The Money of International Business

Exchange Rates

The price of one country’s currency in units of another country’s currency is known as a foreign currency exchange rate.

Learning Objectives

Summarize how exchange rates operate

Key Takeaways

Key Points

  • An exchange rate between two currencies is the rate at which one currency will be exchanged for another.
  • Currency may be free-floating, pegged or fixed, or a hybrid.
  • A currency will tend to become more valuable whenever demand for it is greater than the available supply.
  • Increased demand for a currency can be due to either an increased transaction demand for money or an increased speculative demand for money.

Key Terms

  • floating exchange rate: A floating or fluctuating exchange rate is a type of exchange rate regime wherein a currency’s value is allowed to fluctuate according to the foreign exchange market.
  • fixed exchange rate: Sometimes called a pegged exchange rate, a type of exchange rate regime wherein a currency’s value is matched to the value of another single currency or to a basket of other currencies, or to another measure of value, such as gold.
  • exchange rate: The amount of one currency that a person or institution defines as equivalent to another currency when either buying or selling it at any particular moment.

Exchange Rates

A foreign currency exchange rate between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another’s. Exchange rates are determined in the foreign exchange market. The “forex” or “FX” market is the largest currency exchange market in the world today, where trading averages around 5.3 trillion US dollars per day (data from April, 2013).  

Exchange rates can be quoted in two ways: (1) A direct quote, is to state the number of domestic units of currency per one unit of foreign currency; (2) If an exchange rate is an indirect quote, the exchange rate is stated as the number of foreign units per one unit of domestic currency.

Foreign Exchange for Travelers

People may need to exchange currencies in a number of situations. For example, people intending to travel to another country may buy foreign currency in a bank in their home country, where they may buy foreign currency cash, traveler’s checks, or a travel-card. They can only buy foreign cash from a local money changer.

At the destination, travelers can buy local currency at the airport, at their hotel, a local money changer or dealer, through an ATM, or at a bank branch. When they purchase goods in a store and they do not have local currency, they can use a credit card, which will convert to the purchaser’s home currency at its prevailing exchange rate. If they have traveler’s checks or a travel card in the local currency, no currency exchange is necessary.

If a traveler has any foreign currency left over on his return home, he may want to sell it, which he may do at his local bank or money changer. The exchange rate, as well as fees and charges, can vary significantly on each of these transactions, and the exchange rate can vary from one day to the next.

Fluctuations in Exchange Rates

A currency pair is the quotation of the relative value of a currency unit against the unit of another currency in the foreign exchange market. The quotation EUR/USD 1.25 means that one euro is exchanged for 1.25 US dollars.

Each country, through varying mechanisms, manages the value of its currency. As part of this function, it determines the exchange rate regime that will apply to its currency. For example, the currency may be free-floating, pegged or fixed, or a hybrid.

If a currency is free-floating, its exchange rate is allowed to vary against that of other currencies and is determined by the market forces of supply and demand. This currency is said to have a “floating exchange rate. ” Exchange rates for such currencies are likely to change almost constantly as quoted on financial markets, mainly by banks, around the world.

A movable or adjustable peg system is a system of fixed exchange rates, but with a provision for the devaluation of a currency. For example, between 1994 and 2005, the Chinese yuan renminbi (RMB) was pegged to the United States dollar at RMB 8.2768 to $1.00. China was not the only country to do this; from the end of World War II until 1967, Western European countries all maintained fixed exchange rates with the US dollar based on the Bretton Woods system. But that system had to be abandoned due to market pressures and speculations in the 1970s in favor of floating, market-based regimes.

Still, some governments keep their currency within a narrow range. As a result, currencies become over-valued or under-valued, causing trade deficits or surpluses. A market-based exchange rate will change whenever the values of either of the two component currencies change.

A currency will tend to become more valuable whenever demand for it is greater than the available supply. Conversely, it will become less valuable whenever demand is less than available supply. Increased demand for a currency can be due to either an increased transaction demand for money or an increased speculative demand for money.

Transaction Demand vs. Speculative Demand

The transaction demand is highly correlated to a country’s level of business activity, gross domestic product (GDP), and employment levels. The more people who are unemployed, the less the public as a whole will spend on goods and services. Central banks typically have little difficulty adjusting the available money supply to accommodate changes in the demand for money due to business transactions.

Speculative demand is much harder for central banks to accommodate, which they influence by adjusting interest rates. A speculator may buy a currency if the return (that is the interest rate) is high enough. In general, the higher a country’s interest rates, the greater the demand for its currency.

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Exchange Rates: Example of exchange rates display in Thailand.

Balance of Trade

The balance of trade is the difference between the monetary value of exports and imports in an economy over a certain period.

Learning Objectives

Define the balance of trade

Key Takeaways

Key Points

  • A positive balance is known as a “trade surplus” if it consists of exporting more than is imported; a negative balance is referred to as a trade deficit or, informally, a trade gap.
  • Measuring the balance of trade can be problematic because of problems with recording and collecting data.
  • The cost of production, the cost and availability of raw materials, and exchange rate movements are some factors that can affect the balance of trade.

Key Terms

  • trade surplus: A positive balance of trade.
  • trade credit: a form of debt offered from one business to another with which it transacts
  • balance of trade: The difference between the monetary value of exports and imports in an economy over a certain period of time.
  • trade deficit: A negative balance of trade.

