. An economy in which households, firms, and governments borrow, lend,
and trade internationally.
Purchasing power parity, p. 124. The theory that, in the long run, nominal exchange rates adjust
to equalize the purchasing power of different currencies.
Real exchange rate, p. 117. The rate at which goods and services in one country can be exchanged
for goods and services in another country.

62 Hubbard, O’Brien, and Rafferty | Macroeconomics, Second Edition
Chapter Outline
DID U.S. MONETARY POLICY SLOW BRAZIL'S GROWTH?
By 2011, Brazil had passed the United Kingdom to become the sixth largest economy in the
world. In 2012, Brazil's economic growth began to slow and Brazil's president blamed the U.S.
Federal Reserve. Brazilian firms argued that the high value of the Brazilian currency made it
difficult to sell Brazilian goods in other countries. Beginning in 2007, the Federal Reserve
responded to a financial crisis and recession in the U.S. by lowering interest rates. The Fed
persisted in maintaining low interest rates and in 2012 announced that the policy would continue
at least through mid-2015. Interest rates in Brazil were much higher and as investors sold dollars
and bought reals, the value of the real rose against the dollar. As a result, prices of Brazilian
exports rose in terms of dollars and other foreign currencies.
Teaching Tips
This chapter is new to the second edition. Section 4.1 on the balance of payments is a revised
and updated version of Section 15.1 in Chapter 15 of the first edition. Sections 4.2 and 4.3 are
revised and reorganized versions of Sections 15.3 and 15.4 in Chapter 15 of the first edition.
Section 4.4 is a revised version of the material in Section 3.3 of Chapter 3 in the first edition.
Bringing together this material on the international financial system in an early chapter allows
instructors to bring additional international material into later chapters, should they choose to
do so. However, the text has been organized so that instructors can omit this material without
loss of continuity.
You may wish to remind your students of the Key Issue and Key Question for this chapter:
Key Issue: Some governments allow the value of their currency to fluctuate in foreign-exchange
markets, while other governments fix the value of their currency.
Key Question: What are the advantages and disadvantages of floating versus fixed exchange
rates?
4.1 The Balance of Payments (pages 109–114)

Learning Objective: Explain how to calculate the balance of payments.
Consumers, firms, and investors in one country routinely interact with consumers, firms, and
investors in other countries. Nearly all economies are open economies. An open economy is an
economy in which households, firms, and governments borrow, lend, and trade internationally. A
closed economy is an economy in which households, firms, and governments do not borrow,
lend, or trade internationally. Exports plus imports, a measure of economic openness, increased
from 24% of world GDP in 1960 to 57% of world GDP in 2007. The global recession and financial
crisis reduced incomes worldwide but international trade rebounded to 56% of world GDP in
2010.

The flow of financial assets is at least as important as the flow of goods and services. The
balance of payments is a record of a country's trade with other countries in goods, services and
assets. The balance of payments has three parts:
1. The current account—the part of the balance of payments that records a country’s net
exports, net investment income, and net transfers.
2. The financial account—the part of the balance of payments that records purchases of assets a
country has made abroad and foreign purchases of assets in the country.
3. The capital account—the part of the balance of payments that records (generally) minor
transactions, such as migrants’ transfers, and sales and purchases of non-produced, non-
financial assets.
A. The Current Account

The current account records three items:
1. Net exports, which are the exports and imports of goods and services between the United
States and other countries.
2. Net factor payments, which are the income U.S. households and firms receive on investments
in other countries minus the income foreign households and firms receive on investments in
the United States.
3. Transfers, which are the difference between transfer payments made by U.S. residents to
residents of other countries and the transfer payments residents of other countries make to
residents of the United States.
If its current account is negative, a country runs a current account deficit, which indicates the
country is consuming more than its current income. A current account surplus indicates that a
country is consuming less than its current income. Since the early 1980s, the United States has
consistently run large current account deficits. As a result, funds have flowed from investors in
these economies to developed economies such as the United States and Western Europe.
B. The Financial Account

The financial account records the flow of funds into and out of a country. There is a capital
outflow from the United States when a U.S. firm builds a factory in another country or when an
investor in the United States purchases financial assets of foreign firms or governments. There is a
capital outflow into the United States when a foreign firm builds a factory in the United States or
when a foreign investor purchases financial assets. When firms build factories or buy capital
goods in foreign countries, they are engaging in foreign direct investment. When investors buy
stocks or bonds issued in another country, they are engaging in foreign portfolio investment. Net
capital outflows equal capital outflows minus capital inflows.
C. The Capital Account

The capital account is the least important part of the balance of payments. This account records
minor transactions such as (1) migrants’ transfers and (2) sales and purchases of non-produced,

non-financial assets, including copyrights and trademarks. Prior to 1999, the capital account
recorded all the transactions now included in the financial and the capital account.
The Bureau of Economic Analysis sets up the balance of payments so that when one item
changes in the accounts, there is an offsetting change in another part of the accounts.
As a consequence, the balance of payments is zero, apart from statistical discrepancies. Dollars
held by foreigners are official reserves, and changes in foreign holdings of dollars are official
reserve transactions.
4.2 Exchange Rates and Exchange Rate Policy (pages 115–123)

