38 International Finance
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CHAPTER OUTLINE
The U.S. Trade Deficit and Your Trade Deficit
The Balance of Payments
What Are Exchange Rates?
How Monetary and Fiscal Policy Affect Exchange Rates and How Exchange Rates Affect Aggregate Demand
Fixed vs. Floating Exchange Rates
What Are the IMF and the World Bank?
Takeaway
“Why are we spending our dollars in China and Japan rather than in Ohio and Michigan?”
“Why does America have such a large trade deficit?”
“We need to keep our money at home, not send it abroad!”
So run some common questions and complaints about globalization and international finance. The more connected the world economy becomes, the more these kinds of questions arise and increase in importance.
In Chapter 2, we discussed how specialization and trade let us take advantage of the division of knowledge and comparative advantage and thus raise the standard off living. Gains from trade occur when individuals within a nation trade and people in different countries trade.
It’s important to keep these deep principles in mind when we discuss trade, but we also want to understand more about the kind of international financial events discussed on a daily basis on the financial blogs and in the newspapers. What does it mean when we are told that the dollar is “strong” or “weak”? What is a trade deficit and is it worse than a trade surplus? And why do zombies protest against the World Bank and the International Monetary Fund? What are these strange institutions?
As we will see, some knowledge of international finance is extremely practical. If you wish to do international business, make international investments, or understand how an exchange rate crisis can wreck an economy, you need to know some basic truths about international finance. Understanding international finance will also help you to pick the best place to take a good vacation. And you will even learn why many James Bond movies have a scene set in Switzerland.
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On the surface, international finance is one of the most intimidating fields of economics because the presence of different currencies can be confusing. So let’s begin with some of the key principles behind this chapter:
Gains from trade occur when people trade across different countries with different currencies, just as gains from trade occur within a single nation with a single currency.
The rate of savings is a key variable in understanding international trade and finance.
Market equilibrium means that, at the margin, the gains from holding or spending one currency are equal to the gains from holding or spending some other currency. That sounds simple but we’ll see that this principle will be a building block for understanding the market value of one currency relative to another.