Exports

Income recieved from investment abroad

Investment in US by foreign

Gifts and Aid Recieved

Import Merchandise 

Travel Abroad Expenditure

Oversea Investment by Residents

Gifts and Aid to foreign

Reciept and Payment

Net Earnings on US Investment abroad 

(Dividends and Interest)

Transfers of goods and services or financial assets as a gift

Direct Investment

Securities

Bank Claims and Liability 

Transactions that include all international purchases or sales or assets 

Also includes official reserve assets

Refers to monetary value of international flows associeted with transaction in goods and services, investment income, and unilateral transfers

Gold

Convertible currencies

SDR (Special Drawing Right) which is an asset that could be transferred among countries. IMF manages the stock of SDR 

excess of exports over imports, investment income, and transfers

CA Surplus = Spends less than earns 

Deficit - spend more than earned, borrow

Gov: Net Borrowing = G - T 

Private: Net Borrowing = I - S 

CA Deficit= (G-T) + (I-S) 

It takes 1.38 dollars per pound 

If 1Euro Costs $1.38 

How much is 1$ worth? 

1/1.38 

(inverse of 1.38/1) 

1.38 dollars: 1 Euro 

The difference in buying and selling price of a currency 

Spread quote will increase for a currency that is hardly traded

Ask Rate

or offer rate

The rate of the third currency implied by 2 exchange rates involving 3 currencies 

$/L =A

$/Y =B

L/Y = B/A 

Y/L= A/B 

If exchange rates arent equal there is potential to make a profit by exchanging currencies

Eventually the activity will equate the exchange rates in those markets

(Differs from forward market) 

Only few currencies are traded

Standardized contracts

At a specific Location

Options Market

(american)

Options market

(European)

Currencies may be bought and sold for delivery in a future period 

(If you think depreciation might occur)

-This reduces uncertainty 

Agree to pay 1,000,000

Suppose you want an exercise price of 1.02/$ then your upper bound value is 1,020,000

Durable, Storable, Portable 

Easily Recognized

Divisible into standardized unit 

Cannot easily supplied (has Value) 

Quantity Theory of money 

MV = PQ

Money Supply (Velocity) = Price (Physical volume of goods

Assume P and Q are fixed. 

What happens to M as V+

M - 

P- 

Exports Increase, Imports decrease and CA is restored 

CA Surplus 

Gold +

M+

P+

Imports increase

Exports decrease 

and the CA is restored 

(because we had too much money, now losing) 

1. Small Size

2. Open Economy 

3. Concentrated Trade 

(Trade A lot) Creates certainty for traders

If Bermuda trades a lot with US it should fix its ER with the US 

1. Large Size 

2. Closed Economy 

3. Diversified Trade 

US trades less so they have a float. 

If the depreciation is expected then the ER will depreciate even more due to speculation. 

1. Promote internatioonal monetary cooperation, exchange stanbility, and orderly exchange arrangements 

2. Fosters economic growth and high levels of employment 

3. Provides temporary financial assistance to countries to help ease the balance of payment adjustment

- Open to foreign investment and trade 

- lower wages 

- restrict money supply to control inflation

-removes subsidies 

Member countries will vote. This is equated with amount of financial contribution 

US gets 17% 

US, Japan, Germany, France, UK have almost 40% of the vote

Market Fundamentals 

Market Expectations

Bilateral trade balance

Real income

Real Interest rate

Inflation Rate 

Preference for domestic and foreign products

Production Costs

Monetary and Fiscal Policy 

Trade Policy 

News about future market fundamentals

Speculative opinion about the future ER 

Currency with a lower I will have currency _____________ 

Currency with higher I will have currency _____________

Depreciation

Appreciation

Key: frictionless trade 

No transaction costs

No barriers to trade

Identicle goods in each location

No barriers to price adjustment 

Opportunity for arbitrage 

Buy low and sell high 

Purchasing Power Parity PPP

Relative price level ratio:

Qe/QUS = E$/LPE

If PPP Holds then 

Qe/QUS = 1 

In Qe/US = E$/LPE

                   US 

If the real exchange rate is above 1 

Then foreign goods are relatively expensive

Foreign Currency is over valued

We expect it to depreciate relative to the dollar in the future 

The economist newspaper - invented in 1986 by editor Pam Woodal 

In 2004 they tried using the starbucks tall latte 

1. Transactin costs 

2. Non-traded goods

3. Imperfect competition and large obstacles (like patents) 

4. Price Stickiness