Exchange rates and Trade Balances

Week 9
Presenter:Zheng Zhang

Oct 26, 2012

Zheng Zhang (uiuc)

Exchange rates and Trade Balances

Oct 26, 2012

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Exchange Rates

Trade Balances

Balance of Payments

Zheng Zhang (uiuc)

Exchange rates and Trade Balances

Oct 26, 2012

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Exchange Rates

Definition and Example

Def: Exchange rates specifies how much one currency is worth in
terms of the other (between two currencies)
Ex: US and the UK
How many dollars do you need to buy a pound?
say you need four dollars to buy a pound:
$4 1
Thus, the exchange rate is
$4/1 $1/.25

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Exchange rates and Trade Balances

Oct 26, 2012

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Exchange Rate

Appreciation
Def: Increase in the price of a currency
Ex: if the dollar appreciates, then people from UK will need to pay
more than .25 to buy one dollar
E = $1/.25 $/.50
or, equivalently

Zheng Zhang (uiuc)

$4/1 $2/1(or $4/2)

Exchange rates and Trade Balances

Oct 26, 2012

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Exchange Rate

Depreciation(devaluation)
Def: decrease in the price of a currency
Ex: if the dollar deppreciates, then people from UK will need to pay
less than .25 to buy one dollar
E = $1/.25 $/.10
or, equivalently

Zheng Zhang (uiuc)

$4/1 $10/1(or $4/.4)

Exchange rates and Trade Balances

Oct 26, 2012

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Exchange Rates

Change in demand and supply of a currency

See Figure 1
Suppose the government of the UK decide to increase expenditure to
fight a recession. Part of the money will be spent building road to
improve the transportation system of the country
One of the components needed to build roads is imported from the
US. Thus, the demand for US goods increase. To buy goods from US
exporters, UK importers need US dollars to pay US exporters.
This implies that the demand for $ increase.
See Figure 2

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Exchange rates and Trade Balances

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Exchange Rates

Since UK importers need US dollars, they will come to the US with

lots of British pounds in order to exchange to US dollars, which
increases British pounds supply
demand for dollars supply of pounds
Claim: Dollar Appreciates/Sterling Pound Depreciates See Figure 3

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Exchange rates and Trade Balances

Oct 26, 2012

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Exchange Rates

Trade Balances

Balance of Payments

Zheng Zhang (uiuc)

Exchange rates and Trade Balances

Oct 26, 2012

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Trade Balance

Lets Now look at what happens with trade balance when exchange
rate changes
Def: trade balance=Exports-Imports
Trade Surplus: Trade Balance >0 Trade Deficit: Trade Balance <0
Notice that trade balance is a part of Aggregate
expenditure(aggregate demand), a change in trade balance would
affect AD and therefore equilibrium national income (Real GDP) in a
short run.(AS-AD model)
What is the effect of an appreciation of the dollar on trade balances
of US and UK?
To answer this question, we only need to look at how this would
affect the imports and exports of two countries

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Exchange rates and Trade Balances

Oct 26, 2012

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Trade Balance

There are four agents in our consideration:

US: Exporters and Importers
UK: Exporters and Importers
Assume US and UK are trading two goods that they specialize in
producing:
US produces trucks
UK produces cars
See Figure 4

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Exchange rates and Trade Balances

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Trade Balance

The pattern of exports and imports US: Exporters export trucks and
Importers import cars
UK: Exporters export cars and Importers import trucks
Suppose now the dollar appreciates:
$4/1 $2/1

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Exchange rates and Trade Balances

Oct 26, 2012

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Trade Balance
US Imports
Say the car costs $20, 000
Before the appreciation of the $, the UK exporters received 5,000
per each car sold to americans,because
$20, 000 (

1
) = 5, 000
$4

After the appreciation of the $, the UK exporters received 10,000

per each car sold to americans,because
$20, 000 (

1
) = 10, 000
$2

Since they receive more, UK exporters will supply more, cars to US.
(US imports increases)
Zheng Zhang (uiuc)

Exchange rates and Trade Balances

Oct 26, 2012

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Trade Balance
US Exports
Say the truck costs $10, 000
Before the appreciation of the $, the UK importers pay 2,500 per
each car sold to americans,because
$10, 000 (

1
) = 2, 500
$4

After the appreciation of the $, the UK importers pay 5,000 per

each car sold to americans,because
$10, 000 (

1
) = 5, 000
$2

Since UK importers pay more, they will demand less trucks.(US

exports decrease)
Zheng Zhang (uiuc)

Exchange rates and Trade Balances

Oct 26, 2012

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Trade Balance

UK Exports
Say a car costs 5,000
Before the appreciation of the dollar, US importers paid $20, 000 for
a car.After the appreciation, US importers pay $10, 000, therefore,
they will demand more cars, which increases demand.
UK exports will increase.

Zheng Zhang (uiuc)

Exchange rates and Trade Balances

Oct 26, 2012

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Trade Balance

UK Imports
Say a truck costs 2,500
Before the appreciation of the dollar, US exporters received
$10, 000. After the appreciation, US exporters receive $5, 000,
therefore, US will supply less trucks.
UK imports decreases.

Zheng Zhang (uiuc)

Exchange rates and Trade Balances

Oct 26, 2012

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Trade Balance

Total effects on Trade Balances of two countries

What is the effect of an appreciation of the dollar on trade balance?
(
more US imports and less US exports
Appreciation of the dollar
less UK imports and more UK exports
Consequences:
US trade deficit increases or US trade surplus decreases
UK trade deficit decreases or UK trade surplus increases

Zheng Zhang (uiuc)

Exchange rates and Trade Balances

Oct 26, 2012

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Exchange Rates

Trade Balances

Balance of Payments

Zheng Zhang (uiuc)

Exchange rates and Trade Balances

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Balance of Payments
Definition: The record of a countrys transactions in goods, services, and
assets with the rest of the world; also the record of a countrys sources
(supply) and uses (demand) of foreign exchange.
Current Account
balance of trade(trade balance) A countrys exports of goods and
services minus its imports of goods and services.
Occurs when a countrys exports of goods and services are less than
its imports of goods and services.
balance on current account Net exports of goods plus net exports of
services plus net investment income plus net transfer payments.

Capital Account
balance on capital account In the United States, the sum of the
following (measured in a given period): the change in private U.S.
assets abroad, the change in foreign private assets in the United
States, the change in U.S. government assets abroad, and the
change in foreign government assets in the United States.
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Exchange rates and Trade Balances

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Balance of Payments

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Exchange rates and Trade Balances

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Practice
Many Economists suggested that the recession in the US economy may
prompt investors to sell off their U.S. assets and use the funds to buy
assets in another country say Japan. (Assume exchange rates are flexible)
a Using supply and demand diagrams, show the impact on the markets
for the U.S. dollars and the Japanese yen if the situation above were to
occur? which currency would appreciate and which one would
depreciate?
b Describe the initial effect of this exchange rate movement on trade
flows between U.S. and Japan. Would U.S. trade deficits with Japan
get bigger or smaller as a result of this initial effect?
c How would the change in trade flows between U.S. and Japan affect
US economy

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Exchange rates and Trade Balances

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