ECON 101 Faulkner University Applying Economic Factors Walmart Case Study Discussion



Read Chapters 18 and 19 of Macroeconomics Private and Public Choice.
Review the Case Study Introduction and Case Study Company Profile (attached)

Starting in the Leadership and Teamwork Course (BUS621), you chose a specific country for your assignment and this same case study has been used in each of your courses. For this discussion question, be sure to use your previously selected country.

Discuss how comparative analysis, trade restrictions, tariffs, and exchange rates of your chosen country will impact the decision to expand. You need to take these macroeconomic concepts and apply them directly to the Walmart expansion decision.
Considering the topics you have studied throughout this course, what other economic factors may impact the decision to expand?

Gwartney, J. A., Stroup, R. L., Sobel, R. L., & Macpherson, D. A. (2018). Macroeconomics: Private and public choice (16th ed.). Retrieved from https://www.cengage.comKey Points
The volume of international trade has grown rapidly in recent decades. In the United States,
international trade (imports plus exports) summed to 29 percent of GDP in 2015, compared
with 20 percent in 1980 and 9 percent in 1960.
Comparative advantage rather than absolute advantage is the source of gains from trade. As
long as relative production costs of goods differ, trading partners will be able to gain from trade.
Specialization and trade make it possible for trading partners to produce a larger joint output
and expand their consumption possibilities.
Imports increase the domestic supply and lead to lower prices for consumers. Exports reduce
the domestic supply and push prices upward, but this means the exporters can sell their
products at higher prices. The net effect of international trade is an expansion in total output
and higher income levels for both trading partners.
Import restrictions, such as tariffs and quotas, reduce the supply of foreign goods to domestic
markets. This results in higher prices. Essentially, the restrictions are a subsidy to producers (and
workers) in protected industries at the expense of (1) consumers and (2) producers (and
workers) in export industries. Jobs protected by import restrictions are offset by jobs destroyed
in export-related industries.
Trade restrictions generally provide concentrated benefits to the producers in industries they’re
designed to protect. The costs are spread thinly among consumers in the form of higher prices.
Even though the impact of trade restrictions on the economy as a whole is harmful, they
generate benefits for interest groups that politicians can then tap for campaign contributions
and other side payments.
Persistently open economies have grown more rapidly and have achieved higher per capita
income levels than economies more closed to international trade.
Chapter 19. International Finance and the Foreign Exchange Market
What determines the exchange rate value of the dollar relative to other currencies? Why do
exchange rates change?
What are the alternative types of exchange rate systems? Which types work well and which will
lead to financial problems?
What information is included in the balance-of-payments accounts of a nation? Will the
balance-of-payments accounts of a country always be in balance?
Is a balance-of-trade deficit bad?
Currencies, like tomatoes and football tickets, have a price at which they are bought and sold.
An exchange rate is the price of one currency in terms of another.
— Gary Smith
Trade across national boundaries is complicated by the fact that nations generally use different
currencies to buy and sell goods in their respective domestic markets. The British use pounds;
the Japanese, yen; the Mexicans, pesos; nineteen European countries, the euro; and so on.
Therefore, when a good or service is purchased from a seller in another country, it is generally
necessary for someone to convert one currency to another.
As we previously discussed, the forces of supply and demand will determine the exchange rate
value of currencies in the absence of government intervention. This chapter focuses more
directly on the foreign exchange market. We will consider how exchange rates both exert an
impact on and are influenced by the flow of trade and the flow of capital across national
boundaries. We will also analyze alternative exchange rate regimes and consider some of the
recent changes in the structure of currency markets around the world.
19-1. Foreign Exchange Market
When trading parties live in different countries, an exchange will often involve a currency
transaction. Currency transactions take place in the foreign exchange market, the market where
currencies of different coun-tries are bought and sold. Suppose that you own a sporting goods
shop in the United States and are preparing to place an order for athletic shoes. You can
purchase them from either a domestic or a foreign manufacturer. If you decide to purchase the
shoes from a British firm, either you will have to change dollars into pounds at a bank and send
them to the British producer or the British manufacturer will have to go to a bank and change
your dollar check into pounds. In either case, purchasing the British shoes will involve an
exchange of dollars for pounds.
Suppose the British producer has offered to supply the shoes for 30 pounds per pair. How can
you determine whether this price is high or low? To compare the price of the British-supplied
shoes with the price of those produced domestically, you must know the exchange rate
between the dollar and the pound. The exchange rate is one of the most important prices
because it enables consumers in one country to translate the prices of foreign goods into units
of their own currency. Specifically, the dollar price of a foreign good is determined by
multiplying the foreign product price by the exchange rate (the dollar price per unit of the
foreign currency). For example, if it takes $1.50 to obtain1 pound, then the British shoes priced
at 30 pounds would cost $45 (30 times the $1.50 price of the pound).
