Unit 7

Balance of Payments

• Balance of Payments Defined
• The sum of all the transactions that have taken place between a nation's residents and the residents of all foreign nations.
• Transactions Include:
• Exports and imports of goods
• Exports and imports of services
• Tourist expenditures
• Interest and dividends received or paid abroad
• Purchases and sales of financial or real assets abroad

3 Components

• Current Account
• U.S. trade in currently produced goods and services
• Balance of Current Account is found when all transactions in current account are added.
• Capital Account
• Summarizes the purchase or sale of real or financial assets and the corresponding flows of monetary payments accompanying them.
• Official Reserves Account
• Quantities that central banks of nations hold of foreign currencies
• All three components must equal zero.

Balance of Payments Deficits and Surpluses

• Imbalances between current and capital accounts that cause a drawing down or up a building up of foreign currencies.

Foreign Exchange Market

• Foreign Exchange Market Defined
• A market in which various national currencies are exchanged for one another.
• Exchange Rates
• Equilibrium prices in the markets
• Two Points of Foreign Exchange Markets
• Competitive Market:
• Characterized by large numbers of buyers and sellers dealing in standardized products such as the euro, yen, and the dollar.
• Linkage to All Domestic and Foreign Prices:
• The market price or exchange rate of a nation's currency is an unusual price that links all the domestic prices with all the foreign prices.
• Changes in Foreign Exchange Rates
• Increase in the supply of currency will decrease the exchange rate of a currency.
• Decrease in supply will increase exchange rate.
• Increase in demand, increase in exchange rate.
• Decrease in demand, increase in exchange rate.
• Exchange Rate Determinants / Appreciate & Depreciation
• Buyer's Taste
• Relative Income
• Relative Price Level
• Appreciation: currency increases in value
• Depreciation: exchange rate decreases

Comparative and Absolute Advantage

• Principle of Absolute Advantage
• One country would have an absolute advantage over the other if it is able to produce the same amount of goods with fewer resources.
• Principle of Comparative Advantage
• A nation has the comparative advantage in the production of a product when it can produce the product a lower domestic opportunity cost than it can with a trading partner.
• Terms of Trade
• The rate of exchange of two products that can be determined through negotiation, thus the outcome is the terms of trade.
• Gains from trade are based on comparative advantage.
• Video

Specialization and Trade

• Specialization based on comparative advantage improves global resource allocation.
• Specialization and trade also increase the productivity and the standard of living within a nation.
• There will be a larger global output of goods and services due to specialization and trade.