Learning Objective: Understand the advantages and disadvantages of
different exchange rate policies.
A. Nominal Exchange Rates
The nominal exchange rate is the price of one country's currency in terms of another country's
currency. As exports have become a larger fraction of GDP for most countries, fluctuations in
exchange rates have had an increased effect on domestic economies. An immediate exchange of
one currency for another currency is carried out at the current exchange rate, or the spot exchange
rate. Buyers and sellers of currency can also agree today to exchange currency at some future date
at the forward exchange rate. Agreements to exchange currency at some future date are called
forward exchange contracts or future exchange contracts. Forward contract are typically
negotiated between two firms. Futures contracts are publicly traded on financial exchanges.
Forward and futures contracts allow firms to hedge, or reduce the risk of losses from fluctuations
in exchange rates.
Each currency has a spot exchange rate, also called a bilateral exchange rate, versus every
other currency. A multilateral exchange rate shows how the value of a country's currency is
changing relative to a group of other countries' currencies.
Currency appreciation is an increase in the market value of one country’s currency
relative to another country’s currency. Currency depreciation is a decrease in the market value of
one country’s currency relative to another country’s currency.
B. Real Exchange Rates

The nominal exchange rate tells us how much foreign currency we can receive in exchange for
one unit of domestic currency. But for some purposes economists are more interested in the
terms of trade, the rate at which domestic goods can be exchanged for foreign goods. The real
exchange rate is the rate at which goods and services in one country can be exchanged for goods
and services in another country. Typically, we measure the real exchange rate in terms of the price
level in each country. If E stands for the nominal exchange rate, e the real exchange rate PDomestic
the domestic price level, and PForeign the foreign price level, we have the following expression for
the real exchange rate:
𝑃Domestic
𝑒=𝐸×
𝑃Foreign

For the United States during the period from 1973 to 2012, measured against the currencies of
seven major trading partners, movements in the real exchange rate closely follow movements in
the nominal exchange rate.
C. The Foreign-Exchange Market

Typically, banks trade bank deposits rather than physical currency. The foreign-exchange market
is a virtual, or over-the-counter, market in that most trading takes place between banks that are
linked by computer, rather than at a physical exchange. More than half of all foreign-exchange
transactions involve financial firms in the United States or the United Kingdom.
D. Exchange Rate Policy

Countries follow different exchange rate policies. The United States allows the exchange rate to
be determined in the foreign-exchange market. A country that follows this approach has a
floating exchange rate. Some countries have a fixed exchange rate, or an exchange rate peg,
between their currency and another currency. An agreement among countries about how
exchange rates should be determined is an exchange rate system. Countries have typically used
three major types of exchange rate systems:
1. A fixed exchange rate system

2. A floating exchange rate system
3. A managed float exchange rate system
A fixed exchange rate system is a system in which exchange rates are set at levels
determined and maintained by governments. The two most important fixed exchange rate
systems were the gold standard and the Bretton Woods system. The gold standard lasted from the
nineteenth century to the Great Depression of the 1930s. The Bretton Woods system started in
1944. .By the early 1970s, the difficulty of keeping exchange rates fixed led to the end of the
Bretton Woods system.
Following the collapse of the Bretton Woods system, most countries allowed their
currencies to float. A floating exchange rate system is a system in which the foreign-exchange
value of currency is determined in the foreign-exchange market. Some countries found that this
system led to too much instability in their exchange rates. A managed float exchange rate system
is a system in which private buyers and sellers in the foreign-exchange market determine the
value of currencies most of the time, with occasional government intervention.
E. Policy Choices and the Current Exchange Rate Systems

The current exchange rate system reflects three key policy choices:
1. The United States allows the dollar to float against other major currencies.
2. Seventeen countries in Europe have adopted the euro as their common currency.
3. Some developing countries have pegged their exchange rates against the dollar of another
major currency.

Having a fixed exchange rate can provide important advantages for a country that has extensive
trade with another country. When the exchange rate is fixed, business planning becomes much
easier. In the 1980s and 1990s, some countries feared the inflationary consequences of a floating
exchange rate. A fixed exchange rate can limit inflation but there are difficulties with following a
fixed exchange rate policy because central banks must stand ready to buy or sell their currencies
in exchange for another currency at a fixed rate. Central banks have often found it difficult to
maintain a pegged exchange rate over long periods because they eventually run low on foreign
currency. Another drawback to a fixed exchange rate is that it eliminates one means by which
countries can recover from a recession.
Teaching Tips
As U.S. budget and current account deficits have grown in recent years, policymakers and
analysts have been concerned that the Chinese government, a large buyer of U.S. Treasury debt,
may sell some of its debt holdings.
Michael Pettis, a professor of finance at Peking University, believes these fears may be
overstated: “China’s currency regime . . . does not permit it to convert any … dollars back into
yuan. If it did . . . [its] currency [would] soar, and . . . Chinese exports would collapse—not
something Beijing wants.”
An article in the New York Times notes that market experts have speculated that China
may have been disguising purchases of Treasury securities by making them through other
countries: “It is not easy to see how the Chinese government managed to keep its currency from
rising more rapidly against the dollar if it did not continue buying Treasuries … and there has
been speculation that it shifted purchases to accounts managed by British money managers.”
Sources: Michael Pettis, “China Will Keep Buying U.S. Government Debt,” Wall Street Journal
Asia, December 1, 2008; and Floyd Norris, “Data Shows Less Buying of U.S. Debt by China,”
New York Times, January 21, 2011.
4.3 What Factors Determine Exchanges Rates? (pages 124–130)

Learning Objective: Discuss what factors determine exchange rates.
A. Purchasing Power Parity

Purchasing power parity is the theory that, in the long run, nominal exchange rates adjust to
equalize the purchasing power of different currencies. This theory should hold because, if it did
not, opportunities for arbitrate profits would exist. Arbitrage refers to buying a product in one
market and reselling it in another market at a higher price. In the long run, by buying and selling
currencies in the foreign exchange market, individuals pursuing profit opportunities should cause
the nominal exchange rate to adjust so the real exchange rate equals 1, and purchasing power
parity holds.