Suppose the exchange rate is
pound and that you decide to buy 200 pairs of athletic shoes from the British manufacturer at
30 pounds ($45) per pair. You will need 6,000 pounds in order to pay the British manufacturer. If
you contact an American bank that handles foreign exchange transactions and write the bank a
check for $9,000 (the $1.50 exchange rate multiplied by 6,000), it will supply the 6,000 pounds.
The bank will typically charge a small fee for handling the transaction.
Where does the American bank get the pounds? The bank obtains the pounds from British
importers who want dollars to buy things from Americans. Note that the U.S. demand for
foreign currencies (such as the pound) is generated by the demand of Americans for things
purchased from foreigners. In contrast, the supply of foreign currencies in exchange for dollars
reflects the demand of foreigners for things bought from Ameri-cans.
Exhibit 1 presents data on the exchange rate—the cents required to purchase a European euro,
Japanese yen, British pound, and Canadian dollar—from 2000 to 2016. Under the flexible rate
system present in most industrial countries, the exchange rate between currencies changes
from day to day and even from hour to hour. The exchange rate figures for years prior to 2016
are the average for the year. The 2016 figures are for exchange rates as of March 31, 2016.
Exhibit 1 Foreign Exchange Rates, 2000–2016
When a depreciation in the value of a nation’s currency occurs, more units of the domes-tic
currency will be required to purchase one unit of a foreign currency. For example, as Exhibit 1
shows, it took 200.20 cents to purchase a British pound in 2007, up from 143.96 in 2001. Thus,
the dollar depreciated against the pound during this period. As the result of this depreciation,
goods purchased from British suppliers became more expensive to Americans. At the same
time, the prices of American goods to British con-sumers moved in the opposite direction. A
depreciation of the U.S. dollar relative to the British pound is the same as an appreciation in the
British pound relative to the dollar.
When an appreciation occurs, it will take fewer units of the domestic currency to purchase a
unit of foreign currency. During 2014–2016, the dollar appreciated against the British pound. In
2014, it took 164.84 cents to purchase a British pound, but by 2016 (March), a British pound
could be obtained for only 143.81 cents.
Exhibit 1 also provides an index of the foreign exchange value of the dollar against 26 major
currencies. This broad index provides evidence of what is happening to the dollar’s general
exchange rate value. An increase in the index implies an appreciation in the dollar, whereas a
decline is indicative of a depreciation. Between 2002 and 2011, the dollar depreciated by
approximately 25 percent against these twenty-six currencies. In contrast, between 2011 and
2016, the index increased from 97.2 to 119.4, an appreciation of approximately 23 percent
relative to this broad bundle of currencies. Frequently, people will use the terms “strong” and
“weak” when referring to the exchange rate value of a currency. A currency is said to be strong
when it has been appreciating in value, whereas a weak currency is one that has been
depreciating on the foreign exchange market.
A pure flexible exchange rate system is one in which market forces alone determine the foreign
exchange value of the currency. The exchange rate system in effect since 1973 might best be
described as a managed flexible rate regime. It is flexible because all the major industrial
countries allow the exchange rate value of their currencies to float. But the system is also
“managed” because the major in-dustrial nations have from time to time attempted to alter
supply and demand in the foreign exchange market by buying and selling various currencies.
Compared with the total size of this market, however, these transactions have generally been
small. Thus, the exchange rate value of major currencies like the U.S. dollar, British pound,
Japanese yen, and the European euro is determined primarily by market forces. Several
countries link their currency to major currencies like the U.S. dollar or European euro. As we
proceed, we will investigate alternative methods of linking currencies and analyze the operation
of different regimes.
19-2. Determinants of the Exchange Rate
To simplify our explanation of how the exchange rate is determined, let’s assume that the
United States and Great Britain are the only two countries in the world. When Americans buy
and sell with each other, they use dollars. Therefore, American sellers will want to be paid in
dollars. Similarly, when the British buy and sell with each other, they use pounds. As a result,
British sellers will want to be paid in pounds.
In our two-country world, the demand for pounds in the exchange rate market originates from
the purchases by Americans of British goods, services, and assets (both real and financial). For
example, when U.S. residents purchase men’s suits from a British manufacturer, travel in the
United Kingdom, or purchase the stocks, bonds, or physical assets of British business firms, they
demand pounds from (and sup-ply dollars to) the foreign exchange market to pay for these
Correspondingly, the supply of foreign exchange (pounds in our two-country case) originates
from sales by Americans to foreigners. When Americans sell goods, services, or assets to the
British, for example, the British buyers will supply pounds (and demand dollars) in the exchange
rate market in order to acquire the dollars to pay for the items purchased from Americans.
