166 ❯ Step 4. Review the Knowledge You Need to Score High
With this balance of payments surplus, the Fed transfers the surplus currency back into
official reserves.A Circular Flow of Dollars
With the exception of some statistical discrepancies, the U.S. dollars that Americans send
to foreigners are equal to the U.S. dollars that foreigners send to Americans. It is helpful
to think of the global circulation of dollars as another example of the circular-flow model.
When you buy an imported jacket made in Honduras, this appears in the U.S. current
account as a negative entry, because those dollars are leaving the country. However, what
will a Honduran jacket producer do with those dollars? American dollars in Honduras are
not very useful unless they are being spent on either American-made goods and services or
American assets. One way or another, either through the purchase of an American good
(like a Ford) or the purchase of an American financial asset (like a share of Ford stock),
those dollars will return as a positive entry in either the current or capital account. And
while the Federal Reserve will make short-term adjustments to the official reserves account
to balance the difference between the current account balance and the capital account bal-
ance, in the long-term, dollars that leave the United States will eventually circle back into
the United States. Thus, with all else equal, if Americans import more goods and services
from abroad, the current account will move in the deficit direction but the capital/financial
account will move in the surplus direction as those dollars return.
To summarize:
• U.S. imports require a demand for foreign currency and a supply of U.S. dollars.
• U.S. exports require a supply of foreign currency and a demand for U.S. dollars.
• If Current account balance + Capital account balance < 0, there is a balance of payments
deficit.
• If Current account balance + Capital account balance > 0, there is a balance of payments
surplus.12.3 Foreign Exchange Rates
Main Topics: Currency Markets, Appreciating and Depreciating Currency, Changes in Exchange
Rates, Connection to Monetary Policy
The previous section of the chapter discussed accounting for the flow of goods and services
and currency between trading partners. The foreign exchange market, the topic of the
following section, facilitates the importing and exporting of goods around the world.Currency Markets
When nations trade goods and services, someone in the process is also trading currency.
The rate of exchange between two currencies is determined in the foreign currency market.
Some nations fix their exchange rates, while others are allowed to “float” with the forces
of demand and supply. For example, in the flexible exchange market for euros pictured in
Figure 12.5, the equilibrium $2 dollar price of a euro is at the intersection of the supply of
euros and the demand. Likewise, in the market for dollars seen in Figure 12.6, the equilib-
rium euro price of one dollar is 0.50 euros. This floating exchange rate has an impact on
the balance of payments of both the United States and the European Union.
So:
• The exchange rate between two currencies tells you how much of one currency you
must give up to get one unit of the second currency.
• For example, if $2 = 1 euro, $1 = 0.5 euro.
• For example, if $1 = 10 pesos, $0.10 = 1 peso.KEY IDEATIPTIP