TopicChapter 12PM Exchange rates and the balance of payments

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Topic/Chapter 12(PM)Exchange rates and
thebalance of payments
Business EconomicsFor School of Management
StudentsSpring Semester 2009
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Topic/Chapter 12 Exchange rates and thebalance
of payments

• Will cover
• 12.1 Exchange rates and the balance of payments
• 12.2 Monetary policy in open economies

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12.1 Exchange rates and the balance of payments
Learning outcomes

• By the end of this section, you should
  understand
• The forex market
• Balance of payments accounting
• Internal and external balance

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Open economy macroeconomics

• The openness of the economy of a country is the
  extent to which it trades with the rest of the
  world
• exports and imports are influenced by exchange
  rates and international competitiveness
• trade flows influence financial flows and hence
  monetary and fiscal policy
• When an economy is very open to foreign trade,
  the exchange rate, international competitiveness,
  and the trade balance with foreigners become
  major policy issues

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The foreign exchange market - 1

• Foreign exchange (forex) market
• exchanges one national currency another
• Exchange rate
• price at which two currencies exchange
• Fixed exchange rate regime
• Where the governments, acting through their
  central banks, will buy or sell as much of the
  currency as people want to exchange at the fixed
  rate
• Foreign exchange reserves
• the foreign currency holdings of the domestic
  central bank
• Devaluation
• a fall in the fixed exchange rate
• Revaluation
• a rise in the fixed exchange rate

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The foreign exchange market - 2

• Floating exchange rate regime
• where the exchange rate is allowed to find its
  free market equilibrium without any intervention
  using the foreign exchange reserves
• Appreciation
• Where the exchange rates rises
• E.g. a higher / rate
• Depreciation
• Where the exchange rates falls
• E.g. a lower / rate
• Dirty floating
• means some intervention in the short run but
  allowing the exchange rate to find its
  equilibrium level in the longer run

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The foreign exchange market - 3
DD shows the demand for pounds by Americans
wanting to buy British goods/assets
SS shows the supply of pounds by UK residents
wishing to buy American goods/assets
SS
Exchange rate (/)
A
e1
Equilibrium exchange rate is e1
DD
Quantity of pounds
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The foreign exchange market - 4
If the US demand for UK goods or assets rises,
the demand for shifts right to DD1 The
equilibrium / exchange rate appreciates (point
B)
If the US demand for UK goods or assets falls,
the demand for shifts left to DD2 The
equilibrium / exchange rate depreciates (point
D)
SS
B
Exchange rate (/)
A
e1
D
DD1
D
DD
DD2
Quantity of pounds
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Fixed exchange rate regime - 1
If the fixed exchange rate is e1, the free market
equilibrium rate, then the market clears
unaided But if the demand for pounds increases to
DD1 then in a free market there would be a new
equilibrium at B with the appreciating against
the .
At the fixed exchange rate e1 there is an excess
demand AC for To meet this, the Bank prints AC
extra and sells them in exchange for e1xAC of
which are added to the UK foreign exchange
reserves.
SS
B
Exchange rate (/)
A
C
e1
DD1
DD
Quantity of pounds
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Fixed exchange rate regime - 2
But if the demand for pounds decreases to DD2
then in a free market there would be a new
equilibrium at C with the depreciating against
the .
At the fixed exchange rate e1 there is an excess
supply EA for To defend the fixed exchange
rate the Bank buys EA s, paid for by selling
e1xEA of from the foreign exchange reserves.
SS
Exchange rate (/)
A
e1
E
D
DD
DD2
Quantity of pounds
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Fixed exchange rate regime - 3

• If the demand for on average is DD2 , the Bank
  on average is reducing the UK forex reserves to
  support the at e1
• The is overvalued
• As reserves run out, the government may try to
  borrow foreign exchange reserves from the
  International Monetary Fund IMF, an
  international body that lends to governments in
  short-term difficulties
• But at best this is a temporary solution
• Unless the demand for rises in the long run, it
  will be necessary to devalue the pound

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Floating exchange rate regime
With no intervention the exchange rate is allowed
to adjust to its free market level.
Starting at A if demand increases to DD1the
exchange rate appreciates to B But if it falls
to DD2 it depreciates to D
SS
B
Exchange rate (/)
A
e1
DD1
D
DD
DD2
Quantity of pounds
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The balance of payments - 1