Exhibit 2 illustrates the supply and demand curves of Americans for foreign exchange—British
pounds in our two-country case. The demand for pounds is downward sloping because a lower
dollar price of the pound—meaning a dollar will buy more pounds—makes British goods
cheaper for American importers. The goods produced by one country are generally good
substitutes for the goods of another country. This means that when foreign (British) goods
become cheaper, Americans will increase their expenditures on imports (and therefore the
quantity of pounds demanded will increase). Thus, as the dollar price of the pound declines,
Americans will both buy more of the lower-priced (in dollars) British goods and demand more
pounds, which are required for the purchases.
The implications of the analysis are general. In our multicountry and multicurrency world, the
demand for foreign currencies in exchange for dollars reflects the purchases by Americans of
goods, services, and assets from foreigners. The supply of foreign currencies in exchange for
dollars reflects the sales by Americans of goods, services, and assets to foreigners. The
equilibrium exchange rate will bring the quantity of foreign exchange demanded by Americans
into balance with the quantity supplied by foreigners. It will also bring the purchases by
Americans from foreigners into balance with the sales by Americans to foreigners.
19-3. Why Do Exchange Rates Change?
When exchange rates are free to fluctuate, the market value of a nation’s currency will
appreciate and depreciate in response to changing market conditions. Any change that alters
the quantity of goods, services, or assets bought from foreigners relative to the quantity sold to
them will alter the exchange rate. Let’s consider the major factors that will alter the foreign
exchange value of a nation’s currency.
19-3a. Changes in Income
An increase in domestic income will encourage the nation’s residents to spend a portion of their
addi-tional income on imports. When the income of a nation grows rapidly, the nation’s imports
tend to rise rapidly as well. As Exhibit 3 illustrates, an increase in imports also increases the
demand for foreign exchange (the pound in our two-country case). As the demand for pounds
increases, the dollar price of the pound rises (from $1.50 to $1.80). This depreciation of the
dollar reduces the incentive of Americans to import British goods and services, while increasing
the incentive of the British to purchase U.S. exports. These two forces will restore equilibrium in
the foreign exchange market at a new, higher dollar price of the pound.
Just the opposite takes place when the income of a trading partner (Great Britain in our
example) increases. Rapid growth of income abroad will lead to an increase in U.S. exports,
causing the supply of foreign exchange (and demand for dollars) to increase. This will cause the
dollar to appreciate—the dollar price of the pound will fall, in other words.
What will happen if both countries are growing? Other things constant, it is the relative growth
rate that matters. A country that grows more rapidly than its trading partners will increase its
imports relative to its exports, which will cause the exchange rate value of its currency to fall.
Conversely, sluggish growth of a coun-try’s income relative to its trading partners will lead to a
decline in imports relative to exports, which will cause the exchange rate value of its currency to
rise. Granted, it seems paradoxical that sluggish growth relative to one’s trading partners will
cause a country’s currency to appreciate, but that’s in fact what happens.
19-3b. Differences in Rates of Inflation
Other things constant, domestic inflation will cause the value of a nation’s currency to
depreciate, whereas deflation will cause its currency to appreciate. Suppose prices in the United
States rise by 50 percent while our trading partners are experiencing stable prices. The domestic
inflation will cause U.S. consumers to increase their demand for imported goods (and foreign
currency). In turn, the inflated domestic prices will cause foreigners to reduce their purchases of
U.S. goods, thereby reducing the supply of foreign currency to the ex-change market. As Exhibit
4 illustrates, the exchange rate will adjust to this set of circumstances. In our two-country
example, the dollar will depreciate relative to the pound.
Exchange rate adjustments permit nations with even high rates of inflation to engage in trade
with countries experiencing relatively stable prices. A depreciation in a nation’s currency in the
foreign exchange market compensates for the nation’s inflation rate. For example, if inflation
increases the price level in the United States by 50 percent and the value of the dollar in
exchange for the pound depreciates (such that the value of the foreign currency increases 50
percent), then the prices of American goods measured in pounds are unchanged to British
consumers. Thus, when the exchange rate value of the dollar changes from

, the depreciation in the dollar restores the original prices of U.S. goods to British consumers
even though the price level in the United States has increased by 50 percent.
On the one hand, when domestic prices are increasing more rapidly than those of one’s trading
partners, the value of the domestic currency will tend to depreciate in the foreign exchange
market. On the other hand, if a nation’s inflation rate is lower than that of its trading partners,
then its currency will tend to appreciate.
19-3c. Changes in Interest Rates
Financial investments will be quite sensitive to changes in real interest rates—that is,interest
rates ad-justed for the expected rate of inflation. International loanable funds will tend to move
toward areas where the expected real rate of return (after compensation for differences in risk)
is highest. Thus, increases in real interest rates relative to a nation’s trading partners will tend to
cause that nation’s currency to appreciate. For example, if real interest rates rise in the United
States relative to Britain, British citi-zens will demand dollars (and supply their currency,
pounds) in the foreign exchange market to purchase the high-yield American assets. The
increase in demand for the dollar and supply of pounds will then cause the dollar to appreciate
relative to the British pound.