B. Why Purchasing Power Parity Doesn't Hold Exactly

Even in the long run, we wouldn't expect purchasing power parity to hold exactly for three
reasons.
1. Some goods are perishable, and services such as doctor visits are not traded internationally.
2. Countries impose barriers such as tariffs—taxes on imported goods—and quotas—which are
limits on the quantities of goods that can be exported.
3. Products differ across countries as firms adapt products to local tastes.
So, purchasing power parity gives a reasonable, if not exact, guide to movements of exchange
rates in the long run.
C. The Interest Parity Condition

The huge demand for foreign exchange for financial investment reflects the increase in
international capital mobility in recent decades. Policymakers in many countries have removed
regulations that once hindered financial investments across national boundaries. The return that
a domestic investor receives on a foreign investment is equal to the interest rate on the foreign
investment minus the rate of appreciation of the domestic currency. We would expect that as
investors buy and sell bonds in the global financial market, the differences in interest rates among
bonds in different countries would equal the expected change in exchange rates. The interest
parity condition is the proposition that differences in interest rates on similar bonds in different
countries reflect investors’ expectations of future changes in exchange rates.
In practice, differences in interest rates on similar bonds depend on several factors. First,
investors typically see even similar bonds as having differences in default risk and liquidity.
Second, the transactions costs of purchasing foreign financial assets are typically higher than for
domestic assets. Third, the interest parity condition does not take into account the exchange-rate
risk from investing in a foreign asset.


Market (pages 130–139)
Learning Objective: Use the loanable funds model to analyze the
international capital market.
The long-run real interest rate is most relevant to households and firms making decisions about
whether to invest in long-lived assets, such as houses or factories. The loanable funds model helps
us analyze the determinants of the long-run real interest rate and the flow of funds between U.S.
and foreign financial markets.
In the loanable funds model, the interaction of borrowers and lenders determines the
market real interest rate and the quantity of loanable funds exchanged.
A. Saving and Supply in the Loanable Funds Market
The supply of loanable funds is equal to the supply of saving in the economy. It’s useful to divide
total saving into three sources:
1. Saving from households (SHouseholds), which equals the funds households have left from their
incomes after buying goods and services and paying taxes to the government.
2. Saving from the government (SGovernment), which equals the difference between the government’s
tax receipts and its spending on goods and services and on transfer payments to households.
3. Saving from the foreign sector (SForeign), which equals net exports, or the difference between
exports and imports, but with the opposite sign. Saving from the foreign sector is referred to
as a net capital inflow.
Using symbols:
S = SHouseholds + SGovernment + SForeign.
The basic national income identity is:
Y = C + I + G + NX,
where:
Y = national income
C = consumption expenditure
I = investment expenditure on capital goods, such as factories, houses, and
machinery, and changes in business inventories
G = government purchases of goods and services
NX = net exports of goods and services
Household income equals the amount of funds received by households from the sale of goods and
services (Y), plus what is received from the government as transfer payments (TR) such as Social

Security payments or unemployment insurance payments. Letting T stand for households’ tax
payments, we have the following:
SHouseholds = (Y + TR) − (C + T)
SGovernment = T − (G + TR)
SForeign.= −NX
The quantity of saving supplied increases as the interest rate increases for two reasons:
First, when households save, they reduce the amount of goods and services they can consume.
The higher the interest rate, the greater the reward to saving and the larger the quantity of funds
households will save.
Second, foreign saving depends on the size of net exports. When the U.S. interest rate rises,
foreign investors increase their demand for dollars in order to buy U.S. financial assets, such as
Treasury bills. An increased demand for dollars increases the foreign exchange of the dollar,
reducing U.S. exports and increasing U.S. imports. A fall in exports and a rise in imports makes
net exports a larger negative number, which increases the dollars available for people outside the
United States to invest in U.S. financial markets. So, the higher the interest rate, the greater the
quantity of foreign saving.
B. Investment and the Demand for Loanable Funds

The demand for loanable funds is determined by the willingness of firms to borrow money to
engage in new investment projects and by the demand by households for new houses. In
determining whether to borrow funds, firms compare the real return they expect to make on an
investment with the real interest rate they must pay to borrow the necessary funds. The lower the
real interest rate, the more investment projects firms can profitably undertake and the greater the
quantity of loanable funds firms will demand.
C. Explaining Movements in Saving, Investment and the Real Interest Rate
Equilibrium in the market for loanable funds determines the quantity of loanable funds that flow
from lenders to borrowers and the real interest rate each period. In equilibrium, the value of
saving equals the value of investment. We can use the market for loanable funds to examine the
effect of a government surplus or deficit. When the government’s tax receipts exceed its
spending, the government’s budget is in surplus and the total amount of saving in the economy
increases. The increased saving is shown in a market for loanable funds graph by a shift of the
supply curve of loanable funds to the right. In the new equilibrium saving and investment
increase and the real interest rate decreases. When the government’s spending exceeds its tax
receipts, the budget is in deficit and the total amount of saving in the economy is reduced. The
decreased saving is shown in a market for loanable funds graph by a shift of the supply curve of
loanable funds to the left. In the new equilibrium saving and investment decrease and the real
interest rate increases.

