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None Provided4 “For many years it has been believed that if countries import more than they export and so have a deficit on the current account of the balance of payments then their currencies will tend to fall in value. Yet over the last two years the dollar has been a strong currency even though USA has had a record current account deficit. How can this fact be explained? What does it tell us about the factors, which determine exchange rates? What policy decisions with regard to exchange rates do you think USA and other governments should take in response to these developments?” Exchange Rate, in relation to foreign exchange of money, is the price of a country's currency expressed in terms of one unit of another country's currency. The Foreign Exchange rate indicates the value of any given currency relatively to another. Thus, a pound sterling note is money in the United Kingdom, but is foreign exchange in the U.S. The use of foreign exchange arises because different nations have different monetary units, and the currency of one country cannot be used for making payments in another country. Because of trade, travel, and other transactions between individuals and business enterprises of different countries, it becomes necessary to convert money into the currency of other countries in order to pay for goods or services in those countries. The transfer of money values from one country to another and the determination of the price at which the currency of one country will be surrendered for that of another constitute the main problems of foreign exchange. Foreign exchange is a commodity, and its price fluctuates in accordance with supply and demand. Exchange rates are published daily in the principal newspapers of the world. By international agreement fixed exchange rates with a narrow margin of fluctuation existed until 1973, when floating rates were adopted that fluctuate as supply and demand dictate. Balance of Payments is the relationship between the amounts of money a nation spends abroad and the income it receives from other nations. The balance of payments is officially known as the Statement of International Transactions and includes two main accounts. The first, the current account, tracks activity in merchandise trade - exporting and importing, income earned from investments abroad, money paid to foreign investors, and transactions on which the government expects no returns. The second, the capital account, tracks both loans given to foreigners and loans received by citizens. It is well known that the balance of payments is the reflection of a nation's financial stability in the world market, and because of that the International Monetary Fund (IMF) uses these accounts to make decisions such as qualifying a country for a loan. Strictly speaking, the balance of payments always balances because of official financing. However, a balance of payments deficit means a persistent and large negative balance for official financing. This can be the result of excessive purchases of foreign goods and services or excessive investment overseas. In the short term, a balance of payments deficit can be corrected by continued borrowing of foreign currency, increasing interest rates to attract overseas investors, imposing exchange controls, imposing tariffs and finally import quotas. In the long run, the government can correct a balance of payments deficit by reducing demand in the economy for all goods including imports. The balance of payments can be used as an indicator of a nation's economic stability. Changes in the balance of payments can affect the exchange rate of a country's currency. For example, a deficit in merchandise trade means that the currency of that nation is flooding the world economy, since it is being used to buy the imports that cause the deficit. Unless government controls are used, the value of the currency will most likely depreciate. The United States has a balance of payments deficit worth nearly 4 % of GDP and negative net foreign assets (or foreign debt) worth nearly 20 % of GDP. If U.S. growth is sustained in the medium term, it is quite likely that the balance of trade in goods and services will not improve. The United States is the only major country, or country "bloc," to have a substantial trade deficit and this is proving of great advantage to the rest of the world. If the balance of trade does not improve, there is a danger that over a period of time the United States will be in a position called "debt trap," with an accelerating deterioration both in its net foreign asset position and in its overall current balance of payments (as net income paid abroad starts to explode). According to the above the United States has a balance of payments deficit and because of that the US Dollar, should have fallen. But that is not the case because the US dollar still remains quite a strong currency despite that deficit. More specifically between the beginning of 1999 and late-April 2000 the three major partner currencies for the United States, the yen, the Canadian dollar had been appreciated against the US dollar by 3%, 7% respectively for the two first currencies, and the Euro has depreciated by 19%. However, that was not enough and the US dollar was still remaining a strong currency. Consequently, from the above a question is raising as what other factors apart from the deficit in United States’ current account could keep the dollar at such high levels. In other words what other factors can affect exchange rates. A foreign exchange, or currency, rate as we have already said, is simply the price of one country's money in terms of another's. Although exchange rates are affected by many factors, in the end, currency prices are a result of supply and demand forces. Supply and demand factors are constantly shifting, and the price of one currency in relation to another shifts accordingly. Supply and demand for any given currency, and thus its value, is not influenced by any single element, but rather by several. Economic policy comprises government fiscal policy (budget/spending practices) and monetary policy (the means by which a governments' central bank influences the supply and "cost" of money, which is reflected by the level of interest rates). Government budget deficits or surpluses The market usually reacts negatively to widening government budget deficits, and positively to narrowing budget deficits. The impact is reflected in the value of a country's currency. The trade flow between countries illustrates the demand for goods and services, which in turn indicates demand for a country's currency to conduct trade. Surpluses and deficits in the trade of goods and services reflect the competitiveness of a nation's economy. For example, trade deficits may have a negative impact on a nation's currency. Typically, a currency will lose value if there is a high level of inflation in the country or if inflation levels are perceived to be rising. This is because inflation erodes purchasing power, thus demand, for that particular currency. Reports such as gross domestic