In contrast, when real interest rates in other countries increase relative to rates in the United
States, short-term financial investors will move to take advantage of the higher yields abroad. As
investment funds move from the United States to other countries, there will be an increase in
the demand for foreign currencies and an increase in the supply of dollars in the foreign
exchange market. A depreciation in the dollar relative to the currencies of the countries with
the higher real interest rates will be the result.
19-3d. Changes in the Business and Investment Climate
The inflow and outflow of capital will also be influenced by the quality of the business and
investment envi-ronment. The monetary, legal, regulatory, and tax climates are particularly
important here. Countries that follow a monetary policy consistent with price stability, protect
property rights, keep taxes low, and treat people impar-tially will tend to attract capital. In turn,
the inflow of capital will strengthen the demand for the domestic currency and thereby cause it
to appreciate. In contrast, when investors are concerned about the stability of the monetary
climate, fairness of the legal system, high taxes, and excessive regulation, many will choose to
do business elsewhere. As they do so, an outflow of capital and depreciation in the foreign
exchange value of the domestic currency will result. Thus, other things constant, the foreign
exchange value of a nation’s currency will tend to appreciate when its policy environment is
improving, while it will tend to depreciate if in-vestors believe that the policy climate is
The accompanying Thumbnail Sketch summarizes the major forces that cause a nation’s
currency to appreciate or depreciate when exchange rates are determined by market forces.
19-4. International Finance and Alternative Exchange Rate Regimes
There are three major types of exchange rate regimes:
flexible rates;
fixed rate, unified currency; and
pegged exchange rates.
So far, we have focused on the operation of a flexible rate regime. We now consider the other
19-4a. Fixed Rate, Unified Currency System
Obviously, the 50 states of the United States have a unified currency, the dollar. In addition, the
U.S. dollar has been the official currency of Panama for more than a century. Ecuador adopted
the U.S. dollar as its official currency in 2000, and El Salvador did so in 2001. The currency of
Hong Kong is also closely linked to the U.S. dollar. Hong Kong has a currency board that has the
power to create currency only in exchange for a specific quantity of U.S. dollars
U.S. dollar
. Countries that adopt the currency board approach do not conduct monetary policy. Instead,
they merely accept the monetary policy of the nation to which their currency is tied—the U.S.
policy in the case of Hong Kong. Thus, the United States, Panama, Ecuador, El Salvador, and
Hong Kong have a unified currency regime.
Nineteen countries of the European Union—Austria, Belgium, Cyprus, Estonia,Finland, France,
Germany, Greece, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, Netherlands, Portugal,
Slovakia, Slo-venia, and Spain—have also established a unified currency regime. The official
currency in each of these countries is the euro. Several other European countries, including
Bulgaria, Bosnia, and Herzegovina use a currency board to link their domestic currency to the
euro. Thus, the euro is a unified currency in all of these countries. In turn, the foreign exchange
value of the euro relative to other currencies, such as the dollar, the British pound, and the
Japanese yen, is determined by market forces (flexible exchange rates).
The distinguishing characteristic of a fixed rate, unified currency regime is the presence of only
one central bank with the power to expand and contract the supply of money. For the dollar,
that central bank is the Federal Reserve System; for the euro, it is the European Central Bank.
Those linking their currency at a fixed rate to the dollar or the euro do not conduct monetary
policy; they merely accept the monetary policy of the central bank for their currency. For
example, the former central banks of the countries now using the euro no longer have the
power to create money. In essence, they are now branches of the European Central Bank, much
like the regional and district Federal Reserve banks are branches of the Fed. Similarly, currency
boards do not create additional currency. They merely agree to exchange their domestic
currency for the currency to which it is linked at a fixed rate.
A pure gold standard system, in which each country agrees to exchange units of its domestic
currency for gold at a designated price and fully backs its domestic money supply with gold, is
also a fixed rate, unified system. In this case, the world supply of gold (rather than a central
bank) determines the total supply of money. If a country’s purchases from foreigners exceeded
its sales to them, its supply of gold would fall, which would reduce the domestic supply of
money. This would put downward pressure on the domestic price level and bring the payments
to and receipts from foreigners back into balance. Things would change in the opposite
direction if a country were selling more to foreigners than it was purchasing from them. In this
case, the excess of sales relative to purchases would lead to an inflow of gold, expansion in the
domestic money supply, and higher domestic prices. International financial arrangements
approximated those of a gold standard during the period between the U.S. Civil War and the
establishment of the Federal Reserve System in 1913.
