Open Economy: International Trade and Finance

A . Balance of payments accounts

1 . Balance of trade

The merchandise trade balance, (or simply trade balance) is the difference between a country’s exports and imports of goods alone—not including services.

2 . Current account: Goods & Services, Factor Income Earned, & Transfers (money sent to somebody).

Transactions that don’t create liabilities are considered part of the balance of payments on current account: the balance of payments on goods and services plus factor income and net international transfer payments.

The most important part of the current account: the balance of payments on goods and services, the difference between the value of exports and the value of imports during a given period.

3 . Financial (capital) account: Financial transactions involving governments and/or private investments in assets (land or stock).

Transactions that involve governments or government agencies, mainly central banks:

Example: When the Federal Reserve purchases debt from England.

Private sales and purchases of assets.

Example: General Motors purchases a factory in Mexico

For the current & capital accounts, if the international transaction USES foreign currency to complete the transaction (money going out), it is a debit (negative). If it earns foreign currency (money coming in), it is a credit (positive).

B . Foreign exchange market

1 . Demand for and supply of foreign exchange

Higher interest rates increase savings from one country to the next.

The higher rate in the US increases the incentive to save in the US instead of Britain.

The US banking system will see an increase in supply in loanable funds and Britain will see a decrease in supply of loanable funds.

The flow of money into higher interest rate countries will continue until the REAL interest rate is equal.

2 . Exchange rate determination

An increase in demand for a currency appreciates the currency.

An increase in supply of a currency depreciates the currency.

Inflation in one country will cause consumers to increase demand for other countries products. Increasing the demand for the foreign currency and increasing the supply to the FOREX market...depreciating the currency of the nation experiencing inflation.

3 . Currency appreciation and depreciation

When drawing a FOREX (foreign exchange graph) make sure that the right side (the label for S, D and Q are all the same currency). The left side (the label for the Y-axis and the equilibrium) are both labeled in the currency to be exchanged in the FOREX market.

BELOW: Buying a German product with dollars. Increase the supply of dollars to the FOREX and APPRECIATING the euro (fewer euros to convert to a dollar) and DEPRECIATING the dollar (more dollars to convert to a euro).

BELOW: Buying a US product with Euros. Increasing the demand for dollars and APPRECIATING the dollar or DEPRECIATING the euro.

C . Net exports and capital flows

An increase in capital flows into the U.S. leads to a stronger dollar, which then creates a decrease in U.S. net exports.

A decrease in capital flows into the U.S. leads to a weaker dollar, which then creates an increase in U.S. net exports.

D . Links to financial and goods markets

RELEVANT FRQ QUESTIONS (2010 to present):

2015 #3

2014 #3

2011 #2

2010 #3