Macro Review:
BOP, Exchange Rates
Jeffrey H. Nilsen
http://thedailyshow.cc.com/videos/zjr96n/julian-castro
Balance of Payments
Accounting (part of N.I.P.A.)
assume BNB buys & sells $ to ensure Lev won’t change
(exchange rate “peg”)
Count transaction as:
CREDIT: in-flow of funds,
+
DEBIT: out-flow of funds,
-
Sell good to foreigners => credit (CA)
Sell asset to foreigners => credit (private KFA)
Sell ORA to foreigners => credit (public KFA, i.e. OSB)
Current Account
 Accounts for trade in currently
produced goods & services,
includes
 Net Exports
 Net Factor Payments
 Net unilateral transfers
CAUS as percentage of GDP
Table 5.1 US BOP Accounts 2008
($ Billions)
- 553.5
1998-01
1998-06
1998-11
1999-04
1999-09
2000-02
2000-07
2000-12
2001-05
2001-10
2002-03
2002-08
2003-01
2003-06
2003-11
2004-04
2004-09
2005-02
2005-07
2005-12
2006-05
2006-10
2007-03
2007-08
2008-01
2008-06
2008-11
2009-04
2009-09
2010-02
2010-07
2010-12
2011-05
2011-10
2012-03
2012-08
2013-01
2013-06
2013-11
Current Account of Bulgaria (to 2014 Jan)
1000
500
0
Series1
1998-01 -57.9
-500
-1000
-1500
Capital & Financial Account
(KFA)
 KFA accounts for trade in existing real &
financial assets, including ORA (official reserve
assets)
 If sell domestic house, inflow => KFA
credit
 If buy Boeing shares, outflow => KFA
debit
 KFA Surplus if BG sells more assets
to foreigners than they do to BG
KFABG
Inflow
(Credit)
Sell
KR house
ROW
Leva
Outflow
(Debit) Buy Boeing
shares
Leva
Official Settlements Balance
OSB = 0 if no intervention
 OSB accounts for official
purchase/sales of ORA ($, €, Yen,
Renimbi, gold, special drawing rights)
 Officials: BOK, Fed, ECB
 NO intervention => BNB, Fed don’t
buy/sell ORA
 (the reason to intervene is to try to
influence the exchange rate)
The OSB non-zero if Intervention
BNB buys/sells ORA to influence
euro per lev exchange rate
If tends to appreciate : e.g.
CA, private KFA > 0 (Germans
want many Leva; BNB buys euro
(ORA), selling leva (outflows)
OSB DEBIT offsets CA + (private
KFA credit) so finally
CA + KFA = 0
OSB|BG ROW
(Credit)
Sell
FX
€
Leva
(Debit)
Buy
Leva
€
US KFA
.
.
.
.
Sell good to foreigners => credit (CA)
Sell asset to foreigners => credit (KFA)
Sell ORA to foreigners => credit (KFA)
Fed buys ORA
OSB, 2 parts
(on net positive)
SNB buys $
Swiss buy US houses
KFA surplus
CA deficit
When the SNB buys $ from a Swiss person or bank :
Private Swiss had bought US asset (US sold asset [BoPUS inflow])
So transfer to official account OSB (OSBUS inflow)
11
Emerging Market Volatility in early 2014
http://video.ft.com/3111207196001/
Emerging-market-sell-off-spreadsacross-Asia/Markets
Media Attention on Possible
Argentine Currency Crisis
In 2014, many investors withdrew funds
from emerging markets since expected higher US r;
(have pesos want $ assets). Private outflows.
To prevent peso from depreciating,
Bank of Argentina sells $ for investors’ pesos
BUT : continuing private KFA deficit may deplete BOA’s $ ORA
(FX reserves)
All nations are concerned with exchange rate, but those with pegs
are more prone to problems; often Have CA, KFA deficits
How much depreciation should central bank allow??
Reason for recent depreciation does
Seems UNrelated to CA (in surplus
for a decade)
Review Exchange Rates
Plan
 Nominal vs. real
 PPP: absolute vs. relative
 Determination of “fundamental
exchange rate” where FX amount
supplied = amount demanded
 Peg en : over-valued vs. undervalued
Exchange Rates
 Nominal: How much foreign currency you
receive for 1 unit of home currency, e.g.