Between 1944 and 1971, most of the world operated under a system of fixed exchange rates,
where each nation fixed the price of its currency relative to others. In essence, this was a quasiunified system. It was unified in the sense that the value of one currency was fixed relative to
others over lengthy time periods. But it was not a fully unified system because each country
continued to exercise control over its monetary policy. Nations maintained reserves with the
International Monetary Fund (IMF), which could be drawn on when payments to foreigners
exceeded receipts from them. This provided each with some leeway in the conduct of monetary
policy. However, countries running persistent payment deficits would eventually deplete their
reserves. This constrained the country’s monetary independence and provided its policy-makers
with an incentive to keep its monetary policy approximately in line with that of its trading
partners. Under this fixed exchange rate regime, nations often imposed tariffs, quotas, and
other trade barriers in an effort to keep their payments and receipts in balance at the fixed rate.
Various restrictions on the convertibility of currencies were also common. These problems
eventually led to the demise of the system.
19-4b. Pegged Exchange Rate Regime
A pegged exchange rate system is one in which a country commits itself to the maintenance of a
spe-cific exchange rate (or exchange-rate range) relative to another currency (like the U.S.
dollar) or a bundle of currencies. In contrast with the currency board approach, however,
countries adopting the pegged exchange rate continue to conduct monetary policy. Thus, an
excess of purchases from foreigners relative to sales to them does not automatically force the
country to reduce its domestic money supply.
However, maintaining the pegged rate will restrict the independence of monetary policy. A
country can either
follow an independent monetary policy and allow its exchange rate to fluctuate or
tie its monetary policy to maintain the fixed exchange rate.
It cannot, however, maintain the convertibility of its currency at the fixed exchange rate while
following a monetary policy more expansionary than the country to which its currency is tied.
Attempts to do so will lead to a financial crisis—a situation in which falling foreign currency
reserves eventually force the country to forgo the pegged exchange rate.
This is precisely what happened in Mexico during 1989–1994. Mexico promised to exchange the
peso for the dollar at a pegged rate, but it also expanded its domestic money supply much more
rapidly than the United States. In the early 1990s, this led to a higher rate of inflation in Mexico
than in the United States. Responding to the different inflation rates, more and more people
shifted away from the Mexican peso and toward the dollar. By December 1994, Mexico’s foreign
exchange reserves were virtually depleted. As a result, it could no longer maintain the fixed
exchange rate with the dollar. Mexico devalued its currency, triggering a crisis that affected
several other countries following similar policies.
In 1997–1998, much the same thing happened in Brazil, Thailand, and Indonesia. Like Mexico,
these countries sought to maintain fixed exchange rates (or rates within a narrow band), while
following mone-tary and fiscal policies that were inconsistent with the fixed rate. As their
reserves declined, they were forced to abandon their exchange rate pegs. This was extremely
disruptive to these economies. Imports suddenly became much more expensive and therefore
less affordable. Businesses (including banks) that had borrowed money in dollars (or some other
foreign currency) were unable to repay their loans as the result of the sharp decline in the
exchange rate value of the domestic currency. In turn, these disruptions led to severe economic
Rather than abandoning a pegged rate regime, countries sometimes impose exchange rate
controls when they are no longer able to sustain their pegged rate. Exchange rate controls fix
the rate at which individuals and businesses can convert the domestic currency to foreign
currencies below the market level and prohibit exchange conversions without the authorization
of the government. This has been the situation in Venezuela since 2003. Venezuelans need
foreign currency to purchase goods and services from foreigners, and when they are unable to
obtain it because of the controls, they often turn to the black market. Of course, these illegal
transactions are risky and the black market exchange rate will be higher, often substantially
higher, than the controlled rate. If the conditions in the country continue to deteriorate, the
black market rate may change dramatically. This occurred in Venezuela during 2014–2016. In
early 2014, it took about 80 Venezuelan bolivars to obtain a U.S dollar in the black market, but
just two years later, the black market rate had soared to 1200 boli-vars per dollar. Like other
price controls, exchange rate controls disrupt markets, reduce the gains from trade, and retard
economic progress.
Both economic theory and real-world experience indicate that either a purely flexible exchange
rate regime or a fixed rate, unified regime with a single central bank will work reasonably well.
In contrast, a pegged ex-change rate regime is something like a time bomb. Pushed by political
considerations, monetary policy makers in most countries are unable to follow a course
consistent with the maintenance of pegged rates. Failure to do so, however, eventually leads to
abandonment of the peg and a financial crisis.
