THE BALANCE OF PAYMENTS AND THE

EXCHANGE RATES

Chapter 37 – Lipsey

THE BALANCE OF PAYMENTS (BOP) BALANCE OF PAYMENTS ACCOUNTS• Current Account– Records transactions arising from trade in goods and services,

from income accruing to capital, or from transfers by residents • Two main sections - (1) trade account & (2) merchandise

account• Capital Account– Records transactions related to international movements of

ownership of financial assets. – It does not relate to import or export of physical capital– Short-term and long-term capital flows– Portfolio investment and direct investment

BOP: Current Account

BOP: Capital Account & Foreign Account

THE MEANING OF PAYMENTS BALANCES AND IMBALANCES

THE BALANCE OF PAYMENTS MUST BALANCE OVERALL• The current and capital account balances are necessarily

of equal and opposite size. When added together, they equal zero

DOES THE BALANCE OF PAYMENTS MATTER? • Current Account balance = visible + invisible balances– Favorable balance (credit balance) – receipts > payments– Unfavorable balance (debit balance) – receipts < payments

• The term BOP deficit and BOP surplus must refer to the balance on some part of the payments accounts.

THE MARKET FOR FOREIGN EXCHANGE

• A market where one currency can be converted into another

• Trade between nations requires the exchange of one nation’s currency for that of another –

• Foreign Exchange Transaction• Exchange Rate• Appreciation of a currency• Depreciation of a currency

THE DEMAND FOR AND SUPPLY OF POUNDS

• Foreign exchange rate is just a price requiring demand and supply analysis

• Because one currency is traded for another in the forex market, it follows that a demand for foreign exchange implies a supply of pounds, while a supply of foreign exchange implies a demand for pounds.

THE DEMAND FOR POUNDS

• Demand arises from all international transactions that generate a receipt of foreign exchange:– UK exports– Capital inflows– Reserve currency

• The total demand for pounds– Sum of the above three

• Shape of the Demand curve for pounds – negatively sloped

THE SUPPLY OF POUNDS

• The sources of supply of pounds in the foreign exchange market are merely the opposite side of the demand for dollars.

• The shape of the supply curve of pounds -positively sloped

FIG 37.1 – THE MARKET FOR FORIGN EXCHANGE

THE DETERMINATION OF EXCHANGE RATES

• Where there is no intervention by the Central Bank, the exchange rate is determined by the demand and supply of the currency. This is called a flexible or floating exchange rate.

• When intervention by the Central Bank is used to maintain the exchange rate at (or close) to a particular value, there is said to be a fixed or pegged exchange rate.

• Between these two are a variety of cases including adjustable peg and the managed float

MANAGING FIXED EXCHANGE RATES - FIG 37.2

• Under a fixed exchange rate regime, the Central Bank intervenes in the foreign exchange market to ensure that the exchange rate stays within specified bands.

CHANGES IN EXCHANGE RATES

Changes in demand and supply in the foreign exchange market cause changes in exchange rates

CHANGES IN EXCHANGE RATES cont’d

A RISE IN THE DOMESTIC PRICE OF EXPORTS The effect on the demand for local currency depends on the price elasticity of foreign demand for the local goods A RISE IN THE FOREIGN PRICE OF IMPORTSThe effect on the supply of local currency depends on the price elasticity of demand for foreign goods by locals.

CHANGES IN EXCHANGE RATES cont’d

CHANGES IN PRICE LEVELSe.g. if UK inflation is higher than US inflation then UK exports are expensive in the US and UK imports from US are cheaper, thus the demand for pounds will fall and supply of pounds will rise CAPITAL MOVEMENTS (short term & long term)A significant movement of investment funds has the effect of appreciating the currency of the capital importing country and depreciating the currency of the capital exporting country.

STRUCTURAL CHANGESAn economy can undergo structural changes that alter the exchange rate equilibrium. E.g. a deterioration in quality of a country’s products relative to those of other countries will shift demand and depreciate the currency of the first country.

CHANGES IN EXCHANGE RATES cont’d

THE BEHAVIOR OF EXCHANGE RATESPURCHASING POWER PARITY - PPPThe PPP exchange rate is determined by relative price levels in the two countries. The PPP exchange rate adjusts so that the relative price of the two nations’ goods is unchanged, because the change in the relative values compensates exactly for differences in national inflation rates.PPP governs exchange rate behavior in the long term, but there are often significant deviations from PPP in the short to medium term.

EXCHANGE RATES & THE QUANTITY THEORYAssumption: 2 countries & an exchange rate that follows its PPP value.Quantity theory of money equation for foreign country (*):

M*V* = P*Y* (i)Quantity theory of money equation for home country:

MV = PY (ii)Relationship implied by PPP: prices will be the same in both countries when converted at the current exchange rate: PE = P* (iii)(P=home country price) (P*= foreign country price) (E=exchange rate)Rearrange (i) & (ii) and substitute in (iii): …

…

Foreign money supply (M*) positively related to exchange rate (E)Local money supply (M) inversely related to exchange rate (E)Local real national income (Y) positively related to exchange rate (E)Foreign real national income (Y*) inversely related to exchange rate (E)

EXCHANGE RATES & THE QUANTITY THEORY

EXCHANGE RATE OVERSHOOTINGWhile interest differentials persist, the exchange rate must often deviate from its equilibrium or PPP value: this is referred to as exchange rate overshooting