III. Basic concepts from
international economics
III.1 Balance of Payments
International Transactions
• Three types of transactions (omitting
details):
– Transactions of current account, i.e. export
or import of goods and services
– Transfers of wealth between countries,
recorded on capital account (relatively small)
– Transactions, resulting from the purchase or
sale of financial assets – financial account
• BoP: sum of CA balance and of balance
of other financial transactions
Double-entry bookkeeping
• All international transactions enter BoP
twice
– Whenever transaction results in a payment
into the country, enters as credit (+ sign)
– Whenever transaction results in a payment
outside the country, enters as debit (- sign)
• Remember: every (international)
transaction has 2 sides, as buying/selling
from/to foreigner means (a) you pay/are
being paid, (b) foreigner must spend or
store the payment/must withdraw the
money and convert it into “our” currency
Examples (1)
• Exporting Skoda car: (a) foreign importer
pays to Skoda €20.000 → payment into the
country, + sign; (b) Skoda’s agent abroad
deposits €20.000 in a foreign bank →
domestic subjects purchases claim on foreign
entity, i.e. payment out of country, - sign
• In Austria, you buy a ski-lift ticket and pay
with a credit card: (a) service is imported to
CZ → payment out of country, - sign; (b) skilift company receives a claim (via credit card
settlement system) on your bank account →
foreign entity purchases claim on domestic
entity, payment into the country, + sign
Examples (2)
• UBS trader in London buys CEZ’s
shares for USD500.000: (a) foreigner
buys domestic asset → payment into
the country, + sign; (b) CEZ deposits
the money with foreign bank,
purchasing foreign asset → payment
out of the country, - sign
• Many other examples, see textbooks
Two corollaries
1. Export/import of goods means payment
into/outside the country (+/- sign);
purchase/sale of financial assets
means payment outside/into the
country (-/+ sign)
2. Each transaction automatically means
two offsetting entries into BoP:
Current account + capital account + financial account = 0
Balance of payments, CZ, 2010
mil. CZK
A. Current Account
Trade balance
Exports
Imports
Balance of services
Income balance
Current transfers
B. Capital Account
Total, Groups A plus B
-139,192.1
53,954.4
2,410,623.1
2,356,668.7
66,069.0
-257,704.4
-1,511.1
34,024.9
-105,167.2
C. Financial Account
Direct investment
Abroad
In the Czech Republic
Portfolio investment
Assets
Liabilities
Financial derivatives
Assets
Liabilities
Other investment
182,129.3
97,006.2
-32,507.6
129,513.8
157402.1
13,776.6
143,625.5
-4,104.4
65,748.4
-69,852.8
-68,174.6
Total, Groups A through C
76,962.1
D. Net errors and omissions, valuation changes
Total, Groups A through D
E. Change in reserves (-increase)
Source: Czech National Bank
-35,537.0
41,425.1
-41,425.1
CA Deficit, % GDP, y-data
10
5
0
-5
-10
-15
-20
1992
1995
1998
2001
CZE
D
2004
GRE
2007
2010
Change in reserves
(Official Reserves Transaction)
• International (official) reserves: gold or foreign
currency, held by central banks
• The reserves may change because of 2 reasons:
– Flows, financing exports/imports of assets, must
include an exchange into domestic currency via
domestic Central Bank, foreign Central Bank(s) and
other lenders
– Central Bank itself may buy/sell international reserves
(to influence macroeconomic conditions) - foreign
exchange intervention
• Change in reserves: reflects how domestic
Central Bank and foreign Central Banks and
other lenders finance the CA deficit plus deficit
from of the non-reserve flows on financial
account
What is balance of payments?