19-5. Balance of Payments
Just as countries calculate their gross domestic product (GDP) so that they have a general idea
of their domestic level of production, most countries also calculate their balance of
international payments in order to keep track of transactions across national boundaries. The
balance of payments summarizes the transactions of the country’s citizens, businesses, and
governments with foreigners. Balance-of-payments accounts are kept according to the
principles of basic bookkeeping. Any transaction that creates a demand for foreign currency
(and a supply of the domestic currency) in the foreign exchange market is recorded as a debit,
or minus, item. Imports are an example of a debit item. Transactions that create a supply of
foreign currency (and demand for the domestic currency) on the foreign exchange market are
recorded as a credit, or plus, item. Exports are an example of a credit item. Because the foreign
exchange market will bring quantity demanded and quan-tity supplied into balance, it will also
bring the total debits and total credits into balance.
Exhibit 5 summarizes the balance-of-payments accounts of the United States for 2015. As the
exhibit shows, the transactions can be grouped into one of three separate categories:the
current account, capital account, or the official reserve account. Let’s take a look at each of
these major categories.
19-5a. Current-Account Transactions
Current-account transactions involve only current exchanges of goods and services and current
income flows (and gifts). They do not involve changes in the ownership of either real or financial
assets. Current-account transactions are dominated by the trade in goods and services. The
export and import of merchandise goods are the largest components in the current account.
When U.S. producers export their products, foreigners will supply their currency in exchange for
dollars in order to pay for the U.S.-produced goods. Because U.S. exports generate a supply of
foreign exchange and demand for dollars in the foreign ex-change market, they are a credit
(plus) item. In contrast, when Americans import goods, they will demand for-eign currencies
and supply dollars in the foreign exchange market. Thus, imports are a debit (minus) item.
In 2015, the United States exported $1,513.5 billion of merchandise goods compared with
imports of $2,272.8 billion. The difference between the value of a country’s merchandise
exports and the value of its merchandise imports is known as the balance of merchandise trade
(or balance of trade). If the value of a country’s merchandise exports falls short of the value of
its merchandise imports, it is said to have a balance-of-trade deficit. In contrast, the situation in
which a nation exports more than it imports is referred to as a trade surplus. In 2015, the United
States ran a merchandise-trade deficit of $759.3 billion (line 3 of Exhibit 5).
The export and import of services are also sizable. Service trade involves the exchange of items
like in-surance, transportation, banking services, and items supplied to foreign tourists. Like the
export of merchandise goods, service exports generate a supply of foreign exchange and
demand for dollars. For example, a Mexican business that is insured by an American company
will supply pesos and demand dollars to pay its premiums for the service. Thus, service exports
are recorded as credits in the balance-of-payments accounts of exporting nations. Conversely,
the import of services from foreigners generates a demand for foreign currency and a supply of
dollars in the exchange market. Therefore, service imports are a debit item.
As Exhibit 5 illustrates, in 2015, U.S. service exports were $710.2 billion, compared with service
imports of $490.6 billion. Thus, the United States ran a $219.6 billion surplus on its service trade
transactions (line 6 of Exhibit 5). When we add the balance of service exports and imports to
the balance of merchandise trade, we obtain the balance on goods and services. In 2015, the
United States ran a $539.8 billion deficit (the sum of the $759.3 billion merchandise-trade
deficit and the $219.6 billion service surplus) in the goods and ser-vices account.
Two other relatively small items are also included in current-account transactions:
net income from investments and
unilateral transfers.
Americans have made substantial investments in stocks, bonds, and real assets in other
countries. As these investments abroad generate income, dollars will flow from foreigners to
Americans. This flow of income to Americans will supply foreign currency (and create a demand
for dollars) in the foreign exchange market. Thus, the net income to Americans is entered as a
credit in the U.S. current account. Correspondingly, foreigners earn income from their
investments in the United States. This net income to foreigners is recorded as a debit in the U.S.
current account because the supply of dollars to the foreign exchange market creates a demand
for foreign exchange.
As Exhibit 5 shows, in 2015, Americans earned $783.1 billion from investments abroad, whereas
foreigners earned $591.8 billion from their investments in the United States. On balance,
Americans earned $191.3 billion more on their investments abroad than foreigners earned on
their investments in the United States. This $191.3 billion net inflow of investment income
reduced the size of the deficit on current-account transactions.
Gifts to foreigners, like U.S. aid to a foreign government or private gifts from U.S. residents to
their relatives abroad, generate a demand for foreign currencies and supply of dollars in the
foreign exchange market. Thus, they are a debit item. Correspondingly, gifts to Americans from
foreigners are a credit item. Because the U.S. government and private U.S. citizens gave $135.6
billion more to foreigners than we received from them, this net unilateral transfer was entered
as a debit item on the current account in 2015.
19-5b. Balance On Current Account
The difference between
the value of a country’s current exports (both goods and services) and earnings from its
investments abroad and
the value of its current imports (again, both goods and services) and the earnings of foreigners
on their domestic assets (plus net unilateral transfers to foreigners) is known as the balance on
current account.