Running a budget deficit increases the real interest rate and reduces the level of
investment by firms. By borrowing to finance its deficit, the government will have crowded out
some firms that would otherwise have been able to borrow to finance investment. Crowding out
is the reduction in private investment that results from an increase in government purchases.
D. The International Capital Market and the Interest Rate
The foreign sector affects the domestic interest rate and the quantity of funds available for the
domestic economy. Foreign households, firms, and governments may lend funds to borrowers in
the United States if the expected returns are higher than in other countries.
Borrowing and lending take place in the international capital market, where households,
firms and governments borrow and lend across national borders. The world real interest rate is
the interest rate that is determined in the international capital market. The quantity of loanable
funds that is supplied in an open economy can be used to fund projects in the domestic economy
or abroad. Shifts in the supply or demand for loanable funds in small open economies do not have
much effect on the world real interest rate. Changes in the behavior of lenders and borrowers in
large open economies do affect the world real interest rate.
E. Small Open Economy
In a small open economy, the quantity of funds supplied or demanded is too small to affect the
world real interest rate, so the domestic real interest rate equals the world real interest rate. If the
quantity of loanable funds supplied domestically exceeds the quantity of funds demanded
domestically at that interest rate, the country invests some of its loanable funds abroad. If the
quantity of loanable funds demanded domestically exceeds the quantity of funds supplied
domestically at that interest rate, the country finances some of its domestic borrowing needs with
funds from abroad.
F. Large Open Economy
Shifts in the demand and supply of loanable funds in some countries are sufficiently large that
they affect the world real interest rate, so these countries are considered large open economies.
The factors that cause the demand and supply of funds to shift in a large open economy will affect
not just the interest rate in that economy but the world real interest rate as well. For example, the
decline in investment demand in the United States during the 2007-2009 lowered the world real
interest rate.
Solutions to the End-of-Chapter Questions, Problems,

and Data Exercises
4.1 The Balance of Payments
Learning Objective: Explain how to calculate the balance of payments.

Review Questions
1.1 An open economy is an economy in which households, firms, and governments borrow, lend,
and trade internationally. A closed economy is an economy in which households, firms, and
governments do not borrow, lend, or trade internationally.
1.2 The balance of payments measures all flows of private and government funds between a
domestic economy and all foreign countries. The three components of the balance of payments
are:
1. The current account, which records a country’s net exports, net investment income,
and net transfers.
2. The capital account, which records relatively minor transactions, such as migrants’
transfers, and sales and purchases of non-produced, non-financial assets, such as a
copyrights, patents, trademarks, and rights to natural resources.
3. The financial account, which records purchases of assets a country has made abroad
and foreign purchases of assets in the country.
1.3 A trade deficit occurs when a country’s net exports are negative. A current account deficit
occurs when a country’s current account, which consists of net exports, net investment income,
and net transfers, is negative. A financial account deficit occurs when a country’s purchases of
assets abroad are greater than foreign purchases of assets in the country. It is not possible for a
country to run a balance of payments deficit, because the balance of payments is always zero.
Current account deficits have to be offset by financial account surpluses for the balance of
payments to sum to zero.
Problems and Applications
1.4 a. Current account
b. Financial account
c. Capital account
d. Current account
1.5 If China has a huge trade surplus, its current account is likely in surplus. If China’s current
account is in surplus, its financial account must be in deficit (assuming the capital account is
zero). China must be investing more abroad than foreigners are investing in China, so China has
a net capital outflow. The columnist’s argument seems inaccurate.
1.6 Foreign direct investment occurs when firms build factories or buy physical capital goods in
foreign countries. Foreign direct investment results in a capital inflow for the foreign country in

which the investment is taking place, so it represents a positive financial account balance. A
financial account surplus is needed to fund a current account deficit.
1.7 Although trade is a less significant portion of GDP for the United States than for some other
countries, it is still an economically significant portion of GDP. For example, in 2011 exports were
13.9% of GDP and imports were 17.7% of GDP, so trade is nearly 32% of GDP. In addition, trade
has become more important over time. In 1950, exports were just 4.2% of GDP and imports were
just 3.9% of GDP, so trade has become much more important to the United States over time.
1.8 Net exports − exports = imports: $1,223 − $6,525 = −$5,302.
Income received + income payments = net factor payments: $1,108 + (−$640) = $468.
Net exports + net income + net transfers = balance on current account: $1,223 + $468 + (−$303) =
$1,388.
Balance on financial account – increase in U.S. holdings – net financial derivatives = increase in
foreign holdings: −$1,436 – (−$2,469) − $17 = $1,016.
− (Balance on current account + balance on financial account + balance on capital account) =

statistical discrepancy: − [$1,388 + (−$1,436) + (−$5)] = $53.
Balance on current account + balance on financial account + balance on capital account –

statistical discrepancy = balance of payments: [$1,388 + (−$1,436) + (−$5)] − $53 = $0. (The
balance of payments is always $0.)
4.2 Exchange Rates and Exchange Rate Policy

