TOPIC 10:

INTERNATIONAL
FINANCE
Case & Fair (Ch. 34)
CHAPTER OUTLINE
The Balance of Payment
The current account
The capital account
Equilibrium Output in An Open Economy
Determinants of Imports
Determinants of Exports
Trade Feedback Effect
Price Feedback Effect
Exchange Rate System
Currency appreciation
Currency depreciation
Floating exchange rate
Fixed exchange rate
Factors that Affect Exchange Rate
Purchasing power parity
Relative interest rate
The Effect of Exchange Rate
J-curve effect
BALANCE OF PAYMENTS
 Balance of payments – the record of a
country’s transactions in G & S, and assets with
the rest of the world

 BOP also is the record of a country’s sources

(supply) and uses (demand) of foreign exchange.

 Foreign exchange – all currencies other than

the domestic currency of a given country.
3
BALANCE OF PAYMENTS (CONT.)
 Balance of trade – a country’s exports of G & S
minus its imports of G & S.

 Trade deficit – country’s exports (X) < imports

(IM).

4
United States Balance of Payments, 2011
(+) Goods exports 1497.4
(-) Goods imports 2235.8
(1) NX of goods -738.4
(+) Exports of services 606.0
(-) Imports of services 427.4 All transactions
(2) NX of services 178.6
that bring foreign
(+) Income received on investments 744.6
(-) Income payments on investments 517.6
exchange into the
(3) Net investment income 227.0 U.S. are credited
(4) Net Transfer Payments -133.1 (+); all
(5) Balance on current account (1+2+3+4) -465.9 transactions that
(6) (-) ∆ in private U.S. assets abroad 364.1 cause the U.S. to
(7) (+) ∆ in foreign private assets in U.S. 789.2 lose foreign
(8) (-) ∆ in U.S. govt. assets abroad 119.5 exchange are
(9) (+) ∆ in foreign govt. assets in U.S. 211.8 debited (-) .
(10) Balance on capital account (6+7+8+9) 517.4
(11) Net capital account transactions and financial derivatives 37.7
5
(12 )Statistical discrepancy/ foreign reserves (10+11-5) -89.2 Sources: U.S. Bureau of
ubea1073/jan09/ngky
Economics Analysis
(13) Balance of Payments 0
EQUILIBRIUM OUTPUT IN AN OPEN
ECONOMY
 Planned AE in an open economy:
AE ≡ C + I + G + EX − IM

 The level of imports: When income rises,

imports tend to go up.

IM  mY

 Marginal propensity to import (MPM) – the

change in imports caused by a $1 change in
income.
6
EQUILIBRIUM OUTPUT IN AN OPEN
ECONOMY (CONT.)
 An economy is described by the followings:
C = 100 + 0.75 Yd
I = 150
G = 100
T = 50
EX = 50
IM = 0.25Yd

Calculate the equilibrium output level and balance

of trade.
7
EQUILIBRIUM OUTPUT IN AN OPEN
ECONOMY (CONT.)
 Solution

8
EQUILIBRIUM OUTPUT IN AN OPEN
ECONOMY (CONT.)

AE

Output, Y 9
EQUILIBRIUM OUTPUT IN AN OPEN
ECONOMY (CONT.)
 Assume that govt. implements expansionary
fiscal policy by increasing G to 150.

 Using multiplier approach, explain what happen

to the output.

 Solution:

10
EQUILIBRIUM OUTPUT IN AN OPEN
ECONOMY (CONT.)

AE

Output, Y 11
EQUILIBRIUM OUTPUT IN AN OPEN
ECONOMY (CONT.)
 Now, assume that the country closed the
economy.

 Using multiplier approach, explain what happen

to the output when govt. implements
expansionary fiscal policy by increasing G to 150.

 Solution:

12
DIFFERENCE BETWEEN MULTIPLIERS
 
 Open- economy multiplier:
  − 𝑀𝑃𝐶 + 𝑀𝑃𝑀
𝑘𝑇 =
1−( 𝑀𝑃𝐶 − 𝑀𝑃𝑀 )
 Closed- economy multiplier:

 The multiplier is smaller in an open economy

than in a closed economy.

