AP_Krugman_Textbook

simple.) Purchases and sales of assets are counted in the financial account. At the

equilibrium exchange rate, then, we have the situation shown in Table 42.2: the sum

of the balance of payments on the current account plus the balance of payments on

the financial account is zero.

Now let’s briefly consider how a shift in the demand for U.S. dollars affects equilib-

rium in the foreign exchange market. Suppose that for some reason capital flows from

Europe to the United States increase—say, due to a change in the preferences of Euro-

pean investors. The effects are shown in Figure 42.2. The demand for U.S. dollars in the

foreign exchange market increases as European investors convert euros into dollars to

fund their new investments in the United States. This is shown by the shift of the de-

mand curve from D 1 toD 2. As a result, the U.S. dollar appreciates: the number of euros

per U.S. dollar at the equilibrium exchange rate rises from XR 1 toXR 2.

What are the consequences of this increased capital inflow for the balance of pay-

ments? The total quantity of U.S. dollars supplied to the foreign exchange market

still must equal the total quantity of U.S. dollars demanded. So the increased capital

inflow to the United States—an increase in the balance of payments on the financial

424 section 8 The Open Economy: International Trade and Finance

Equilibrium in the Foreign Exchange Market: A Hypothetical Example

European purchases To buy U.S. goods To buy U.S. assets: Total purchases

of U.S. dollars and services: 1.0 of U.S. dollars:

(trillions of U.S. 1.0 2.0

dollars)

U.S. sales of U.S. To buy European To buy European Total sales

dollars (trillions of goods and services: assets: of U.S. dollars:

U.S. dollars) 1.5 0.5 2.0

U.S. balance of U.S. balance of

payments on the payments on the

current account: financial account:

0.5 0.5

table42.2

figure 42.2

An Increase in the Demand

for U.S. Dollars

An increase in the demand for U.S. dollars

might result from a change in the preferences

of European investors. The demand curve for

U.S. dollars shifts from D 1 toD 2. So the equi-

librium number of euros per U.S. dollar

rises—the dollar appreciates.As a result, the

balance of payments on the current account

falls as the balance of payments on the finan-

cial account rises.

Exchange rate

(euros per

U.S. dollar)

E 2

E 1

Supply of

U.S. dollars

D 1

D 2

XR 1

XR 2

Quantity of U.S. dollars

2. ...leads to an
   appreciation of
   the U.S. dollar.
   
   
   1. An increase in
      the demand for
      U.S. dollars...