The current-account balance provides a summary of all current-account transactions. As with
the balance of trade, when the value of the current-account debit items (import-type transactions) exceeds the value of the credit items (export-type transactions), we say that the
country is running a current-account deficit. Alternatively, if the credit items are greater than
the debit items, the country is running a current-account surplus. In 2015, the United States ran
a current-account deficit of $484.1 billion.
Because trade in goods and services dominates current-account transactions, the trade- and
current-account balances are closely related. Countries with large trade deficits (surpluses)
almost always run substantial cur-rent-account deficits (surpluses).
19-5c. Capital-Account Transactions
In contrast with current-account transactions, capital-account transactions focus on changes in
the ownership of real and financial assets. These transactions are composed of
direct investments by Americans in real assets abroad (or by foreigners in the United States) and
loans to and from foreigners.
When foreign-ers make investments in the United States—for example, by purchasing stocks,
bonds, or real assets from Americans—their actions will supply foreign currency and generate a
demand for dollars in the foreign exchange market. Thus, these capital inflow transactions are a
Conversely, capital outflow transactions are recorded as debits. For example, if a U.S. investor
purchases a shoe factory in Mexico, the Mexican seller will want to be paid in pesos. The U.S.
investor will supply dollars (and demand pesos) on the foreign exchange market. Because U.S.
citizens will demand foreign currency (and supply dollars) when they invest in stocks, bonds,
and real assets abroad, these transactions enter into the bal-ance-of-payments accounts as a
debit. As we noted earlier, the international exchange rate regime is not a pure flexible rate
system. Countries with pegged exchange rates will often engage in reserve transactions in an
effort to maintain their pegged rate. Like other capital flows, these transactions are recorded as
debits and credits. Even countries with flexible exchange rates may engage in reserve
transactions to influence their exchange rate. When a nation’s currency is appreciating rapidly, a
country may try to slow the appreciation by pur-chasing foreign financial assets. Conversely,
when a currency is depreciating, the country may attempt to halt the depreciation by using
some of its foreign currency reserves to purchase the domestic currency in the foreign exchange
market. Because of the credibility and widespread use of the U.S. dollar, these transactions
often in-volve assets denominated in dollars, particularly bonds issued by the U.S. Treasury.
When foreign governments and central banks purchase U.S. securities, they will increase the
demand for the dollar in the foreign exchange market, causing the foreign exchange value of the
dollar to be higher than would otherwise be the case. There is a positive side to these purchases
of the dollar. If foreign governments did not have confidence in both the economy and the
monetary policy of the United States, they would not want to purchase and hold U.S. financial
In 2015, foreign investments in the United States (capital inflow) summed to $673.2 billion,
whereas U.S. investments abroad (capital outflow) totaled $531.5 billion. In 2015, there was
also a net capital inflow of $348.6 billion from other currency transactions (including the
statistical discrepancy). Because the capital inflow exceeded the outflow, the United States ran a
$490.4 billion capital-account surplus in 2015.
19-5d. Official Reserve Account
When a country follows a flexible exchange rate policy, the transactions of its official reserve
account will be small relative to the size of the foreign exchange market. This is the case for the
United States. In 2015, the net official reserve transactions of the United States were $6.3
19-5e. The Balance of Payments Must Balance
The sum of the debit and credit items of the balance-of-payments accounts must balance. Thus,
the following identity must hold:
Current-Account Balance
Capital-Account Balance
Official Reserve-Account Balance
However, the specific components of the accounts need not balance. For example, the debit
and credit items of the current account need not be equal. Specific components may run either
a surplus or a deficit. Nevertheless, because the balance of payments as a whole must balance,
a deficit in one area implies an offsetting surplus in other areas. Similarly, even though market
forces will bring about an overall balance, there is no reason to expect that the trade flows
between any two countries will be in balance. See the accompanying Myths of Economics box
feature on this topic.
19-6. Exchange Rates, Current Account Balance, and Capital Inflow
Exhibit 6 presents data on the foreign exchange value of the dollar, current-account balance,
and inflow of cap-ital for the United States since 1978. (Note: While the data in the middle
frame are for the cur-rent-account balance, the trade balance figures would be virtually
identical because trade in goods and services is the dominant component of the current
account.) The link between the inflow of capital and the cur-rent-account deficit is clearly
visible. As the middle and lower panels illustrate, the two are mirror images. When the inflow of
capital increases, the current-account (trade) balance shifts toward a deficit. Correspondingly,
when net capital inflow shrinks, so, too, does the current-account deficit. This is the expected
outcome under a flexible rate system. With flexible rates, the overall payments to and receipts
from foreigners must balance. Thus, a deficit in one area is not an isolated event. If a nation
runs a current-account (trade) deficit, it must also run a capital-account (plus official reserve
account) surplus of equal magnitude.