 Some of the extra consumption is on foreign

products and not on domestically produced G13&
S.
DETERMINANTS OF IMPORTS
1. After- tax real wage

2. After- tax non- labour income

3. Interest rates

4. Relative prices of domestically produced &

foreign- produced goods

14
DETERMINANTS OF EXPORTS
1. The rest- of- the world wages

2. The rest- of- the world wealth

3. The rest- of- the world non- labour income

4. The rest- of- the world interest rates

5. The rest- of- the- world prices for goods 15

TRADE FEEDBACK EFFECT &
PRICE FEEDBACK EFFECT
 Trade feedback effect– the tendency for an
increase in the economic activity of one country
to lead to a worldwide increase in economic
activity, which then feeds back to that country.

16
TRADE FEEDBACK EFFECT &
PRICE FEEDBACK EFFECT
 Price feedback effect – the process by which a
domestic price increase in one country can
“feed back” on itself through EX & IM. An
increase in the price level in one country can
drive up prices in other countries.

17
EXCHANGE RATE SYSTEM
 Exchange rate – the price of one country’s currency in
terms of another country’s currency; the ratio at which
2 currencies are traded for each other.

 A fall in the value of one currency in terms of another

currency is called currency depreciation.

 A rise in value of one currency in terms of another

currency is called currency appreciation.

18
EXCHANGE RATE SYSTEM
 Floating/ market-determined exchange rates –
exchange rate that are determined by the
unregulated forces of supply and demand.

 Fixed exchange rate – the price of the currency

set by govt.

 Equilibrium exchange rate occurs when Qs of

currency = Qd of currency.
19
FLOATING EXCHANGE RATE SYSTEM

E, ($/RM)

Qty of RM
FLOATING EXCHANGE RATE SYSTEM
The Supply of and Demand for RM
Some Buyers and Sellers in International Exchange Markets:
United States and Malaysia

The Demand for RM (Supply of Dollars)

1. Firms, households, or governments that import Msia goods into the United
States or want to buy Msia-made goods and services
2. U.S. citizens traveling in Msia
3. Holders of dollars who want to buy Msia stocks, bonds, or other financial
instruments
4. U.S. companies that want to invest in Msia
5. Speculators who anticipate a decline in the value of the dollar relative to the
RM
The Supply for RM (DD of Dollars)
1. Firms, households, or governments that import U.S. goods into Msia or
want to buy U.S.-made goods and services
2. Msia citizens traveling in the United States
3. Holders of RM who want to buy stocks, bonds, or other financial
instruments in the United States
4. Msia companies that want to invest in the United States
5. Speculators who anticipate a rise in the value of the dollar relative to the
RM
 Foreign Exchange Market
The Market for RM
E, ($/RM)

Qty of RM
If Msians want to buy U.S. Goods/Services they must give up their RM in order to obtain
Dollars.
Initially the _____ of RM is going to _______________ in the Market for RM.
Notice that the Dollar Price Per RM is now lower than it was at the previous equilibrium
point. It NOW takes _________ RMs to buy a dollar. The RM has __________ in value
relative to the Dollar.
Or It NOW takes __________ dollars to buy a RM. The U.S has ____________ in value
relative to the RM.
 Foreign Exchange Market
The Market for RM
E, ($/RM)

Qty of RM
If U.S citizen want to buy Msia Goods/Services they must give up their Dollars in order to
obtain RM. Quantity of Dollars
Initially the __________ of RM is going to ___________ in the Market for RM.
Notice that the Dollar Price Per RM is now higher than it was at the previous equilibrium
point. It NOW takes ________ RM to buy a dollar. The RM has _____________ in value
relative to the Dollar.
Or It NOW takes ________ dollars to buy a RM. The dollar has ____________ in value
relative to the RM.
FACTORS THAT AFFECT EXCHANGE
RATE (CONT.)
1. Purchasing power parity: The Law of One Price:

 Purchasing- power- parity – a theory of

international exchange holding that exchange
rates are set so that the price of similar goods in
different countries is the same.