Learning Objective: Understand the advantages and disadvantages of
different exchange rate policies.
Review Questions
2.1 In an open economy like the United States, trade is conducted internationally. Economists
and policymakers worry about fluctuations in exchange rates because exchange rates affect
international trade. For example, when the currency appreciates, exports become more expensive
and imports become cheaper, so net exports tend to decrease. When the currency depreciates, net
exports tend to increase.
2.2 a. A nominal exchange rate is the value of one country’s currency in terms of another
country’s currency. A real exchange rate is the rate at which goods and services in one country
can be exchanged for goods and services in another country.
b. A bilateral exchange rate is a country’s exchange rate versus every other individual
currency. A multilateral exchange rate shows how the value of a country’s currency is changing
relative to a group of other countries’ currencies.

c. A currency appreciation is an increase in the market value of one country’s currency

relative to another country’s currency. A currency depreciation is a decrease in the market value
of one country’s currency relative to another country’s currency.
d. A fixed exchange rate system is a system in which exchange rates are set at levels
determined and maintained by governments. A floating exchange rate system is a system in which
the foreign-exchange value of currency is determined in the foreign exchange market.
2.3 The gold standard was a fixed exchange rate system in which a country’s currency consisted of
gold coins and paper currency that the government was committed to redeeming for gold.
Exchange rates were determined by the amount of gold in each country’s currency, and the size of
a country’s money supply depended on the amount of gold available. The Bretton Woods system
was a fixed exchange rate system established in 1944, under which the United States pledged to
buy or sell gold at a fixed rate of $35 per ounce. The central banks of all other countries that
joined the system pledged to buy and sell their countries’ currencies at a fixed rate against the
dollar. No countries were willing to redeem their paper currency for gold domestically, but the
United States would redeem dollars for gold if the dollars were presented by a foreign central
bank.
2.4 The current exchange rate system has three key aspects: 1. The United States allows the dollar
to float against other major currencies. 2. Seventeen countries in Europe have adopted the euro as
their common currency. 3. Some developing countries have pegged their exchange rates against
the dollar or another major currency.
2.5 a. A strong yen means that the yen has a high value relative to the currencies of other
countries.
b. With a strong yen, it takes more foreign currency to purchase yen, so the foreign
currency prices of automobiles produced in Japan is higher than it would be with a weak yen. The
result is likely a decline in the quantity of Japanese automobiles demanded by foreign car buyers
and lower profits for the Japanese automobile companies.
c. By moving production overseas, for instance to the United States, the Japanese
automobile companies would incur costs in U.S. dollars rather than in yen. With a strong yen, it
takes more dollars to purchase yen, so automobiles produced in Japan would be relatively more
expensive than if the same automobiles were produced in the United States. Moving production
to a country with a “weaker” currency than the “strong” yen would allow for relatively less
expensive production and therefore greater sales and profits.
2.6 a. €1.3 x ($16/€10) = 2.08 bottles of wine in France per bottle of wine in the United States.
b. ¥100 x ($10/¥950) = 1.05 books in Japan per book in the United States.

c. £1.5 x ($45/£30) = 2.25 shirts in the United Kingdom per shirt in the United States.
2.7 A system like Bretton Woods kept exchange rates generally fixed. A fixed exchange rate is
generally preferable for importers and exporters because it removes the risk of fluctuations in
currency values. Therefore, it makes it easier for importers and exporters to determine the prices
their products will sell for.
2.8 a. A country can overvalue its currency by purchasing its own currency in foreign exchange
markets.
b. A country might want to overvalue its currency because an overvalued currency reduces
the domestic price of imports.
c. The central bank must use its reserves of foreign currency to purchase its own currency to
maintain an overvalued exchange rate. . Eventually, the country will run out of foreign
exchange reserves and be unable to maintain the overvaluation of its currency.
2.9 Bank depositors were not afraid that their banks would fail. They were afraid that countries
like Greece might stop using the euro and go back to their own currency. In that case, deposits in
these banks would be converted from euros to old currencies. If the conversion was done on the
basis of one euro for one unit of the country’s old currency, depositors would lose if the old
currency lost value in exchange for the euro. Because the United States does not share a common
currency with other countries, depositors in U.S. banks would not be likely to share the same
fears.
2.10 Potential investors being “wrong-footed” means that these investors would be surprised by
being put into an unexpected or difficult situation. Investing in euros and being paid in drachmas
would be bad for investors because it is widely expected that if Greece would abandon the euro
and go back to using the drachma, the drachma would likely depreciate in value following the
conversion and investors would suffer heavy losses.
4.3 What Factors Determine Exchange Rates