0.50 € per 1 lev
euro
* lev
eN P
eR 
PFor
eR 
0.50 euro
eN 
1 lev
lev
BG good
euro
Germ angood
 Real (eR): how many German goods you
get for 1 BG good
(0.50)  (12)
If mavrud costs 12 leva & same wine costs 5
eR 
 1.2
5
euro in Germany, eR = 1.2 (German wine
per bottle mavrud)
Real exchange rate > 1:
Consumers choose 1 Bulgarian vs. > 1
identical German goods
Nominal depreciation: eN falls (get fewer € for 1 lev)
eR rises (real appreciation) => Get more German wine for
each case mavrud (so more difficult to sell mavrud in D)
Purchasing Power Parity
(long run influence)
eR 
eN P
PFor
 ABSOLUTE PURCHASING POWER PARITY (PPP) =>
assuming free trade, identical goods: goods
eR  1
trade 1-for-1 only =>
=>
(same eprice
N P  PForin $ )
0.50(euro / lev) *12leva  5euro
 If doesn’t hold,
pressure to return to PPP:
 PBG or eR falls due to unsold BG goods
 or PDE rises due to high demand for German goods
Express absolute PPP as:
eN 
PFor
P
PFor / P
Pounds per $
(US domestic,
UK foreign)
Relative PPP Instead ?
eN P
eR 
PFor
 Absolute PPP does NOT hold because:
 1. services (especially) not subject to int’l
competition;
 2. trade barriers don’t allow international P to
equalize
 Relative PPP: instead of er = 1, assume er
constant over time
e N
  For  
eN
 Relative PPP => eN will appreciate to extent
euro π > BG π
Nations with higher inflation (vs. $)
experience greater depreciation
Lane (1999) What determines the nominal exchange rate, some cross sectional evidence. CJE
Finding Eqbm eN
FX Market
 LevaS: BG public
supplies leva to get
euro $ to buy Airbus
Jets & VW shares
High eN: BG want lots
of euro since German
Goods are cheap
Low eN: BG wants few
euro since German
goods high cost
 LevaD: Germans
demand Leva to buy
Mavrud & real estate
Low eN: Germans want
many Leva since Mavrud
cheap
FX Market Shifts
Lev Supply
(Lev appreciates)
Quality of BG
goods improves
Lev demand
Foreign interest
Rate rise ??
Floating en & Policy
 Float: en set by S & D IN ABSENCE
OF central bank intervention
 (zero OSB)
“Fixed” Exchange Rate
Regime (e.g. Bulgaria)
 Pure peg: the BNB commits to
buy/sell € to maintain 0.5 € per lev
rate
 Often not pure; even in float,
national bank may intervene if
believe currency overvalued (tough
for exporters) e.g. Switzerland
http://video.ft.com/1145014411001/Swissie-pegdestabilising/Editors-Choice
(Switzerland generally allows its Swiss Franc to float)
Important Issue in Pegs
 Compare peg value to value that e
would have without intervention (at
fundamental value, where SFX = DFX )
 Undervalued peg may be strategy to
increase exports
 Overvalued peg may bring currency
crisis
Recall: policy changes in exchange rate are “revaluation” & “devalua
Undervalued Peg
 ePEG < efundamental
 Low ePEG =>
 American public buys many cheap
Chinese goods, assets => Chinese CA,
KFA both surplus
 BUT EDYUAN: To maintain peg, PBoC
must sell yuan & buy $ (ORA) OSB
debit
Central Bank
$↑
Y↑
Result: PBoC holds 2 trillion $
Overvalued Peg
(Bulgaria pre-financial crisis)
 ePEG > eFUND: CA, KFA
deficit
 Policy choices:
 1. Devalue to get to
eFUND
 2. e.g. tax IM to cut
LevS (raising eFUND)
 3. Soak up ESLEV: sell
$, buy lev (must
abandon peg if no
more $ !!)
Germans:
Mavrud too
costly
Central Bank
$↓
lev ↓
Cheap VW,
D. assets
Speculative Attack
 Germans fear lev assets
lose value if BNB devalues
At 0.5 €/lev, share of Bulgartabak at 100 lev
worth 50 € in Germany
If BNB devalues to 0.25€/lev => value drops to 25 €
 Sell lev assets => levS
shifts out
 Fear makes ESLEV worse,
BNB needs more $ to
maintain overvalued peg
=> peg less sustainable
Compare Peg to Float
 Peg cuts volatility and costs to trade.
Disciplines M policy (limits BNB
ability for discretionary M policy =>
lower π)
 But float allows M policy to stabilize Y