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Summary

Capital Flows and the Balance of Payments

• 1. A country’s balance of payments accounts summarize its transactions with the rest of the world. The balance of payments on the current account, or the current account, includes the balance of payments on goods and services together with balances on factor income and transfers. The merchandise trade balance, or trade balance, is a frequently cited component of the balance of payments on goods and services. The balance of payments on the financial account, or the financial account, measures capital flows. By definition, the balance of payments on the current account plus the balance of payments on the financial account is zero.
• 2. Capital flows respond to international differences in interest rates and other rates of return; they can be usefully analyzed using an international version of the loanable funds model, which shows how a country where the interest rate would be low in the absence of capital flows sends funds to a country where the interest rate would be high in the absence of capital flows. The underlying determinants of capital flows are international differences in savings and opportunities for investment spending.

The Foreign Exchange Market

• 3. Currencies are traded in the foreign exchange market; the prices at which they are traded are exchange rates. When a currency rises against another currency, it appreciates; when it falls, it depreciates. The equilibrium exchange rate matches the quantity of that currency supplied to the foreign exchange market to the quantity demanded.
• 4. To correct for international differences in inflation rates, economists calculate real exchange rates, which multiply the exchange rate between two countries’ respective currencies by the ratio of the countries’ price levels. The current account responds only to changes in the real exchange rate, not the nominal exchange rate. Purchasing power parity is the exchange rate that makes the cost of a basket of goods and services equal in two countries. While purchasing power parity and the nominal exchange rate almost always differ, purchasing power parity is a good predictor of actual changes in the nominal exchange rate.

Exchange Rate Policy

• 5. Countries adopt different exchange rate regimes, rules governing exchange rate policy. The main types are fixed exchange rates, where the government takes action to keep the exchange rate at a target level, and floating exchange rates, where the exchange rate is free to fluctuate. Countries can fix exchange rates using exchange market intervention, which requires them to hold foreign exchange reserves that they use to buy any surplus of their currency. Alternatively, they can change domestic policies, especially monetary policy, to shift the demand and supply curves in the foreign exchange market. Finally, they can use foreign exchange controls.
• 6. Exchange rate policy poses a dilemma: there are economic payoffs to stable exchange rates, but the policies used to fix the exchange rate have costs. Exchange market intervention requires large reserves, and exchange controls distort incentives. If monetary policy is used to help fix the exchange rate, it isn’t available to use for domestic policy.

Exchange Rates and Macroeconomic Policy

• 7. Fixed exchange rates aren’t always permanent commitments: countries with a fixed exchange rate sometimes engage in devaluations or revaluations. In addition to helping eliminate a surplus of domestic currency on the foreign exchange market, a devaluation increases aggregate demand. Similarly, a revaluation reduces shortages of domestic currency and reduces aggregate demand.
• 8. The fact that one country’s imports are another country’s exports creates a link between the business cycles in different countries. Floating exchange rates, however, may reduce the strength of that link.