Learning Objective: Discuss what factors determine exchange rates.
Review Questions
3.1 Purchasing power parity is the theory that in the long run, nominal exchange rates adjust to
equalize the purchasing power of different currencies. Purchasing power parity will not hold
exactly in the long run because not all products are traded internationally; non-tradable goods
and services are a large component of GDP; countries impose barriers to trade that limit the
individual pursuit of profit opportunities; and products differ across countries as firms adapt
products to local tastes. These differences limit the individual’s profit opportunities.
3.2 Percentage change in E = πForeign − πDomestic, where E is the nominal exchange rate and π is the
inflation rate. This equation tells us that the percentage change in the nominal exchange rate is

equal to the difference between the foreign and domestic inflation rates. An increase in the price
level—that is,. Inflation—is a decrease in the purchasing power of the currency. The equation
states that if the foreign currency’s purchasing power is falling faster than the domestic currency
then the exchange rate will appreciate. In contrast, if the foreign currency’s purchasing power is
falling slower than the domestic currency then the exchange rate will depreciate.
3.3 The interest parity condition is the proposition that differences in interest rates on similar
bonds in different countries reflect investors’ expectations of future changes in exchange rates.
3.4 Exchange rate fluctuations mean currencies are either appreciating or depreciating relative to
other currencies. An appreciation hurts firms that are exporting goods but helps firms that have
borrowed in foreign currencies or that import goods and services. A depreciation helps firms that
are exporting goods but hurts firms that have borrowed in foreign currencies or that import
goods and services.
3.5 An appreciation of the euro makes German goods more expensive in the United States, and so
U.S. goods will be relatively cheaper than they were before. You are therefore likely to purchase
more U.S. goods and fewer German goods.
3.6 a. You will need $2,000 × 12 = 24,000 pesos.
b. It depends on whether purchasing power parity holds. If it does, then the same amount
pesos would be appropriate. However, the Big Mac index and other measures of
purchasing power parity usually indicate that the peso is undervalued relative to the
dollar, and so you would need fewer than 24,000 pesos to achieve the same standard of
living.
3.7 An implication of purchasing power parity is that the percentage change in the nominal
domestic exchange rate equals the difference between the foreign inflation rate and the domestic
inflation rate. Because the inflation rate in the United Kingdom is 3% greater than the inflation
rate in the United States, the dollar should appreciate by 3% versus the pound.
3.8 It is not certain. If the interest rate parity condition holds, then investors must be expecting
the value of the yen will appreciate relative to the value of the currencies from countries where
interest rates are high, so the expected return on investments in Japan and these other countries
should be the same. Also, investments in these other countries may have higher default risks and
lower liquidity than investments in Japan, and by investing in other countries, Japanese investors
will be taking on exchange-rate risk if the yen appreciates by more than the difference in interest
rates in Japan and these high-interest countries.
3.9 U.S firms would run the risk of the Brazilian real depreciating relative to the U.S. dollar, which
might cause the U.S. firms to suffer losses greater than the different between interest rates in

Brazil and interest rates in the United States. If the interest parity condition holds, then investors
must be expecting the value of the Brazilian real will depreciate relative to the value of the dollar.
3.10 The Fed engaging in a monetary policy of low interest rates has led to the U.S dollar
depreciating relative to other currencies. The higher value of these foreign currencies relative to
the dollar has made exports from these countries more expensive, reducing the amount of exports
and slowing economic growth in these countries.
3.11 a. Foreign currency debt is the debt owed by firms who have taken out loans in foreign
currencies, typically from foreign banks.
b. Firms in Brazil would have foreign currency debt because they had taken out loans in
countries with lower interest rates than they would pay if they had borrowed in Brazil.
c. Typically, these firms will be earning most of their revenues in Brazilian reals. By
having to make payments on foreign currency debt in the currency of the country where loans
were obtained, fluctuations in exchange rates could make it either more or less expensive for these
firms to exchange Brazilian currency for the needed currency to make loan payments. For
example, if the real depreciates relative to the U.S. dollar, more reals are needed to exchange for
dollars to make payments for loans obtained in the United States. If the real appreciates relative to
the dollar, fewer reals are needed to make the loan payments.

Market
Learning Objective: Use the loanable funds model to analyze the
international capital market.
Review Questions
4.1 The supply of loanable funds is determined by the willingness of households to save, by the
extent of government saving, and by the extent of foreign saving that is invested in U.S. financial
markets. The demand for loanable funds is determined by the willingness of firms to borrow
money to engage in new investment projects and by the demand of households for new houses.
4.2 The real interest rate is the cost of borrowing funds. The demand curve is downward sloping
because at lower interest rates the cost of borrowing funds is lower, so it is cheaper to finance
investment projects or new residential housing through borrowing. As a result, more investment
projects are profitable and more households want to purchase new homes, so the quantity
demanded of loanable funds increases. Therefore, the demand curve for loanable funds slopes
downward. The real interest rate is also the reward to households for saving. As the real interest
rate increases, the reward for saving increases, so households save more and the quantity supplied
of loanable funds increases. Therefore, the supply curve for loanable funds slopes upward.
Foreign saving also responds to real interest rates. When the U.S. interest rate rises, foreign
investors increase their demand for dollars to buy U.S. financial assets, such as Treasury bills. An

