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 IMPORTS
The 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 LEVELS
e.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.
CHANGES IN EXCHANGE RATES cont’d
STRUCTURAL CHANGES
An 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.
THE BEHAVIOR OF EXCHANGE RATES
PURCHASING POWER PARITY - PPP
The 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 THEORY
Assumption: 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): …
EXCHANGE RATES & THE QUANTITY THEORY
…
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 RATE OVERSHOOTING
While interest
differentials
persist, the
exchange rate
must often deviate
from its
equilibrium or PPP
value: this is
referred to as
exchange rate
overshooting