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1 Lectures 33-39: BOP & Exchange Rate Systems Components of BOP Exchange rate and its determination.

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Presentation on theme: "1 Lectures 33-39: BOP & Exchange Rate Systems Components of BOP Exchange rate and its determination."— Presentation transcript:

1 1 Lectures 33-39: BOP & Exchange Rate Systems Components of BOP Exchange rate and its determination

2 2 Fall 2007 NU-FAST Zahid Siddique BOP Accounts Balance of Payment is record of a countrys international transactionssum of current and capital accounts BOP = CA + KA –Current Account is record of a countrys international trade in currently produced goods and services. Include: X – M = NX, called trade or merchandise balance Net investment income = Investment income earned on foreign assets by home residents - Investment income paid to foreigners on home assets –earnings include interest payments, dividends or royalties on bonds, stocks, patents or assets –also include Net Factor Payment (NFP) Unilateral Transfers include payments that do not involve purchase of goods, services or assets CA = X – M + Net income from abroad + Unilateral Transfer

3 3 Fall 2007 NU-FAST Zahid Siddique BOP Accounts –Capital Account is record of a countrys international trade in existing assets, whether real or financial If assets are traded among private individuals, then it appears on private capital account –Includes Capital inflow: occurs when a resident of country sells an asset to someone in another country Capital outflow: occurs when a resident of country purchases an asset from abroad –both in shape of FDI and PFI KA = Value of capital inflow – Value of capital outflow

4 4 Fall 2007 NU-FAST Zahid Siddique BOP Accounts –Official Reserve Transactions (ORT) or Official Settlement Balance is conducted by central bank When buyer/seller of assets is central bank, transaction appears on ORT account Includes –assets (other than domestic money or securities) that can be used in making international payments e.g. gold, government securities of other economies, foreign bank deposits or IMF created assets

5 5 Fall 2007 NU-FAST Zahid Siddique Schematic representation of BOP Accounts and Sub-accountsCumulative Balance Current Account (CA) 1)Merchandise Services (Transportation, Tourism, Business & professional services) Merchandise / Trade balance = Exports – Imports 2) Net investment income BO goods & income = (X – M) + Investment income received on foreign assets by home residents - Investment income paid to foreigners on domestic assets 3) Unilateral transfer Government grants Private remittances CA Balance = X – M + Net income from abroad + Unilateral Transfers

6 6 Fall 2007 NU-FAST Zahid Siddique Schematic representation of BOP Accounts and Sub-accountsCumulative Balance Capital Account (KA) 1)Direct investment 2)Portfolio investment Long & short term KA Balance = Value of capital inflow – Value of capital outflow Over all BOP = CA + KA Official reserve transaction 1)Changes in foreign CBs holding of domestic assets 2)Changes in home CBs holding of foreign assets Gold, foreign exchange reserves, IMF credits

7 7 Fall 2007 NU-FAST Zahid Siddique How to record transactions? The rule can be defined in two equivalent ways –transaction involving flow of funds into a country is a credit item and entered with plus sign, and transaction that involves flow of funds out of a country is a debit item and entered with minus sign –Alternatively, whatever leaves country is recorded as credit item and whatever enters is recorded as debit item ExportsCredit item with plus sign ImportsDebit item with minus sign Sell of domestic assetsCredit item Purchase of foreign assets Debit item (b/c claim to asset enters country) Purchase of assets by home CBDebit item

8 8 Fall 2007 NU-FAST Zahid Siddique Relationship among three: The Balance By definitionCA + KA + ORT 0 This is due to Double Entry Book-keeping –Every complete economic transaction is recorded twice, once as debit and once credit b/c each transaction involves something leaving the country in exchange for something entering (except for unilateral transfers) Thus, every swap of goods/services has offsetting effects on the sum of CA, KA and ORT Since it is an accounting identity, it has not much importance! The important statistics are (i) CA balance and (ii) BOP balance –The two statistics show whether a country is spending beyond its means, and –whether there is net supply of, or demand for, its currency Consider an example Identity, not equation

9 9 Fall 2007 NU-FAST Zahid Siddique Relationship among three: The Balance Let BOP = 0 initially, and a Pakistani exports of worth $100 –Pakistan is now running CA (and hence BOP) surplus The person can use this $100 in following ways a)may import from US of worth $100 –an export credit entry in CA will be offset by another import debit entry in CA and BOP surplus will vanish Current Account Exports+ $100 Imports- $100 CA Balance0 Capital Account No transaction KA Balance0 BOP0

10 10 Fall 2007 NU-FAST Zahid Siddique Relationship among three: The Balance b)may buy US assets of $100 may be in the form of US currency account –This involves capital outflow which implies KA deficit equal to CA surplus (KA = - CA), BOP = 0 and ORT = 0 This can be recorded as Current Account Exports+ $100 Imports0 CA Balance + $100 Capital Account Capital outflow- $100 KA Balance - $100 BOP0

11 11 Fall 2007 NU-FAST Zahid Siddique Relationship among three: The Balance c)If country is running CA surplus and private residents are not acquiring foreign assetsi.e. may decide to convert dollars with rupee through some bank bank may loan it to an individual for US imports or purchase of assets, then same as above happens or central bank must be acquiring foreign assets so country will have surplus on CA, and KA = 0 while ORT = - BOP Current Account Exports+ $100 CA Balance + $100 Capital Account KA Balance0 BOP+ $100 CBs holding of foreign assets- $100 surplus both on CA and BOP BOP = - ORT