increased demand for dollars increases the foreign exchange value of the dollar, reducing U.S.
exports and increasing U.S. imports. A fall in exports and a rise in imports makes net exports a
larger negative number, which increases the dollars available for people outside the United States
to invest in U.S. financial markets. So, the higher the interest rate, the greater the quantity of
foreign saving and the greater the quantity supplied of loanable funds.
4.3 Because Monaco is a small open economy, the world real interest rate would not be affected
by the government of Monaco running a large government budget deficit.
4.4 a. If the quantity of loanable funds demanded in the rest of the world is greater than the
quantity of loanable funds supplied, foreign borrowers will want to borrow more from
international capital markets than is available. These borrowers would have an incentive to offer
lenders in the United States an interest rate greater than 5%.
b. If the quantity of loanable funds supplied in the rest of the world is greater than the
quantity of loanable funds demanded, foreign borrowers will want to borrow less from
international capital markets than is available. These borrowers would have an incentive to offer
lenders in the United States an interest rate less than 5%.
4.5 a. If households decide to consume less, household saving increases. As a result, national
saving increases, causing the supply curve for loanable funds to shift to the right from S1 to S2. The
equilibrium real interest rate falls, and the equilibrium quantity of funds loaned and borrowed
increases.
b. If government spending decreases then government saving increases. As a result,

national saving increases, causing the supply curve for loanable funds to shift to the right from S1

to S2. The equilibrium real interest rate falls, and the equilibrium quantity of funds loaned and
borrowed increases.

c. If businesses become pessimistic about future profitability, they will want to invest less.
As a result, the demand for loanable funds decreases, causing the demand curve to shift to the left
from D1 to D2. The equilibrium real interest rate falls, and the equilibrium quantity of funds
loaned and borrowed falls.
d. If new capital goods become more profitabl,e businesses will want to invest more. As a
result, the demand for loanable funds increases, causing the demand curve for loanable funds to
shift to the right from D1 to D2.
The increase in the budget deficit reduces government saving, so national saving
decreases. As a result, the supply of loanable funds decreases, causing the supply curve for
loanable funds to shift to the left from S1 to S2.
Both of these shifts lead to higher real interest rates, so we know that the real interest rate
will increase. However, the equilibrium quantity of loanable funds may increase, decrease, or stay
the same (as is represented in the graph). The change in the quantity of loanable funds depends
on how large the shift in the demand curve is relative to the shift in the supply curve.

4.6 Because this country is a small open economy, it has no effect on the world real interest rate,
so we know that the real interest rate will not change. The budget deficit affects the domestic
supply of loanable funds and leaves the domestic demand for loanable funds unchanged. Because
the real interest rate is unchanged and the domestic demand curve for loanable funds is
unchanged, domestic investment and borrowing remains unchanged. However, the budget
deficit causes the domestic supply of loanable funds to shift to the left. Because domestic
borrowing remains constant, the country increases foreign borrowing.
4.7 This country is a large open economy, so changes in the domestic market for loanable funds
does affect the world real interest rate. The increase in business taxes will decrease the domestic
demand for loanable funds, shifting the demand curve to the left from D1 to D2. The quantity of
loanable funds supplied exceeds the quantity of loanable funds demanded at the original interest
rate, so the domestic and the world real interest rate will decrease. After the shift in the domestic
demand curve and at the initial real interest rate, the domestic quantity supplied of loanable funds
exceeds the domestic quantity demanded of loanable funds. The decrease in domestic demand
means that the country will now lend internationally.

4.8 a. Increased investment spending will cause the domestic demand curve to shift to the right.
The world real interest rate will not change, so the amount of domestic borrowing will
increase or the amount of international lending will decrease.
b. An increase in expected taxes will decrease investment spending, which will decrease the
domestic demand for loanable funds. The world real interest rate will not change, so the
amount of domestic borrowing will decrease or the amount of international lending will
increase.
c. The reduction in consumption spending will increase the domestic supply of loanable
funds. The real world interest rate will not change, so the amount of domestic borrowing
will decrease or the amount of international lending will increase.
d. The new tax on saving will decrease the domestic supply of loanable funds. The real world
interest rate will not change, so the amount of domestic borrowing will increase or the
amount of international lending will decrease.
4.9 a. Increased investment spending will cause the domestic demand curve to shift to the right.
The domestic and the world real interest rate will both increase. The domestic quantity of
loanable funds demanded will exceed the domestic quantity of loanable funds supplied at
the original interest rate, so the country will borrow internationally or decrease
international lending.
b. An increase in expected taxes will decrease investment spending, which will decrease the
domestic demand for loanable funds. The domestic and world real interest rate will both
decrease. The domestic quantity of loanable funds supplied will exceed the domestic
quantity of loanable funds demanded at the original interest rate, so the country decrease
domestic borrowing or increase international lending.
c. The reduction in consumption spending will increase the domestic supply of loanable
funds, so both the domestic and the world real interest rate will decrease. The domestic
quantity of loanable funds supplied will exceed the domestic quantity of loanable funds
demanded at the original interest rate, so domestic borrowing will decrease or
international lending will increase.
d. The new tax on saving will decrease the domestic supply of loanable funds, so the both the
domestic and world real interest rate will increase. The domestic quantity of loanable
funds demanded will exceed the domestic quantity of loanable funds supplied at the
original interest rate, so the country will increase domestic borrowing or decrease
international lending.
4.10 If the United Kingdom (U.K.) is a small open economy and the U.K. government runs a
budget deficit, investors in the U.K. will borrow funds internationally at the unchanged
world real interest rate, so crowding out will not occur.

