Question

For each of the following, indicate how it would affect the U.S. balance of payments if exchange rates were fixed: a. You spent the summer traveling in Europe. b. Your uncle in Canada sent you \(\$ 20\) as a birthday present. c. You bought a new Honda, made in Japan. d. You bought a new Honda, made in Ohio. e. You sold some stock you own on the Tokyo Stock Exchange.

Short answer

Answer: Spending the summer in Europe will negatively affect the U.S. balance of payments. Receiving 20 dollars from an uncle in Canada will positively affect the U.S. balance of payments. Buying a new Honda made in Japan will negatively impact the U.S. balance of payments. Buying a new Honda made in Ohio will not have any impact on the U.S. balance of payments. Selling stocks on the Tokyo Stock Exchange will positively affect the U.S. balance of payments.

Step-by-step solution

Spending the summer in Europe

When you spend your summer traveling in Europe, you are most likely going to spend your money in local European currencies. This will lead to an increase in the demand for foreign currency and an outflow of the U.S. dollars (USD). This situation will bring a deficit in the balance of payments as more U.S. dollars are leaving the country than coming in. Thus, this will negatively affect the U.S. balance of payments.

Receiving 20 dollars from your uncle in Canada

When you receive a 20-dollar gift from your uncle in Canada, there is an inflow of CAD 20 to the United States, which needs to be converted into USD. In this case, there is an increase in demand for USD, which improves the balance of payments. This transaction leads to a positive effect on the U.S. balance of payments.

Buying a new Honda made in Japan

Purchasing a new Honda made in Japan requires you to convert your USD into Japanese yen. This transaction will result in an outflow of USD, increasing the demand for Japanese yen and causing a negative impact on the U.S. balance of payments.

Buying a new Honda made in Ohio

When you buy a new Honda produced in Ohio, you are purchasing goods made within the United States. This transaction is considered a domestic transaction, and it doesn't require any conversion of currency or involvement in the foreign exchange market. Therefore, this transaction will not have any impact on the U.S. balance of payments.

Selling stocks on the Tokyo Stock Exchange

When you sell stocks on the Tokyo Stock Exchange, you will receive Japanese yen for the transaction. You will probably need to convert this Japanese yen back to USD, thus increasing the demand for USD. This scenario will result in an inflow of foreign currency to the United States, positively affecting the U.S. balance of payments.

Key concepts

Fixed Exchange Rates

Fixed exchange rates, often referred to as pegged exchange rates, are exchange rates that are held constant or pegged to the value of another currency or a basket of currencies. Under a fixed exchange rate system, the value of a country's currency is tied to the value of another single currency or to another measure of value, such as gold.

For example, if the United States had a fixed exchange rate system, it would choose to peg the USD to a foreign currency, say the Euro, at a fixed rate. This means that the exchange rate between the USD and Euro would not fluctuate daily on the foreign exchange market. Instead, it would remain at the set rate unless changed by the government or monetary authority.

Impact on Balance of Payments

Under fixed exchange rates, governments need to maintain large reserves of foreign currency to manage the balance of payments. When people travel abroad, as in the textbook exercise where someone spent the summer in Europe, there is pressure on the balance of payments. The government has to supply foreign currency to the market to maintain the pegged rate, which can lead to a deficit if not matched by an equivalent inflow. Conversely, receiving money from abroad or selling assets in foreign markets could lead to a surplus, improving the balance of payments, if the inflow of foreign currency exceeds the outflow.

Foreign Currency Transactions

Foreign currency transactions involve exchanging one currency for another. These transactions occur every day and are facilitated by the foreign exchange market, which determines the rates at which currencies are exchanged. This market is integral to international trade and finance because it enables the conversion of one currency to another so that transactions can be completed internationally.

When engaging in foreign currency transactions, consumers and businesses must be cognizant of the exchange rate as it directly affects the cost of goods and services purchased abroad. As seen in the textbook example, buying a car made in Japan involves converting USD to Japanese yen, leading to an outflow of USD and affecting the U.S. balance of payments. Similarly, selling stocks on the Tokyo Stock Exchange results in an inflow of Japanese yen, which when converted to USD, improves the balance of payments due to the increase in demand for USD.

Significance in a Fixed Exchange Rate System

In the context of fixed exchange rates, these foreign currency transactions require the government or the central bank to intervene to maintain the fixed rate. This could involve buying or selling currencies to balance supply and demand and stabilize the value of their currency. This process can be costly and challenging to sustain over long periods, especially if a country's economy faces significant trade imbalances.

International Trade and Finance

International trade and finance encompass the global exchange of goods, services, and capital. International trade is fundamental for nations to acquire resources they cannot produce efficiently themselves, and for them to sell their goods and services in foreign markets. Finance underpins this trade by providing the necessary funds and means for transaction settlements across borders.

In international trade, the balance of payments is a key indicator as it records all economic transactions between residents of a country and the rest of the world. It includes the trade balance, which is the difference between export and import of goods and services, as well as financial transfers and investments. Each foreign transaction has an impact, such as the various scenarios presented in the textbook exercise.

Exchange Rate Implications

The state of a country's balance of payments is greatly influenced by its exchange rate regime. For example, under fixed exchange rates, a country needs to maintain a certain level of foreign reserves to manage trade imbalances. Excessive outflows of currency, such as when importing goods like the Japanese car, can weaken the balance of payments, while inflows, such as receiving money from abroad or earning from investments like stock sales in Tokyo, can strengthen it.

To simplify, think of the balance of payments as a ledger. When the country sells something to someone abroad or receives investment, it's like putting money into the bank. But when it spends on foreign goods or someone invests abroad, it's like making a withdrawal. And just like a bank account, too many withdrawals compared to deposits can lead to issues, which is why countries care so much about these international economic relationships.