Fundamental Questions

1. How do individuals of one nation trade money with individuals of another nation?

2. How do changes in exchange rates affect international trade?

3. How do nations record their transactions with the rest of the world?

Teaching Objectives

The primary purpose of this chapter is to introduce the student to the international dimension of the world economy. The exchange rate, or the price of foreign exchange, affects international trade by altering the price that foreign purchasers must pay for domestic goods. The chapter also introduces the balance of payments system, which accounts for the flows of goods, services, and capital between countries.

The unique feature of this chapter is the outline of how money is exchanged in markets. The relationship between the exchange rate and international trade is also an important concept discussed here.

How exchange rates affect the prices foreign individuals pay for domestic products warrants special attention. The material on the relationship between the current and capital accounts also deserves special emphasis.

These ideas will be important in later chapters when the international dimension of macroeconomic theory and policy is emphasized.

Key Term Review

foreign exchange
foreign exchange market
exchange rate
balance of payments
double-entry bookkeeping
current account
surplus
deficit
balance of trade
capital account

Lecture Outline and Teaching Strategies

1. The Foreign Exchange Market

The foreign exchange market is a global market in which people trade one currency for another.

Teaching Strategy: Note that foreign exchange markets are not located in any particular place. Rather, they are made up of decentralized currency traders linked by telecommunications equipment and computer networks.

1.a. Exchange rates: The exchange rate is the price of one country's money in terms of another country's money.

Teaching Strategy: Ask your students to think of the foreign exchange market in terms of the supply of and demand for foreign exchange. Then, ask them to consider what factors (especially interest rate differentials and price differentials) might cause exchange rates to change.

1.b. Exchange rate changes and international trade: Changes in exchange rates affect the demand for and supply of goods traded internationally.

2. The Balance of Payments

The balance of payments is a record of a country's trade in goods, services, and financial assets with the rest of the world.

2.a. Accounting for international transactions: The balance of payments is an accounting system based on double-entry bookkeeping.

2.b. Balance of payments accounts: To classify transactions, the balance of payments accounts use the current account, net exports, and unilateral transfers.

2.c. The current account and the capital account: The current account reflects the movement of goods and services; the capital account reflects the flow of financial assets.

Teaching Strategy: Use the current U.S. trade deficits and capital account surpluses to illustrate how the two accounts balance. Make sure that you follow an international transaction through the balance of payments accounts to show how the accounts balance.