13.

4 Changes in exchange rate and the balance of payments

Instructions: ​Assume that the United States and Germany are major trading partners and that
the two countries current accounts are in balance. Both the Euro and the US dollar exchange
rates are floating.

1. Demand in Germany for American capital equipment rises.

a. Illustrate and explain the effect on the foreign exchange markets for the US dollar
and the Euro:

b. Explain the changes you illustrated above:

To purchase capital equipment made in the US, German firms must exchange
their Euros for US$, hence the supply of Euros in the US increases, causing the
Euro to depreciate, while the demand for US$ in Germany increases, causing
the US$ to appreciate

c. Describe and explain the short-run effects on the current and financial account
balances for:

i. the United States:

America’s current account balance will move towards surplus as exports
increase to Germany

ii. Germany:
Germany’s current account will move towards deficit as imports increase
from the US

d. Explain what changes will occur in the long-run to bring the current and financial
 account balances back towards zero for:

i. the United States:

The appreciation of the US$ resulting from the increase in Germany’s
purchase of American capital equipment will, in the long-run, make
America’s other exports more expensive to German consumers, leading
to a fall in demand for US goods and a movement in the US current
account back towards deficit.

ii. Germany:
The depreciation of the Euro resulting from Germans supplying more
Euros to the US market will, in the long-run, make Germany’s exports
cheaper to American consumers, leading to an increase in Demand for
German goods and a movement in the German current account back
towards surplus.

2. The European Central Bank lowers interest rates across the Eurozone:
a. Illustrate and explain the effect on the foreign exchange markets for the US dollar
and the Euro:
b. Explain the changes you illustrated above:
Lower interest rates in the Eurozone will make investments in European assets
less attractive to American investors. Hence, the supply of US$ entering the
Eurozone to convert to Euros in order to acquire European asset decreases,
causing the US$ to appreciate, and the demand for Euros decreases, causing
the Euro to depreciate

c. Describe and explain the short-run effects on the current and financial account
balances for:
i. the United States:
In the short-run, the US financial account will move towards surplus as
American demand fewer European assets, leading to an inflow of funds
as investors bring their money back to the US

ii. Germany:
In the short-run, the German financial account will move towards deficit
as American investors pull their money out of German and other
European assets due to the lower rate of return.

d. Explain what changes will occur in the long-run to bring the current and financial
account balances back towards zero for:
i. the United States:
 The stronger dollar will cause demand for American exports to fall (as
they are now more expensive abroad), which, over time, will cause the
US$ to depreciate again, causing both the current account (which had
moved towards deficit) and the financial account (which had moved
towards surplus) to return to a balance of zero.

ii. Germany:
The weaker Euro will cause demand for German exports to increase
(as they are now cheaper abroad), which, over time, will cause the Euro
to appreciate again, causing both the current account (which had
moved towards surplus) and the financial account (which had moved
towards deficit) to return to a balance of zero.

3. Assume the United States is currently experiencing a current account deficit. The
American government has decided to take action to reduce the deficit in the current
account.
a. Outline three justifications for the the American government’s decision to take
action to reduce the nation’s current account deficit.
i. The deficit’s effect on domestic employment:
A current account deficit means the country is exporting less and
importing more, so there will be fewer jobs in the export sector.

ii. The deficit’s effect on indebtedness:

The current account deficit must be offset by a financial account
surplus, meaning foreigners will own many of the country’s assets. A
financial asset foreigners will buy with their surplus funds from their
current account is government debt. Hence, one of the consequences
of the current account deficit is increased foreign indebtedness.

iii. The deficit’s effect on foreign ownership of domestic assets:

In addition to government debt, foreigners may acquire ownership of
real assets (property, factories, etc…) with their surplus funds from the
current account imbalance. This represents a surplus in the financial
account, but also means foreigners will own an increasing share of
domestic assets.

4. The Chairwoman of the US Federal Reserve Bank announces that the Bank will
intervene in the forex markets to devalue the dollar. Show the effect of this policy on the
foreign exchange diagrams for the US dollar and for the Euro.
5.
a. Explain what the Fed must do to devalue the dollar, as you have illustrated
above.
Either a reduction in US interest rates or a direct intervention in the forex
market through which the Fed supplies dollars and buys euros to reduce the
value of the dollar against the Euro

b. Explain the likely long-run consequences of an undervalued US dollar on

i. the United States’s current and financial account balances with Germany
If the dollar remains undervalued in the long-run, the US current
account will experience a persistent surplus. The US financial account,
due to the artificially weak dollar, will experience a persistent deficit (as
foreigners are deterred from investing in lower value US assets)

ii. Germany’s current and financial account balances with the United States
Germany’s current account will experience persistent deficits with the
US, and its financial account will experience persistent surpluses (as
Americans will wish to increase their holdings of German assets due to
the Euro’s higher value)

c. Explain how each of the alternative measures below could have been used to
reduce the United States’s current account deficit.
i. Increased protectionism:
Increased protectionism by the US government would have reduced US
demand for imports, increasing the country’s net exports and reducing
the US current account deficit.
ii. Expansionary supply-side policies:
Expansionary supply-side policies increase the competitiveness and
lower the cost of US manufacturers, making US goods cheaper to
foreign consumers, increasing US exports and reducing the current
account deficit

iii. Contractionary fiscal policy:

Contractionary fiscal policies (such as higher income taxes) would
reduce US households’ disposable incomes, reduce overall
consumption (including that of imports), reduce the US price level
(making cheaper US goods more attractive to foreign consumers) and
reduce the current account deficit

iv. Of the three policies above, which is most beneficial for the American
economy in the long-run? Justify your answer.
The most beneficial method of reducing the current account deficit is
definitely expansionary supply-side policies, since their successful
implementation will not only reduce the US trade deficit, but also fuel
long-run economic growth and an increase in real incomes for the
American household.