Two confusing notions, but both valid:
• BoP as a statistical account on macrolevel, a record of international
transactions (sums up to zero)
• An usual interpretation (by economists,
journalists, politicians):
BoP = CA balance + capital account balance + nonreserve part of financial account balance
• Also called Official Settlements Balance,
equal to change in reserves (with sign
reversed)
Statistical remark on „reserves“
• Official reserves transaction („change
in reserves“) is an item from BoP
statistics, but differs from another
indicator:
• Change in „International Reserves“ –
an item, published separately, usually
within BoP statistics as well
International Investment Position
• On of the interpretation of current account:
change in net foreign wealth (see LII.2)
• Consequently, current account surplus/deficit
changes the level of country foreign wealth,
i.e. difference between assets owned both by
private and public entities abroad and assets
owned by foreigners in domestic country
• However, there are other factors, influencing
current value of assets, either at home or
abroad
– e.g. fall of stock prices during recent crisis
• Resulting indicator: International investment
position
Statistical remark: IIP and external
debt
• Two different indicators, but with
similar dynamics
• Again: both published within BoP
statistics
International Investment Position
and External Debt, CZ, mil. CZK
2,000,000.00
1,000,000.00
0.00
-1,000,000.00
-2,000,000.00
InterInvPos
ExDebt
-3,000,000.00
1993
1997
2001
2005
2009
III.2 Floating exchange rate
Definition
• Price of one currency in terms of other
currency, 1€ = 24 CZK, 1$ = 18 CZK
– Direct and indirect quotation, here always
direct
• ExR – enables to compare domestic and
foreign prices and to determine and
compare values of various assets in other
country’s currency
– 1 Octavia in CZ: 552,000 CZK
– 1 Passat in D: 25,000 €
– value of exported Octavia in D: 23.000 €
– Octavia cheaper
Depreciation and appreciation
• Depreciation of domestic currency against a
foreign one is a fall of the price of domestic
currency in terms of units of foreign currency
– Remark!!! – using direct quotation, the numerical
value of ExR increases: e.g., between 1998 and 2000,
depreciation of CZK against $ from 1 $ = 28 CZK to 1
$ = 40 CZK
• Appreciation is an increase of the price of
domestic currency in terms of units of foreign
currency
– The numerical value of ExR decreases: in past 6
years CZK appreciated against € from approx. 1 € =
30 CZK to 1 € = 24 CZK
Foreign Exchange Market
• ExR – relative price of two currencies and like
any price, it is determined by demand and
supply foreign currencies
• What generates supply and demand for forex?
Three factors:
– Flow of exports and imports (transactions on current account)
– Intention to invest wealth into foreign assets, i.e. speculation
on higher yields abroad than at home
– Hedging
• Participants: commercial banks, corporations,
non-bank financial institutions, central banks
• Characteristics of today’s forex market:
integrated, electronic, global trading (almost
“ideal” market)
• Different measures of ExR (see bellow)
• Notation: (nominal) exchange rate E
Arbitrage
• There can be no different prices in different
places, application for forex market:
• If, e.g., € is cheaper in New York than in
Frankfurt and elsewhere, then the profit can
be made by buying in N.Y. and selling
elsewhere, but this increases demand for € in
N.Y. and drives its price there up  in
general, quick leveling of ExR on all markets
• Remark: do understand well the concept of
arbitrage, it will apply – in different situations
- again and again
Different exchange rates
• Immediate trading, value date (2 days)
– Published ExR – for wholesale
transactions (over 1 MUSD)
– Retail: bank fees, retail spread
• Forward rates, different time horizons
• Futures, options
Nominal ExR: USD/EUR, d-data
1.7
15.7.2008
13.12.2009
1.5
1.3
13.10.2011
27.10.2008
1.1
9.6.2010
0.9
26.10.2000
0.7
4/1/1999
4/1/2003
4/1/2007
4/1/2011
Nominal ExR: CZK/USD, m-data
27.10.2000
42,13
45.00
40.00
35.00
17.2.2009
23,33
30.00
30.9.2011
17,83
25.00
20.00
22.7.2008
14,45
15.00
10.00
1/1/2000
1/1/2002
1/1/2004
1/1/2006
1/1/2008
1/1/2010
Nominal ExR: CZK/EUR, m-data
38.00
12.5.2000
37,04
36.00
34.00
32.00
17.2.2009
29,47
30.00
28.00
30.9.2011
24,56
26.00
22.7.2008
23,01
24.00
22.00
1/1/2000
1/1/2002
1/1/2004
1/1/2006
1/1/2008
1/1/2010
Nominal Effective ExR
• Market (nominal) ExR above: price of unit of foreign
currency in terms of units of domestic currency
– Reflects just market situation, relations between the two
economies, probably many other facts, speculation, etc.
– In our definition above: numerical increase = depreciation,
numerical decrease = appreciation
• Nominal Effective Exchange Rate: price of unit of a
domestic currency in terms of a basket of main foreign
currencies
– it is price of unit of domestic currency (i.e. numerical
increase means appreciation, decrease depreciation)
– Numerically: weighted (usually geometric) average of
different nominal exchange rates, where weights are the
trade shares (with main trading partners), constructed as an
index (base year = 100)
– Increase (appreciation) means loss of competitiveness of
domestic economy compared to main trading partners,
decrease (depreciation) vice versa
Nominal Effective ExR
m-data, I/2003 = 100
140
130
120
110
100
90
80
70
60
1993-01
1996-01
1999-01
CZK
2002-01
USD
2005-01
EUR
2008-01
2011-01
III.3 Asset approach to ExR and
forex market
Forex market
• Not the only approach, see bellow
• Floating ExR – price of currency,
determined by supply and demand
• Basic logic: foreign exchange is an
asset that people (institutions) can
invest in
– There are other reasons why people
demand forex, but the investment is the
prevailing one
Demand for foreign currency
assets
• Why there is larger or smaller demand?
