foreign exchange – buying selling foreign assets/currency 

• daily transactions reached $3 trillion in 2000
• allows countries to have trade surplus and deficit
  • trade deficit >> buying more than selling >> must borrow to make up the difference

balance of payments – accounts describing country’s transactions w/ rest of the world 

• current account (aka above the line) – payments to and from the rest of the world
  • investment income – received by US residents on holdings of foreign assets, by foreign residents on holdings of US assets
  • net transfers received – net value of payments of foreign aid that’s given and received
  • current account balance – sum of net payments to/from rest of the world (in surplus or deficit)
• capital account (aka below the line) – flow of US assets
  • net capital flows (capital account balance) – increase in foreign holdings of US assets minus increase in US holdings of foreign assets
  • accounts for either surplus or deficit in current account
• statistical discrepancy – difference between current and capital account
  • most likely due to mismeasurement
• trade deficit >> foreign countries buy more US assets >> inflow of foreign capital >> US must pay more yearly interest to foreign countries
  • ie. current situation w/ China (using trade surplus w/ US to buy US stocks, give loans)
  • bad for the domestic economy
  • domestic current account increases >> foreign current account decreases

choice of domestic/foreign assets – choosing between domestic or foreign assets 

• would not hold assets and money in different currencies
• US bonds worth $(1+it) next year
• foreign bonds worth $(1/Et+1) (1+i*t)Et
  • i*t = nominal interest in terms of foreign interest
  • Et+1 = expected exchange rate next year (need to exchange back in order to use)
• arbitrage relation >> 1+it = (Et/Et+1)(1+i*t)
  • aka uncovered interest parity relation (UIP)
  • ignores transaction costs and risk (exchange rate uncertain >> introduces another uncertainty factor by holding foreign assets)
• it ~ i*t - (Et+1-Et)/Et
  • domestic interest rate about equal to foreign interest rate minus expected depreciation rate of domestic currency