product (GDP), employment levels, retail sales, capacity utilization and others, detail the levels of a country's economic growth and health. Generally, the more healthy and robust a country's economy, the better its currency will perform, and the more demand for it there will be. Another factor affecting the exchange rate between the US Dollar and other currencies is the merchandise trade balance. By definition, the merchandise trade balance is the net difference between the value of merchandise being exported and imported into a particular country. For example, consider the exchange rate for Australia dollar and US dollar. Australia imports products from the US. In order to pay for them, Australians need US dollars. Therefore, the Australian companies trade Australian dollars for US dollars. The net effect is an increase in the supply of US dollars and Australian dollars. The Australian demand for American goods and services contributes to the demand for US dollars while American purchases of Australian goods and services contribute to the supply of Australian dollars. The net difference between Australian purchases of American goods and services, and vice versa, is the merchandise trade balance between the two countries. The rate of inflation is another factor influencing currency exchange rates. Consumers try to avoid the eroding effect inflation has on their purchasing power. Consequently, goods from countries with a low inflation rate become more attractive than the goods from countries with higher inflation. As a result of that, the currency from the lower inflation country rises in value, while the currency from the higher inflation country falls in value. Both the inflation factor and the purchasing power of the currencies directly impact currency exchange rates. For example, if the United States is experiencing lower inflation than it’s trading partner Germany, the Deutsch mark /United States dollar ratio rises to reflect the growing price level in Germany relative to the United States. This fact is rooted in the concept of a purchasing power parity, which holds that, over the long run, a currency exchange rate adjusts to reflect the difference in price levels between countries. Speculation is another factor that affect exchange rates. Speculation is the process of buying and selling such items as securities, commodities, or land in the hope of sudden increases in their value, and often with the risk of sudden decline. If expectations of future value of a currency are pessimistic it is going to be very likely that holders of that currency will start selling in order not to incur in losses and try to benefit by buying another currency that’s likely to be more stable. The US and Canadian dollar pair is now probing through resistance levels not seen since October 1998. The recurring theme throughout 2000: "Resistance is futile!" It is interesting to look at how the USD has strengthened since January 2000. The upward trend went from $1.4450 at the end of January to $1.4700 at the end of August, a move of 2 � cents over 8 months. The rate of increase accelerated rapidly in the September to November period, from $1.4700 to $1.5550, a move of 8 � cents in just 3 months. The penetration of each resistance opened even higher levels of resistance, as the new focus. The all time high of $1.5850 is now in sight, just 3 cents away. It seems that the market really wants to test the high. Expect increased volatility going into year-end at near record levels. Watch for a dramatic correction lower, however, when this trend finally breaks. Chart 1 (below) shows the United States current balance of payments (expressed as a percent of GDP) since 1950. In the early post-war years there was generally a surplus, but since 1982 there has been a deficit that has trended upwards, however with large fluctuations, reaching a post-war record of 3.6% of GDP in the third quarter of 1999. Net property income from abroad has fallen from about 1% of GDP (positive) in the early 1980s to a small negative in 1999. The U.S. Current Account and Related Series (Percentages of GDP) The current account deficit has generated a large and growing debt owed by the United States to foreigners, which some people prefer to call the United States negative net asset position (NNAP). As we can see in chart number 2 below, the NNAP reached about -17 % of GDP in the middle of 1999. With the current account deficit running at nearly 4 % of GDP and a further rise in stock prices. The NNAP will probably reach -20 % of GDP by the end of this year. Net Foreign Assets (Percentages of GDP) Source: Survey of Current Business (SCB), Citibase. In 1999 the United States incurred a trade deficit in goods of $328.8 billion on a Census basis and $345.6 billion on a balance- of-payments basis (BoP). A surplus in services trade of $80.6 billion gave a deficit of $265.0 on goods and services (BoP) for the year. For September 2000, the trade deficit in goods increased to $40.2 billion from $36.7 billion in August. Overall U.S. trade deficits reflect a shortage of savings in the domestic economy and a reliance on capital imports to finance that shortfall. Financial, budgetary and other policies may affect the size of the trade deficit, while trade and capital flows affect the exchange value of the U.S. dollar. A large overall trade deficit may also indicate that certain U.S. industries are having difficulty competing with imports at home and in markets abroad. This may generate trade friction and pressures for the government to do more to open foreign markets, shield U.S. producers from foreign competition, or assist U.S. industries to become more competitive. Since 1976, the United States has incurred continual merchandise trade deficits. They increased dramatically from $36.5 billion in 1982 to a peak in 1987 at $159.6 billion. The deficit dropped to $74.1 billion in 1991 but rose to $345.6 billion in 1999 (BoP). Much of the improvement in the U.S. trade deficit between 1987 and 1991 resulted from a depreciation of the dollar and the recession in 1990-1991. The multilateral trade-weighted real value of the U.S. dollar reached a high in 1985, then dropped sharply from 1986 through 1988. However, the worsening of the deficit in 1993-95 can be attributed primarily to the faster recovery from recession in the United States than in Europe or Japan. In 1997-99, the Asian financial crisis caused a sizable fall in U.S. exports to Asia and a marked increase in U.S. imports from Asia. The broadest measure of U.S. international economic transactions is the balance on current account. In addition to merchandise trade, it includes trade in services and unilateral transfers. The current account deficit increased in 1999 to a record $331.5 billion from $217.1 billion in 1998. After reaching a peak of $160.7 billion in 1987, the current account deficit had fallen steadily through 1991 when it reached a surplus of $6.6 billion. Economic projections indicate that the current account deficit may reach between $430-$450 billion in 2000. Bibliography:

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