– Investment, rate of return, real rate of return,
domestic and foreign interest rate (r, r*)
– Risk, liquidity – not considered here (later)
Note: often believed – demand for forex assets because of
international trade (cash, deposits). Today less
important, level of demand – given the global business
– determined by portfolio investment
• Basic rule (assumption): people always
hold assets with the highest expected
real rate of return
Exchange rate and asset return
• 1 (M) CZK investment into domestic
bonds
– At interest r, one year return 1+r
• The same amount invested into € bonds
– more steps:
– CZK into € - investing (1/E) €
– 1 year return at foreign interest r* (in €) :
1 E1  r* 
– 1 year return in CZK at expected exchange
rate E e :
1 E 1  r* Ee


Equilibrium on the forex
market
• Equilibrium: assets (deposits) of all currencies
offer the same expected real rate of return
• Formally:
1  r  1 E 1  r* Ee
• Approximately:
e
E
E
*
rr 
E
• In words:


– Expected rate of return, expressed in domestic
currency, on foreign deposits is approximately equal to
foreign interest rate plus the rate of expected
depreciation of domestic currency against a foreign
one
– In equilibrium, both rate of return (in domestic
currency) must be equal  equilibrium E0 determined
Adjustment towards equilibrium (1)
• If E > E0 → return on domestic assets
larger → people try to sell foreign and
buy domestic assets, but nobody is
ready → larger amount of foreign
currency per unit of domestic one
offered → E (appreciation)
• If E < E0 – vice versa
Adjustment towards equilibrium (2)
E
Return on domestic deposits
E1
Expected return on foreign
deposits inversely related
to today’s exchange rate
E0
Ee  E
r 
E
E2
*
r
Expected returns
III.4 Monetary approach to ExR
and forex market (PPP)
Law of one price
• Starting concept: if prices (and ExR) quickly
adjust and there are no barriers to trade, no
transportation and other costs, then
arbitrage erases any price differences
between different geographical locations
(when prices converted to the same
currency)
• If we consider Octavia and Passat to be the
same product (VW Group car of the same
class), then price of Octavia could not remain
552,000 CZK too long:
– Arbitrage: Germans would travel to CZ, buying
Passats and Octavias here → increasing the price
from 552,000 CZK
Purchasing Power Parity
• Suppose that markets (both domestic and
foreign) are fully competitive and prices quickly
adjust
• Than prices, when converted into same currency,
must be equal, i.e. PPPxP*=P or
PPP = P/P*
• This definition: absolute PPP
• Changes in PPP solely determined by changes in
relative price levels: faster domestic inflation →
depreciation, faster foreign inflation →
appreciation
• Not approved by reality, even in the long run
(when prices adjust)
– In literature (Mankiw or Krugman&Obstfeld), see
anecdotic evidence, based upon the so-called Big Mac
index
Relative PPP
• Absolute PPP – not workable concept →
weaker version for PPP definition of ExR
• On the absolute levels PPP is far from
everyday reality, but it may still apply when
we consider changes in prices and exchange
rates
• Relative PPP: percentage change in the ExR
between two currencies is equal the
difference in percentage changes in national
price levels
• Formally E - E-1  E-1  π - π*
– Where inflation π  P - P-1  P-1
• Remark: the expression is good
approximation for small inflation values
Why PPP?
• Empirically, exchange rates are very far
from ratio of price levels, i.e. absolute
PPP can not be considered as a proper
representation of exchange rate
– Even relative PPP performs empirically
badly
• Reasons:
– Trade barriers and non-tradables
– Non-competitive markets
– Different consumer baskets and difference
in inflation measurements
– Important starting point for other concepts
III.5 Real exchange rate
Relative prices of goods
• Nominal ExR: relative price of two currencies,
its level on the forex market
• International trade: people make decisions,
comparing relative prices of comparable
goods, that can be purchased either on
domestic market or in a foreign country,
provided that prices are allowed to adjust
• Problem on macroeconomic level, when
comparing two countries: each country has
different basket of commodities that are
purchased
• Back to starting example: suppose that CZ and
D produce only Octavias and Passats
Octavia vs. Passat Again
• Price of foreign goods in terms of domestic
goods, how to construct?