• Balance of payments
• records all transactions between a country and
  the rest of the world
• Current account
• records international flows of goods, services,
  income and transfer payments
• Visible trade (net trade in goods)
• exports and imports of goods (cars, food, steel)
• Invisible trade (net trade in services)
• exports and imports of services (banking,
  shipping, tourism).
• Together Visible and Invisible trade gives the
  trade balance or net exports of goods and
  services
• Net transfer income from abroad
• Net interest income on foreign assets and other
  international net transfer payments (such as
  foreign aid)
• So Current Account is the net trade balance plus
  the net transfer income from abroad
• Capital account
• shows international flows of transfer payments
  relating to capital items
• Covers payments received from the EU, transfer of
  capital into and out of the UK by migrants, and
  UK forgiveness of debt.
• Typically small

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The balance of payments - 2

• Financial account
• records international purchases and sales of
  financial assets
• Balancing item
• a statistical adjustment
• would be zero if all previous items had been
  correctly measured
• reflects a failure to record all transactions in
  the official statistics.
• So Balance of Payments
• records the net monetary inflow from abroad when
  households, firms, and the government make their
  desired transactions
• Official financing
• This is always of equal magnitude and opposite
  sign to the balance of payments
• measures the international transactions that the
  government must take to accommodate all the other
  transactions in the balance of payments accounts

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The UK Balance of Payments 2003 (bn)
The balance of payments - 3
Note typing errors in text book
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Floating exchange rates and the balance of
payments

• If the exchange rate is free to move to its
  equilibrium, there is no need for intervention
  and forex reserves are constant
• the exchange rate equates the supply and demand
  for pounds
• a current account surplus is exactly matched by a
  deficit of the combined capital and financial
  accounts (plus balancing item)
• a current account deficit is exactly matched by a
  surplus of the combined capital and financial
  accounts (plus balancing item)

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Fixed exchange rates and the balance of payments

• With a fixed exchange rate the balance of
  payments can be in deficit or surplus
• to maintain the exchange rate the central bank
  must sell foreign currency to buy pounds to cover
  a deficit and vice versa to cover a surplus.
• This is the official financing
• But continual deficits may require devaluation

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Real exchange rates - 1

• Important to distinguish between nominal and real
  values
• And international competitiveness depends upon
• The real exchange rate
• the relative price of domestic and foreign goods,
  when measured in a common currency
• And can depreciate for three reasons
• A fall in the nominal exchange rate
• A rise in the price of foreign goods
• A fall in the price of UK goods

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Real exchange rates - 2
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Internal and external balance

• For a trading nation (such as the UK) policy
  makers need to ensure that there is both
  internal and external balance
• Internal balance
• a situation for a country when aggregate demand
  equals potential output
• External balance
• a situation for a country when the current
  account of the balance of payments is zero
• The combination of internal and external balance
  is the long-run equilibrium for the economy.

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12.2 Monetary policy in open economies Learning
outcomes

• By the end of this section, you should
  understand
• Monetary policy with fixed exchange rates
• The impact of devaluation
• Monetary policy with floating exchange rates

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Monetary policy underfixed exchange rates - 1

• Perfect capital mobility means expected total
  returns on assets in different currencies must be
  equal if huge capital flows are to be avoided.
• A positive interest differential must be offset
  by an expected exchange rate fall of equal
  magnitude.
• This is the interest parity condition
• With fixed exchange rates and perfect capital
  mobility, domestic interest rates must match
  foreign interest rates
• Therefore monetary policy is powerless

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Monetary policy underfixed exchange rates - 2

• I.e. Suppose the UK MPC tried to raise UK
  interest rates above those in the US with a fixed
  exchange rate regime.
• There would be a massive inflow of financial
  capital to take advantage of the high interest
  rate
• This would result in a balance of payments
  surplus and excess demand for pounds forcing the
  Bank of England to print more pounds to buy
  foreign exchange reserves
• This results in a rise in UK money supply which
  bids down the interest rates again, hence the
  attempt to raise interest rates is thwarted by
  the capital inflow then induced.

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Monetary policy underfloating exchange rates

• As seen under fixed exchange rates, domestic
  monetary policy is powerless
• But under floating exchange rates, the converse
  is true
• A rise in the domestic interest rate will
• Reduce domestic demand
• Raises the exchange rate thus reducing net export
  demand
• The domestic demand effect is reinforced by the
  exchange rate effect on competitiveness.