 A high rate of inflation in one country relative to

another puts pressure on the exchange rate
between the 2 countries, and there is a general
tendency for the currencies of relatively high- 24

inflation countries to depreciate.

Example:
 If a dollar (or any other currency) could buy more coffee in the
US than in Japan, international trader could profit by buying
coffee in the US and selling in Japan.

 This export of coffee from the US to Japan would drive up the US

price of coffee (in response to greater demand) and drive down
the Japanese price (in response to greater supply).

 Conversely, if a dollar could buy more coffee in Japan than in the

US. It will drive down the price of coffee in the US and drive up
the price in Japan

 In the end, the law of one price tell us that a dollar must buy the
same amount of coffee in one country 25
FACTORS THAT AFFECT EXCHANGE
RATE (CONT.)
Exchange rates responds to changes in relative
prices:
Assume RM & $ traded under floating exchange
rate system.
The ↑ P in the U.S makes imports relatively less
expensive in U.S. U.S. citizens are likely to ↑ their
spending on IM from Msia, shifting the DRM to the right.
At the same time, the Msia see U.S. goods getting more
expensive and ↓ their dd for exports from the U.S,
shifting SRM shifts to the left.
The RM appreciates, and the dollar is worth less. 26
Factors That Affect Exchange Rate
(cont.)
Exchange rates responds to changes in relative
prices:
E, ($/RM)

27
Qty of RM
Factors That Affect Exchange Rate
(cont.)
2. Relative interest rates:
 Higher r in one country will attracts investors
to the country’s securities market.

 Currency tends to appreciate when the

country is having a relatively high interest
rate.

28
FACTORS THAT AFFECT EXCHANGE
RATE (CONT.)
Exchange rates responds to changes in relative
interest rates:
If U.S. interest rates ↑ relatiave to Msia interest rates,
Msian holding RM may be attracted into the U.S.
securities market.
To buy bonds in the United States, Msia buyers must
exchange RM for dollars. The SS of RM shifts to the
right.
However, U.S. citizens are less likely to be interested in
Msia securities because interest rates are higher at home.
The DD for RM shifts to the left. 29
The result is a depreciated RM and a stronger dollar.
Factors That Affect Exchange Rate
(cont.)
Exchange rate responds to changes in relative r:
E, ($/RM)

Qty of RM 30
 THE EFFECTS OF EXCHANGE RATES
 A depreciation of a country’s currency is likely to
increase its GDP.
 When a country’s currency depreciates, import
prices increases and export prices fall.
 Hence, imports decreases and exports increases;
stimulate economic growth.
 Economists believed that when a currency starts to
depreciate, the balance of trade is likely to worsen
for the first few quarters.
31
 THE EFFECTS OF EXCHANGE
RATES (CONT.)
 J- curve effect – following a currency
depreciation, a country’s balance of trade may get
worse before it gets better.

 Balance of trade = (dollar price of exports x

quantity of exports) – (dollar price of imports x
quantity of imports)

 The initial effect is likely to be negative when there

32
is a depreciation; the value of imports increases in
short run.
THE EFFECTS OF EXCHANGE RATES (CONT.)
 When RM depreciates, imports’ price is higher than exports’
price. It takes a while for consumers and firms to realize
that the relative prices have changed.
 This will cause the imports value increase, hence BOT
worsens. A depreciation may lead to an initial deterioration
of the trade balance
 After some times, lower exports’ price will attract demands
for domestic goods.
 Exports will increase while imports will decrease.
 Eventually, exports and imports respond, and depreciation
leads to an improvement of the trade balance.
33
The Effects of Exchange Rates
(cont.)
J- curve effect:
Change in balance of trade
+

0 Quarters after the

beginning of depreciation

34