Balance of Payments and Foreign Exchange

International Economics

Chapter 6

Chapter 6 Balance of Payments and Foreign Exchange

6.1 Balance of Payments

6.2 Foreign Exchange Market and Exchange Rates

6.3 Exchange Rate System

6.1 Balance of Payments

A balance of payments (BP) sheet is an accounting record of all monetary transactions between a country and the rest of the world. These transactions include payments for the country's

exports (X) and imports (M) of goods, services, and financial capital, as well as financial transfers.

The BP summarizes international transactions for a specific period, usually a year. Some countries also keep such a record on a quarterly basis.

A credit transaction is one that results in a receipt of a payment from foreigners.

A debit transaction is one that leads to a payment to foreigners.

Double entry accounting systemEach credit entry is balanced by a debit entry, and

vice versa. So the recording of any international transactions leads to two offsetting entries.

6.1 Balance of Payments

6.1 Balance of Payments

The balance of payments consists of two primary subaccounts:the current account (CA) the capital and financial account (KA)

6.1 Balance of Payments

The current account (CA) refers to the monetary value of international flows associated with transactions in goods and services, factor income, and unilateral transfers. the balance of trade

the difference between a country's exports of goods and services and its imports of goods and services.

net factor incomethe money received from investments made abroad;the money sent by individuals working abroad, known as

remittances, to their families back home. net unilateral transfer

Private transfer payment Government transfers

6.1 Balance of Payments

The capital and financial account (KA) reflects net change in national ownership of assets. The capital account

capital transfers– the transfer of ownership on fixed assets– the transfer of funds received to the sale or acquisition of fixed assets– the transfer of goods and financial assets by migrants leaving or entering a

country– debt forgiveness

the acquisition or disposal of non-financial and non-produced assets The financial account

foreign direct investmentportfolio investmentother investment reserve assets

Except reserve assets which are public-sector transactions, all other components of the capital and financial account are categorized into private-sector transactions.

6.1 Balance of Payments

The overall BP sheet will always balance when all types of payments are included

Imbalances are possible on individual components of the BP. trade balance

exports of goods and services minus imports of goods and services

current account balance capital and financial account balance overall BP balance

the current account plus the capital and financial account except for reserve assets

Most frequently, when we mention an imbalance in the BP, we actually refer to the current account balance.

6.1 Balance of Payments

Automatic Adjustment of the Balance of Payments Price-Specie Flow Mechanism

Under a gold standarda positive balance of trade => gold inflow => a rise in

money supply => higher prices of goods and services => a fall in export, a rise in import => a neutral balance

Criticisms:– The classical linkage between changes in a country’s

gold supply and changes in its money supply no longer exists.

– The full employment on which the quantity theory of money holds is not common.

– In a modern industrial world, prices and wages are sticky in a downward direction.

Chapter 6 Balance of Payments and Foreign Exchange

6.1 Balance of Payments

6.2 Foreign Exchange Market and Exchange Rates

6.3 Exchange Rate System

6.2 Foreign Exchange Market and Exchange Rates

The foreign exchange market is a worldwide decentralized over-the-counter financial market for the trading of currencies. It is the largest and most liquid financial market in the world. Levels of access:

the inter-bank market, made up of the largest commercial banks and securities dealers.

smaller bankslarge multi-national corporations large hedge fundssome other financial institutions. National central banks also participate in the foreign

exchange market to align currencies to their economic needs.

6.2 Foreign Exchange Market and Exchange Rates

The exchange rate between two currencies specifies how much one currency is worth in terms of the other. Direct Quotation v.s. Indirect Quotation Appreciation v.s. DepreciationTypes of Foreign Exchange Transaction

Spot transactionForward transactionCurrency swap

6.2 Foreign Exchange Market and Exchange Rates

Supply of and Demand for Foreign Exchange

S

D

f

e

e0

f0

e↑

e↓

(Depreciation)

(Appreciation)

6.2 Foreign Exchange Market and Exchange Rates

Determinants of Exchange Rates Economic Factors

Economic policiesGovernment budget deficit or surplus Balance of trade levels and trends Inflation levels and trends Economic growth and health Productivity of an economy

Market PsychologiesFlights to qualityLong-term trends Buy the rumor, sell the fact Economic figures Technical trading considerations

Chapter 6 Balance of Payments and Foreign Exchange

6.1 Balance of Payments

6.2 Foreign Exchange Market and Exchange Rates

6.3 Exchange Rate System

6.3 Exchange Rate System

The exchange rate system is the way a country manages its currency in respect to foreign currencies and the foreign exchange market.

6.3 Exchange Rate System

Types of Exchange Rate Regime Floating exchange rate

A type of exchange rate system wherein a currency's value is allowed to fluctuate according to the foreign exchange market.

– In cases of extreme appreciation or depreciation, a central bank will normally intervene to stabilize the currency. Thus, the exchange rate system of floating currencies may more technically be known as managed floating.

Fixed exchange rate (pegged exchange rate)It matches a currency's value to the value of another single

currency or to a basket of other currencies, or to another measure of value, such as gold.

Currency boardA monetary authority which is required to maintain a fixed

exchange rate with a foreign currency.