Unit 7

Foreign exchange (FOREX) 

• the buying and selling of currency 
• Any transaction that occurs in the balance of payments necessitates foreign exchange 
• The exchange rate (e) is determined in the foreign currency markets - [ex. the current exchange rate is approximately 8 yuan to 1 dollar] 

Changes is exchange rates 

• exchange rates (e) are a function of the supply and demand for currency 

• an increase in the supply of currency will decrease the exchange rate of a currency 
• A decrease in supply of a currency will increase the exchange rate of a currency 
• An increase in demand for a currency will increase the exchange rate of a currency 
• A decrease in demand for a currency will decrease the exchange rate of a currency 

Appreciation and depreciation 

• appreciation of a currency occurs when the exchange rate of that currency increases (e⬆️) 
• Depreciation of a currency occurs when the exchange rate of that currency decreases (e⬇️) 

Exchange rate determinants 

1. Consumer tastes 
2. Relative income 
3. Relative price level 
4. Speculation 

Exports and imports 

• the exchange rate is a determinant of both exports and imports 
• Appreciation of the dollar causes American goods to be relatively more expensive and foreign goods to be relatively cheaper this reducing exports and increasing imports 
• Depreciation of the dollar causes American goods to be relatively cheaper and foreign goods to be relatively more expensive thus increasing exports and reducing imports 

Balance of Trade

Individual:Exists when a person can produce more of a certain good/ service than someone else in the same amount of time ( or can produce a good using the least amount of resources) 

National:  When a country can produce more of a good/service than the another country can in the same time period.

Comparative Advantage

Person or nation has a comparative advantage in the production of a product when it can produce the product at a lower domestic opportunity cost than a trading partner.

 Input:(TVs produced per hour,  Miles per gallon)
Output:(# of hrs. to do jobs,  # of acres to feed horses)

Specialization and Trade

              Gains from trade are based on comparative advantage, not absolute advantage. (countries should trade if they have a lower opportunity cost)

Balance of Payments

:Measure of money inflows and outflows between the U.S. and the rest of the world. 

Inflow = credits

Outflow = debits

Balance of payment divided:

1. Current Account

2. Capital/Financial Account

3. Official Reserves Account

Current Account: 

• Balance of Trade of Net Exports

             - Exports = credit to balance

              -Imports = debit to balance

• Net Foreign Income
• Net Transfers (tend to be unilateral)

               -Foreign Aid = debit to current account

Capital/Financial Account:

• Balance of capital ownership
• Includes the purchase of both real and financial assets 
• Direct investments in the US is a credit to the capital account
• Direct investment by US firms/individuals in a foreign country are debits to the capital account 
• Purchase of foreign financial assets represents a debit to the capital account 
• Purchase of domestic financial assets by foreigners represents a credit to the capital account.

               

         *Current Account and Capital account should zero each other out.*

Official Reserves 

The foreign currency holdings of the US Federal Reserve System

Balance of payments surplus = Fed accumulates foreign currency

BOP payments = Fed depletes its reserves of foreign currency 

*Official Reserves zero out BOP*

Active vs. Passive Official Reserves

• US is passive in its use of official reserves.
• It does not seek to manipulate the dollar exchange rate