As Exhibit 6 demonstrates, there is a close relationship between an inflow of capital and trade
(and current account) deficits. When foreigners are making more “investments” in a country
than the residents of the country are making abroad, a capital account surplus will occur. In
turn, the capital account sur-plus generally leads to a trade (and current account) deficit. In
essence, trade (and current-account) deficits are the flip side of capital inflows.
Whether an inflow of capital is good or bad depends on the source of the inflow and how the
funds are used. When the inflow of capital occurs because the investment environment of the
country is attractive and foreigners are providing the funds for productive investments, this is a
positive development. The investments will increase the machines, tools, and other capital
assets available to domestic workers, which will increase both their future productivity and
earnings. Clearly, trade and current account deficits arising from this source will exert a positive
impact on both the country’s current and future income.
However, if the inflow of capital is used to increase current consumption or to finance
unproductive pro-jects, it will reduce future income. In recent years, a substantial portion of the
capital inflow to the United States has been used to finance federal budget deficits. This
borrowing has made it possible for Americans to consume more today, but the interest
expenses will mean less consumption in the future. Further, to the extent the borrowed funds
are channeled into counterproductive projects and subsidies for favored businesses and interest
groups, they will reduce future income. As the financial troubles of Greece illustrate, when this
process is taken to a high level, it can lead to indebtedness to foreigners that will even endanger
the creditworthiness of a government.
When considering the significance of the U.S. trade deficit, one should keep two points in mind.
First, no legal entity is responsible for the trade deficit. It reflects an aggregation of the
voluntary choices of businesses and individuals. Thus, it is not like a business loss or even the
budget deficit of a government. Second, to a large degree, the inflow of capital reflects the
confidence of investors in both the U.S. economy and the policies of the United States. If either
should become less attractive in the future, the situation would change. For example, if the
United States continued to run large deficits that push the federal debt to high levels, the
confidence of both domestic and foreign investors would diminish. This would lead to a decline
in the capital inflow and a reduction in the trade deficit. As the experience of Greece indicates,
this is not an attractive way to shift the trade balance toward a surplus.
Key Points
Because countries generally use different currencies, international trade usually involves the
conversion of one currency to another. The currencies of different countries are bought and sold
in the foreign exchange market. The exchange rate is the price of one national currency in terms
of another.
The dollar demand for foreign exchange arises from the purchase (import) of goods, services,
and assets by Americans from foreigners. The supply of foreign currency in exchange for dollars
arises from the sale (ex-port) of goods, services, and assets by Americans to foreigners. The
equilibrium exchange rate will bring these two forces into balance.
With flexible exchange rates, the following will cause a nation’s currency to appreciate:
rapid growth of income abroad (and/or slow domestic growth)
low inflation (relative to one’s trading partners)
rising domestic real interest rates (and/or falling rates abroad), and
improvement in the business and investment environment. The reverse of these conditions will
cause a nation’s currency to depreciate.
There are three major types of exchange rate regimes:
flexible rates;
fixed rate, unified currency; and
pegged exchange rates. Both flexible rate and fixed rate, unified currency systems work quite
well. Pegged rate systems, however, often lead to problems because they require that the
nation follow a monetary policy consistent with maintaining the pegged rate. Political pressure
often makes this difficult to do.
The balance-of-payments accounts provide a summary of transactions with foreigners. There
are three major balance-of-payments components:
the current account,
capital account, and
the official reserve account. The balances of these three components must sum to zero, but the
individual components of the accounts need not be in balance.
Under a pure flexible rate system, there will be no official reserve-account transactions. Under
these circum-stances, the current and capital accounts must sum to zero. This implies that an
inflow of capital will shift the current account toward a deficit, while an outflow of capital will
move the current account toward a surplus.
Trade deficits are not necessarily bad. Countries that grow rapidly and follow policies that
investors find attrac-tive will tend to experience an inflow of capital and a trade deficit.
However, if the inflow of capital is used to finance a higher level of current consumption or
channeled into unproductive projects, future income will be adversely affected
There is no reason to expect that bilateral trade between countries will balance. A country will
tend to run a bi-lateral trade deficit with countries that are low-cost producers of items that it
imports in large quantities.
Part 5. Applying the Basics: Special Topics in Economics
Economics is about how the real world works
Economics has a lot to say about current issues and real-world events. How are government
spending, taxes, and borrowing affecting the future prosperity of Americans? Does the current
Social Security system face problems, and what might be done to minimize them? Are stocks a
good investment for a young person? What caused the economic crisis of 2008, and what are
the important lessons we need to learn from it? What might be done to improve the quality of
health care? How can we best protect the environment? This section focuses on these topics
and several other current issues.

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