THE EXCHANGE RATE AND THE BALANCE OF PAYMENTS
1. Use the diagram below to illustrate the effects of the following events on the exchange rate:
a. In 2005, the United State ran a current account deficit of $792 billion. Reassuringly, the same table shows that private foreigners invested $1,212 billion to finance this spending. However some observers expected that the enthusiasm for American investments would wane substantially. According to Blumberg News, “The deficit reached an all-time high of 7 percent of gross domestic product in the fourth quarter of 2005. A growing deficit would pose a risk should investors sour on U.S. assets and diversify to other countries.” (“Current-account deficit hits record.” Bloomberg News. Chicago Tribune. Chicago, Ill.: Dec 19, 2006. pg. 3). If this report is correct and if U.S. investors also come to believe that U.S. assets are less desirable compared to foreign assets, what will be the effect on the U.S. exchange rate?
b. “But the dollar’s weakness also becomes part of the reason that foreigners don’t want to invest here. When the dollar is falling, they lose money when converting the proceeds from the sale of their dollar-denominated investments back to their local currencies.” (Beck, Rachel. “Where has foreign money gone?” Seattle TimesApril 23, 2003: pg. E.2) If people expect that the dollar will continue to depreciate, what will be the effect on the U.S. exchange rate?
2. “The trade deficit is the mechanism allowing consumption and investment in the U.S. to grow faster than in Europe and Japan. The issue for the U.S. is whether it’s worth the interest costs. It’s the same question facing a small business: Should it borrow money to expand the payroll, train employees, buy land and machines, conduct R&D, build inventory? Profit and credit-worthiness help make the decision.” (Malpass, David. “Embrace the Deficit,” Wall Street Journal. Dec 21, 2006. pg. A.16.) What information would you need to decide whether or not the foreign borrowing necessary to finance the U.S. current account deficit is “worth the interest costs?
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