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International Finance

24 April, 2015 - 11:52

Learning Objectives

  • Define a country’s balance of payments, and explain what is included on the current and capital accounts.
  • Assuming that the market for a country’s currency is in equilibrium, explain why the current account balance will always be the negative of the capital account balance.
  • Summarize the economic arguments per se against public opposition to a current account deficit and a capital account surplus.

There is an important difference between trade that flows, say, from one city to another and trade that flows from one nation to another. Unless they share a common currency, as some of the nations of the European Union do, trade among nations requires that currencies be exchanged as well as goods and services. Suppose, for example, that buyers in Mexico purchase silk produced in China. The Mexican buyers will pay in Mexico’s currency, the peso; the manufacturers of the silk must be paid in China’s currency, the yuan. The flow of trade between Mexico and China thus requires an exchange of pesos for yuan.

This section examines the relationship between spending that flows into a country and spending that flows out of it. These spending flows include not only spending for a nation’s exports and imports, but payments to owners of assets in other countries, international transfer payments, and purchases of foreign assets. The balance between spending flowing into a country and spending flowing out of it is called its balance of payments.

We will simplify our analysis by ignoring international transfer payments, which occur when an individual, firm, or government makes a gift to an individual, firm, or government in another country.Foreign aid is an example of an international transfer payment. International transfer payments play a relatively minor role in the international financial transactions of most countries; ignoring them will not change our basic conclusions.

A second simplification will be to treat payments to foreign owners of factors of production used in a country as imports and payments received by owners of factors of production used in other countries as exports. This is the approach when we use GNP rather than GDP as the measure of a country’s output.

These two simplifications leave two reasons for demanding a country’s currency: for foreigners to purchase a country’s goods and services (that is, its exports) and to purchase assets in the country. A country’s currency is supplied in order to purchase foreign currencies. A country’s currency is thus supplied for two reasons: to purchase goods and services from other countries (that is, its imports) and to purchase assets in other countries.

We studied the determination of exchange rates in the chapter on how financial markets work. We saw that, in general, exchange rates are determined by demand and supply and that the markets for the currencies of most nations can be regarded as being in equilibrium. Exchange rates adjust quickly, so that the quantity of a currency demanded equals the quantity of the currency supplied.

Our analysis will deal with flows of spending between the domestic economy and the rest of the world. Suppose, for example, that we are analyzing Japan’s economy and its transactions with the rest of the world. The purchase by a buyer in, say, Germany of bonds issued by a Japanese corporation would be part of the rest-of-world demand for yen to buy Japanese assets. Adding export demand to asset demand by people, firms, and governments outside a country, we get the total demand for a country’s currency.

A domestic economy’s currency is supplied to purchase currencies in the rest of the world. In an analysis of the market for Japanese yen, for example, yen are supplied when people, firms, and government agencies in Japan purchase goods and services from the rest of the world. This part of the supply of yen equals Japanese imports. Yen are also supplied so that holders of yen can acquire assets from other countries.

Equilibrium in the market for a country’s currency implies that the quantity of a particular country’s currency demanded equals the quantity supplied. Equilibrium thus implies that

EQUATION 30.1

Quantity of currency demanded=quantity of currency supplied

In turn, the quantity of a currency demanded is from two sources:

  1. Exports
  2. Rest-of-world purchases of domestic assets

The quantity supplied of a currency is from two sources:

  1. Imports
  2. Domestic purchases of rest-of-world assets

Therefore, we can rewrite Equation 30.1 as

EQUATION 30.2

Exports+(rest-of-world purchases of domestic assets) = imports+(domestic purchases of rest-of-world assets)