International Trade - The Balance of Payments and Exchange Rates

Module 3 International Economics – International Trade

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International Trade Assessment:-

Trade

Buying and selling goods and services from other countries
The purchase of goods and services from abroad that leads to an outflow of currency from the COUNTRY – Imports (M)
The sale of goods and services to buyers from other countries leading to an inflow of currency to the COUNTRY – Exports (X)

The Flow of Currencies:

Specialisation and Trade

Different factor endowments mean some countries can produce goods and services more efficiently than others – specialisation is therefore possible:

Absolute Advantage:

Where one country can produce goods with fewer resources than another

Comparative Advantage:

Where one country can produce goods at a lower opportunity cost – it sacrifices less resources in production

Balance of Payments

When countries trade there are financial transactions among businesses or consumers of different nations
Money constantly flows into and out of a country
The system of accounts that records a nation’s international financial transactions is called its balance of payments (BP)
It records all financial transactions between a country’s firms, and residents, and the rest of the world usually over a year
The BP is maintained on a double-entry bookkeeping system

The BP is the difference between receipts and payments

The BP includes three accounts:

Balance of Payments and Exchange Rate

If a country’s expenditures consistently exceed its income, its standard of living falls
Its exchange rate vis-à-vis foreign monies declines
When foreign currencies can be traded for more dollars, U.S. products are less expensive for foreign customers and exports increase
Simultaneously foreign products are more expensive for U.S. buyers and the demand for imported goods is reduced

Balance of Trade

Difference in value between its Exports and Imports
Export is the sale of goods and services to foreign markets
Import is the purchase of goods and services from foreign sources
Difference in value between its Exports and Imports

Favorable Balance of Trade :

When Exports are more than Imports

Negative Balance of Trade or Trade Deficit :

When Imports are more than Exports

Trade deficits may contribute to

failure of business ,
loss of jobs ,
lower standard of living and other economic and social problems

Exchange Rates

Floating Exchange Rates:

Price determined only by demand and supply of the currency – no government intervention – India

Fixed Exchange Rates:

The value of a currency fixed in relation to an anchor currency – not allowed to fluctuate – UAE

Dirty Floating or Managed Exchange Rate:

Rate influenced by government via central bank around a preferred rate – China

Foreign Exchange Markets

Foreign exchange: all forms of internationally-traded monies including currency, bank deposits, checks, and electronic transfers.

Foreign exchange market: the global marketplace for buying and selling national currencies

Exchange rates fluctuate constantly. E.g., yen-dollar

exchange rate:

1985 – 240 yen to the U.S. dollar.
2017 – 114 yen to the dollar (nearly 40% appreciation).

How Exchange Rates are Determined

In a free market, the “price” of any currency (rate of exchange) is determined by supply and demand:

The greater the supply of a currency, the lower its price
The lower the supply of a currency, the higher its price
The greater the demand for a currency, the higher its price
The lower the demand for a currency, the lower its price

Appreciation and Depreciation: Example

Euro appreciation: If the euro-dollar exchange rate goes from one euro = $1.25 to one euro = $1.50, the euro becomes expensive to Americans

Euro depreciation: If the euro-dollar exchange rate goes from one euro = $1.25 to one euro = $1.00, the euro then becomes cheaper to Americas

Foreign Exchange Rate

Ratio of the currency of one nation to the currency of another nation

When the value of the currency depreciates

exports are profitable and imports cost more
China keeps its currency intentionally depreciated as it Exports more than it imports !!!

When the value of the currency appreciates

exports become less profitable and imports cost less
Decrease in Japanese exports to U.S.; Increase in U.S. exports to Japan

Example – Currency Depreciation- good for exports

Suppose $1= 114 Yen Which means Yen is a weaker currency. Now when Japan exports , it will receive 114 yen x for 1 $. Suppose the currency depreciated further;

Now $1 = 120 yen

So now it will receive 120 yen for 1$ which is profitable

Example – Currency Appreciation – good for imports

Suppose $1= 100 Yen which means the currency has appreciated Now when Japan imports , it will spend only 100 yen for 1 $. Suppose the currency appreciated further;

Now $1 = 95 yen

So now Japan will spend 95 yen for 1$ when importing which is profitable.

Exchange Rates

Determinants of Exchange Rates:

Exchange rates are determined by the demand for and the supply of currencies on the foreign exchange market

The demand and supply of currencies is in turn determined by:

Relative interest rates
The demand for imports (D£)
The demand for exports (S£)
Investment opportunities
Speculative sentiments
Global trading patterns
Changes in relative inflation rates

Exchange Rates