International Finance

Lecture 3

EXCHANGE RATE AND BALANCE OF PAYMENTS

After studying this unit, you will be able to:

Describe the foreign exchange market, define the exchange rate, and distinguish between the nominal exchange rate and the real exchange rate

Calculate the real exchange rate

Explain how the exchange rate is determined day by day

Explain the factors that influence the demand for and supply of rand

Show the demand for and supply of rand graphically, and indicate equilibrium in the foreign exchange market

Evaluate the effect of changes in the demand for and supply of rand on the equilibrium exchange rate, and show it graphically

After studying this unit, you will be able to:

Discuss the long-run trends in the exchange rate and explain interest rate parity and purchasing power parity

Discuss the balance of payments accounts and explain what causes an international deficit

Calculate the various balances of the balance of payments

Compare the alternative exchange rate policies and explain their long-run effects

Themes of this unit:

1.Currencies and Exchange Rates

2.The Foreign Exchange Market

3.Changes in Demand and Supply: Exchange Rate Fluctuations

4.Financing International Trade

5.Exchange Rate Policy

Currencies and Exchange Rates

Foreign currency is obtained in exchange for domestic currency in the foreign exchange market.

The nominal exchange rate is the value of one currency in terms of another currency.

The Foreign Exchange Market

Exchange Rates

Economic agents who supply or demand foreign exchange

• Exporters– Suppliers of goods to foreign buyers receive payments in foreign currency

that they exchange for local currency thus they tend to supply foreign currency onto the local foreign exchange market.

• Importers– These require foreign exchange to pay for the goods that are acquired from

elsewhere in overseas.

• Foreign investors– Foreign investors buy SDG in other to acquire assets such as buildings in

the Sudan or shares in Sudanese businesses.

• Speculators– They operate in the foreign currency market in order to make profit by

buying and selling the foreign exchange.

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Exchange rate regimes

• Copeland identifies three broad categories:– Floating rates

– fixed rates and

– managed floats

• The International Monetary Fund classifies exchange rate arrangements into eight categories:

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Exchange rate arrangements in the 185 IMF member countries

No. Exchange rate arrangement 2007 2008

1 No separate legal tender 5.32 5.32

2 Currency board 6.91 6.91

3 Conventional peg 33.5 32.45

4 Peg with horizontal band 2.66 1.60

5 Crawling band 0.53 1.06

6 Crawling peg 3.19 4.26

7 Managed floating 25.53 23.4

8 Independently floating 18.62 21.28

IMF (2009), Annual Report of Exchange rate arrangement and exchange rate restrictions, International Monetary Fund, Washington, D.C.

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Exchange Rate regimes since 1940

Source: People’s Bank of China, 20099

Exchange Rate Structure

• Unitary• Dual• Multiple

– Most countries are moving towards a unitary exchange rate market for sake of market efficiency among others.

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Attributes of the ideal regime

• The best regime ought to have three important attributes, this is usually described as the “impossible trinity”:– Exchange rate stability– Full financial integration– Monetary independence

• The forces at play in economics do not allow the simultaneous attainment of all three goals.

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Fixed versus floating

• A country’s choice of exchange rate regime depends on national priorities such as:– Inflation– Unemployment– Interest rate– Trade balances and – Economic growth

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Fixed versus floating

• Countries will go for a fixed rate regime for the following reasons:– Stability in international prices

– Inherent anti-inflationary nature of fixed prices

• Fixed regime:– Need for central bank to maintain large quantities of hard

currencies and gold to defend the fixed rate.

– Fixed rates may be maintained at rates that are out of tune with economic fundamentals.

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Nominal and Real Exchange Rates

The real exchange rate is the relative price of foreign-produced goods and services to locally produced goods and services.

The Effective Exchange Rate

The effective exchange rate is the average exchange rate of the rand against a basket of currencies.

Questions About the Exchange Rate

The Foreign Exchange Market

Demand and supply in the foreign exchange market determine the exchange rate.

The Demand for One Money Is the Supply of Another Money

Demand in the Foreign Exchange Market

The exchange rate

World demand for South African exports

Interest rates in South Africa and other countries

The expected future exchange rate

The Law of Demand for Foreign Exchange

Exports Effect

Expected Profit Effect

Demand Curve for South African Rand

Supply in the Foreign Exchange Market

The exchange rate

South African demand for imports

Interest rates in South African and other countries

The expected future exchange rate

Demand Curve for South African Rand

The Law of Supply of Foreign Exchange

Imports Effect

Expected Profit Effect

Supply Curve for South African Rand

Market Equilibrium

The equilibrium exchange rate makes the quantity of rand demanded equal the quantity of rand supplied.

Changes in Demand and Supply: Exchange Rate Fluctuations

Changes in the Demand for South African Rand

World Demand for South African Exports

South African Interest Rate Relative to the Foreign Interest Rate

The Expected Future Exchange Rate

Changes in the Supply of South African Rand

South African Demand for Imports

South Africa’s Interest Rate Relative to the Foreign Interest Rate

The Expected Future Exchange Rate

Changes in the Exchange Rate

An Appreciating South African Rand: 2002–2006

A Depreciating Rand: 1999–2001

Financing International Trade

International trade, borrowing, and lending are financed by using foreign currency.

A country’s international transactions are recorded in its balance of payments.

Balance of Payments Accounts

The balance of payments consists of a:

current account

capital transfer account

financial account

change in net gold and other foreign reserves.

An Individual’s Balance of Payments Accounts

Borrowers and Lenders

Debtors and Creditors

Current Account Balance

Net Exports

The current account balance is similar to net exports and is determined by the government sector balance plus the private sector balance.

Where Is the Exchange Rate?

Exchange Rate Policy

An exchange rate can be flexible, fixed, a crawling peg.

To achieve a fixed or a crawling exchange rate, a central bank must intervene in the foreign exchange market.

Flexible Exchange Rate

Fixed Exchange Rate

Crawling Peg

The People’s Bank of China in the Foreign Exchange Market

Why Does China Fix Its Exchange Rate?