Balance of Trade

The balance of trade (or net exports, sometimes symbolized as NX) is the difference between the monetary value of exports and imports of output in an economy over a certain period. It is the relationship between a nation’s imports and exports. A positive balance is known as a “trade surplus,” if it consists of exporting more than is imported; a negative balance is referred to as a “trade deficit” or, informally, a “trade gap.” The balance of trade is sometimes divided into a goods and a services balance. The trade balance is identical to the difference between a country’s output and its domestic demand (the difference between what goods a country produces and how many goods it buys from abroad; this does not include money re-spent on foreign stock, nor does it factor in the concept of importing goods to produce for the domestic market).

Measuring the balance of trade can be problematic because of problems with recording and collecting data. As an illustration of this problem, when official data for all the world’s countries are added up, exports exceed imports by almost 1%; it appears the world is running a positive balance of trade with itself. This cannot be true, because all transactions involve an equal credit or debit in the account of each nation. The discrepancy is widely believed to be explained by transactions intended to launder money or evade taxes, smuggling and other visibility problems. However, especially for developed countries, accuracy is likely. Factors that can affect the balance of trade include:

  • The cost of production (land, labor, capital, taxes, incentives, etc.) in the exporting economy vis-à-vis those in the importing economy
  • The cost and availability of raw materials, intermediate goods and other inputs
  • Exchange rate movements
  • Multilateral, bilateral and unilateral taxes, or restrictions on trade
  • Non-tariff barriers, such as environmental, health, or safety standards
  • The availability of adequate foreign exchange with which to pay for imports
  • Prices of goods manufactured at home (influenced by the responsiveness of supply)

In addition, the trade balance is likely to differ across the business cycle. In export-led growth (such as oil and early industrial goods), the balance of trade will improve during an economic expansion. However, with domestic demand-led growth (as in the United States and Australia), the trade balance will worsen at the same stage in the business cycle as these economies will import additional raw materials and finished goods.

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US Trade Balance: U.S. trade balance from 1980-2010

Balance of Payments

Balance of payments (BOP) accounts are an accounting record of all monetary transactions between a country and the rest of the world.

Learning Objectives

Define the balance of payments (BOP) account

Key Takeaways

Key Points

  • Balance of payments (BOP) accounts are an accounting record of all monetary transactions between a country and the rest of the world.
  • Sources of funds for a nation, such as exports or the receipts of loans and investments, are recorded as positive or surplus items.
  • Uses of funds, such as for imports or to invest in foreign countries, are recorded as negative or deficit items.
  • When all components of the BOP accounts are included they must equal zero with no overall surplus or deficit.

Key Terms

  • balance of payments: an accounting record of all monetary transactions between a country and the rest of the world
  • Current Account: In economics, the current account is one of the two primary components of the balance of payments (the other being the capital account). It is the sum of the balance of trade (i.e., net revenue on exports minus payments for imports), times income (earnings on foreign investments minus payments made to foreign investors), and cash transfers.
  • Capital Account: In macroeconomics and international finance, the capital account (also known as financial account) is one of two primary components of the balance of payments, the other being the current account. Whereas the current account reflects a nation’s net income, the capital account reflects net change in national ownership of assets.

Balance of Payments

Balance of payments (BOP) accounts are an accounting record of all monetary transactions between a country and the rest of the world. These transactions include payments for the country’s exports and imports of goods, services, financial capital, and financial transfers. The BOP accounts summarize international transactions for a specific period, usually a year, and are prepared in a single currency, typically the domestic currency for the country concerned. Sources of funds for a nation, such as exports or the receipts of loans and investments, are recorded as positive or surplus items. Uses of funds, such as for imports or to invest in foreign countries, are recorded as negative or deficit items.

When all components of the BOP accounts are included, they must sum to zero with no overall surplus or deficit. For example, if a country is importing more than it exports, its trade balance will be in deficit, but the shortfall will have to be counter-balanced in other ways – such as by funds earned from its foreign investments, by running down central bank reserves, or by receiving loans from other countries.

While the overall BOP accounts will always balance when all types of payments are included, imbalances are possible on individual elements of the BOP, such as the current account, the capital account excluding the central bank’s reserve account, or the sum of the two. Imbalances in the latter sum can result in surplus countries accumulating wealth, while deficit nations become increasingly indebted.

The term balance of payments often refers to this example: a country’s balance of payments is said to be in surplus (balance of payments is positive) by a certain amount if sources of funds (such as export goods sold and bonds sold) exceed uses of funds (such as paying for imported goods and paying for foreign bonds purchased) by that amount. There is said to be a balance of payments deficit (the balance of payments is said to be negative) if the former are less than the latter.

Under a fixed exchange rate system, the central bank accommodates those flows by buying up any net inflow of funds into the country or by providing foreign currency funds to the foreign exchange market to match any international outflow of funds, thus preventing the funds flows from affecting the exchange rate between the country’s currency and other currencies. Then the net change per year in the central bank’s foreign exchange reserves is sometimes called the balance of payments surplus or deficit.

Alternatives to a fixed exchange rate system include a managed float where some changes of exchange rates are allowed, or at the other extreme a purely floating exchange rate (also known as a purely flexible exchange rate). The central bank does not intervene with a pure float to protect or devalue its currency, it allows the rate to be set by the market. The central bank’s foreign exchange reserves do not change.

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Current Account Balance, 2006: Current Account balance, 2006, U.S. dollars, per capita