Data Exercises
D4.1 a. Data from FRED, answers will vary

b. Data from FRED, answers will vary. The exchange rate has been somewhat unstable,
rising significantly from 1980-1985, falling dramatically from 1985-1995, rising again
from 1995-2001, then falling again from 2001-2012. A falling exchange rate makes U.S.
exports more affordable and makes imports to the United States more expensive, and a
rising exchange rate makes U.S. exports less affordable and makes imports to the United
States less expensive. Because the United States imports more than it exports, a falling
exchange rate should increase net exports and a rising exchange rate should decrease net
exports.
c. Data from FRED, answers will vary
D4.2 a. Data from FRED, answers will vary

b. Data from FRED, answers will vary. The current account movements should be similar
to the exchange rate movements from the previous question.
D4.3 a. Data from Treasury Department, answers will vary

b. Data from Treasury Department, answers will vary
D4.4 a. Data from BIS, answers will vary

b. Data from BIS, answers will vary
c. Nominal EERs are calculated as geometric weighted averages of bilateral exchange
rates. Real EERs are the same weighted averages of bilateral exchange rates adjusted by
relative consumer prices.
D4.5 a. Data from FRED, answers will vary.

b. The exchange rates are quoted as units of foreign currency per U.S. dollar.c. To find
the price of a Big Mac in each using the exchange rate in U.S. dollars , it would be found
The Foreign Big Mac Price
by: for example in Japan if the price is 300 yen, then the
That country′s exchange rate
dollar price would be 300 divided by the yen/U.S. dollar exchange rate.
d. To make the most profit, you would want to buy Big Macs where they have the
cheapest price in dollars and sell them where they have the most expensive price in
dollars.

b. Answers will vary based on the actual data found in part a. Economic theory would
predict that if the exchange rate changed such that the dollar appreciated against the yen,
then the amount of U.S. exports to Japan would decrease.

b. Answers will vary based on the actual data found in part a. Economic theory would
predict that if the exchange rate changed such that the dollar appreciated against the yen,
then the amount of U.S. imports from Japan would increase.

b. To compute the percentage change, it is:

(The most recent exchange rate − The exchange rate one month earlier)
× 100
The exchange rate one month earlier
c. If the percentage change is positive then it is showing that the value of the euro is
appreciating and the dollar is depreciating. If the percentage change is negative, then it is
showing that the value of the euro is depreciating and the dollar is appreciating.

b. Total Gross Saving = Gross Private Savings + Gross Government Saving
c. The Supply of loanable funds represents the total gross saving.
d. The shift of the supply of loanable funds curve will depend on the actual change in
total gross saving. If total gross saving decreases, then there will be a new supply curve to
the left of S1.

b. Gross government savings represent the relationship between tax revenue and
government spending. For example, if gross government savings is negative, then it
represents the government budget is in a deficit.
c. If Gross government savings is zero, then the budget is balanced. If gross government
savings is negative, then the budget is in a deficit. If gross government savings is
positive, then the budget has a surplus. The change in gross government savings will vary
based on actual data.
d. The following graph shows the loanable funds market with a decrease in gross
government savings that will shift the supply curve to the left and increase real interest
rates. If there is no change in gross government savings, then the graph will remain at the
original equilibrium. An increase in gross government savings will shift the supply curve
to the right and decrease real interest rates.


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The Global Financial System: Brief Chapter Summary

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Chapter 4

The Global Financial System

4.2 Exchange Rates and Exchange Rate Policy (pages 115–

4.3 What Factors Determine Exchanges Rates? (pages 124–

4.4 The Loanable Funds Model and the International Capital

List of Key Terms

©2014 Pearson Education

4.1 The Balance of Payments (pages 109–114)

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A. The Current Account

B. The Financial Account

C. The Capital Account

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4.2 Exchange Rates and Exchange Rate Policy (pages 115–123)

A. Nominal Exchange Rates

B. Real Exchange Rates

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C. The Foreign-Exchange Market

D. Exchange Rate Policy

1. A fixed exchange rate system

E. Policy Choices and the Current Exchange Rate Systems

©2014 Pearson Education

4.3 What Factors Determine Exchanges Rates? (pages 124–130)

A. Purchasing Power Parity

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B. Why Purchasing Power Parity Doesn't Hold Exactly

C. The Interest Parity Condition

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4.4 The Loanable Funds Model and the International Capital

A. Saving and Supply in the Loanable Funds Market

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B. Investment and the Demand for Loanable Funds

C. Explaining Movements in Saving, Investment and the Real Interest Rate

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D. The International Capital Market and the Interest Rate

E. Small Open Economy

Solutions to the End-of-Chapter Questions, Problems,

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Problems and Applications

1.4 a. Current account

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1.8 Net exports − exports = imports: $1,223 − $6,525 = −$5,302.

− (Balance on current account + balance on financial account + balance on capital account) =

Balance on current account + balance on financial account + balance on capital account –

4.2 Exchange Rates and Exchange Rate Policy

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c. A currency appreciation is an increase in the market value of one country’s currency

Problems and Applications

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4.3 What Factors Determine Exchange Rates

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Problems and Applications

3.6 a. You will need $2,000 × 12 = 24,000 pesos.

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4.4 The Loanable Funds Model and the International Capital

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Problems and Applications

b. If government spending decreases then government saving increases. As a result,

©2014 Pearson Education

©2014 Pearson Education

©2014 Pearson Education

©2014 Pearson Education

©2014 Pearson Education