• Example (nom.ex.rate 1 € = 24 CZK):
• CZ
Octavia
552,000 CZK
• D
Passat
25,000 €
• Price of Passat in terms of Octavia?
– Price of Passat in CZK: 25,000x24=600,000
CZK
– In terms of 1 Octavia: 600,000/552,000=1.09
– “Real ex.rate” between Passat and Octavia:
1 P =1.09 O
Real ExR - Definition
• Generalization to the economy-wide level
– Problem of “comparable good”: price over standard
(reference, typically purchased) basket of purchases in
both countries in a given period of time (e.g. a week,
months, year, etc.)
– Important: when constructing price indexes, relatively
larger weight on commodities, produced (and
consumed) domestically
• Formally (see example on Octavia and Passat
above):
e=(E.P*)/P
– Direct quotation again: price (expressed in domestic
currency) of a reference basket (considered as one unit)
in a foreign country relative to the reference basket in
domestic country (again considered as one unit)
• Real appreciation, e decreases
• Real depreciation, e increases
Real exchange rate and price level (1)
• Alternative interpretation: e = E.(P*/P) - ratio of foreign
and domestic price levels, when both expressed in
domestic currency
– Real ExR evaluates the purchasing power of domestic
currency over foreign goods
• If e < 1, then foreign price level relatively lower than
domestic one, domestic goods relatively more
expensive, so less competitive
• if e > 1, then foreign price level relatively higher than
domestic one, domestic goods relatively cheaper, so
more competitive
• Real depreciation: fall of purchasing power of domestic
currency over the goods in foreign country
• Real appreciation: increase of purchasing power over
foreign goods
Real exchange rate and price level
(2)
Changes in real ExR:
• Change in nominal ExR: nominal
depreciation (appreciation) → real
depreciation (appreciation)
• Change in relative price levels:
– increase in relative domestic inflation → real
appreciation, domestic goods relatively more
expensive
– increase in relative foreign inflation → real
depreciation, domestic goods relatively
cheaper
Real Effective Exchange Rate
(REEF)
• In reality, country trades with many
foreign counterparts
• For a given country’s trade, usually a
limited number of other countries
decisive
– E.g. CZ: Euro zone, SK
• REEF: weighted average of real ExRs
with these decisive trading partners
– Weighs: shares of trade with particular
country on total trade with the group of
decisive countries
REER: CZK, EUR
I/2005=100, m-data
140
130
120
CZK
EUR
110
100
90
80
70
1/1/1998
1/1/2002
1/1/2006
1/1/2010
III.5 Fixed exchange rate
Definitions
• So far: exchange rate assumed as
completely flexible, ready for immediate
adjustment  floating exchange rate
– Perfect floating – theoretical concept only
(almost)
• In reality – different level of central banks’
(state) interventions
– Managed floating (today) – technically is ExR
floating, but central banks try to intervene to
moderate the movements of exchange rates
– Fixed exchange rate – central bank fixes the
exchange rate in various ways
Different ways of fixing ExR
• Full fix: central banks are prepared to trade any
amount of currencies at given fixed rate
• Regional currency arrangements, in the past or
today’s Euro
• Policies for developing countries or countries in
transition, different types of fixing (for more
detailed discussion of following concepts see
later Lectures):
– Pegging to other currencies, horizontal bands,
crawling peg, crawling bands, currency boards
Fixed ExR and supply of money (1)
• LII: brief discussion of money supply
• Fixed ExR – how does Central Bank maintain
the fix?
• Through open market operations
– When market pressure towards devaluation
(market selling domestic currency, i.e. excess
supply), Central Bank buys assets, denominated
in domestic currency (increasing demand for it,
offsetting excess supply)
– When market pressure towards revaluation
(excess demand), Central Bank sells assets,
denominated in domestic currency (increasing its
supply, offsetting excess demand)
Fixed ExR and supply of money (2)
• Consequence of the fix: supply of
money (monetary policy) is not fully
independent, but must follow market
pressures towards domestic currency
• Will be discussed more in detail in later
Lectures
– But this basic finding will be needed
already in Lecture IV, when discussing
gold standard
Literature to Lecture III
• Krugman, P.R., Obstfeld, M.:
International Economics, Theory and
Policy, Pearson, Addison Wesley,
Boston 2006 (7th ed.), Ch. 13 and Ch.
15
• Mankiw, Ch. 7, pp. 205-220
and references there