12 12 Fall 2007 NU-FAST Zahid Siddique Relationship among three: The Balance Thus, BOP shows net supply of foreign currency (or net demand for domestic currency) after the private sector has made all its desired CA and KA transactions –If BOP > 0, ORT must be negative which means CB is adding to its foreign exchange reserves (or is supplying domestic currency that private agents demand in foreign market) –If BOP < 0, ORT must be positive, means CB is selling foreign exchange reserves (or buying domestic currency that private agents want to sell in foreign market) This shows that ORT = - BOP, i.e., ORT is negative of the sum of items on BOP account –Therefore, ORT is termed as accommodating entry in BOP accounts (b/c it always adjusts to keep BOP = 0) while the other (CA and KA) accounts are said to be autonomous

13 13 Fall 2007 NU-FAST Zahid Siddique The issue of deficit CA deficit may be expressed as difference between value of exports and imports of goods and services To see this, begin from national income identity –With slight rearrangements –It says that if output > domestic spending, NX > 0 (i.e., we have trade surplus), and if output < domestic spending, NX < 0 (i.e, we have trade deficit) –CA deficit then means a country is importing more than it is exportingignoring other small fractions in this total imports subtracted to find expenditures only on domestic goods

14 14 Fall 2007 NU-FAST Zahid Siddique The issue of deficit Another way to express deficit is the difference between national savings and investment Rearranging national income identity as –LHS is national saving, S N To see this, note that S N = S private + S public, where summing up we have LHS –so we have –means trade surplus if (S – I) > 0, and deficit if (S – I) < 0 Deficit now reflects low level of national savings relative to investment or a high rate of investmentor both

15 15 Fall 2007 NU-FAST Zahid Siddique The issue of deficit CA deficit matters b/c amount flowing to foreigners is used to buy assets in domestic countryi.e. CA deficit is financed by selling domestic assets –stream of incomes on assets is paid to foreigners thus limiting resources available for investment If foreigners are not buying our assets, country faces depreciation on its currency (to be discussed later) Deficit is highly unjustified if it is in shape of for consumption goods (as is case for Pakistan) due to insolvency issues Bearable if borrowing are used to finance investment that has a higher marginal product than interest rate –problematic if private financing not available in future consumption, investment, and government expenditures must be curtailed to repay in short order its past borrowings

16 16 Fall 2007 NU-FAST Zahid Siddique Exchange rate History of modern financial system evolution later, if possible Nominal Exchange rate is relative price of two currencies –Can be expressed in two ways measures how many units of domestic currency I can get in exchange for one unit of foreign currency measures how many units of foreign currency can be purchased by one unit of domestic currency US authors prefer first while Europeans prefer second definition –change in definition changes direction of movement of ER

17 17 Fall 2007 NU-FAST Zahid Siddique Exchange rate Real Exchange rate is relative price of two countries goods; i.e. how many units of foreign good can I get in exchange of one unit of domestic good, also called terms of trade Consider an example –a burger costs Rs240 in Pakistan and $2 in US –to compare where it is cheaper, covert its price into a common currency –if 1$ = Rs60, then US B costs Rs 120 which means that US B costs one-half of a Pak B ; i.e. two US B can be exchanged with one of Pak B –algebraically, Cancel out i.e. 1 US B = 0.5Pak B same as above now in same currency unit

18 18 Fall 2007 NU-FAST Zahid Siddique Exchange rate Putting formally, –If real exchange rate is high, foreign goods are cheaper while domestic ones are expensive, and vice versa However, with $/Rs definition of ER, formula becomes –Dont get confused if you find different versions in different books –Tip: refer to the definition of exchange rate for solution

19 19 Fall 2007 NU-FAST Zahid Siddique Purchasing Power Parity (PPP) Relation b/w nominal and real ER can be derived simply Assume all countries producing one and same good –None will exchange both goods but on one-to-one bases; i.e. –idea that similar domestic and foreign goods should have same price in terms of same currency is called PPP purchasing power of two currencies should be same across countries an application of the law of one price at international level due to the process of arbitrage Above expression implies that says that e nom should equal ratio of foreign to domestic price

20 20 Fall 2007 NU-FAST Zahid Siddique Purchasing Power Parity (PPP) If US B = $2 and Pak B = Rs240, then Data shows PPP does not holdneither in short nor long run –Many reasons account for it Countries dont produce similar goods Not all types of goods in a basket are freely traded Transaction costs and barriers against trade matter To see the general relationship b/w e nom and e real, apply percentage change on e real expression using log-rule or for PPP to hold, 1$ = Rs120 Difference b/w foreign and domestic inflation

21 21 Fall 2007 NU-FAST Zahid Siddique Purchasing Power Parity (PPP) –so we have –says that e nom is affected by inflation in two countries. It depreciates if real exchange rate decreases; or rate of domestic inflation is higher than foreign If e real is constant over time, then E.g. with US B = $2, Pak B = Rs240 and if π f = 0 while π d = 10% –after one year, still US B = $2 but Pak B = Rs264 –PPP predicts that e nom should change to –Similar result also holds for interest rate parity %Δe nom is exactly 10%

22 22 Fall 2007 NU-FAST Zahid Siddique Digression on terminologies Flexible exchange rate is one determined by the supply and demand conditions of a currency in the foreign exchange market (the market for international currencies) Fixed exchange rate is one determined by government at official level and is changed only by government actions Managed-floating exchange rate is one in which exchange rate responds to market conditions while central bank also intervenes to prevent undesirable movements in exchange rate Depreciation is a reduction in the value of a currency by market forces under flexible exchange rate system –increases in exchange rate means domestic currency depreciates and foreign currency appreciates (when exchange rate is defined as units of domestic currency / foreign currency)

23 23 Fall 2007 NU-FAST Zahid Siddique Digression on terminologies Appreciation is increase in the value of a currency due to market forces under flexible exchange rate system –decreases in exchange rate implies that domestic currency appreciates and foreign currency depreciates Devaluation is the reduction in the value of a currency by official government action under fixed exchange rate system Revaluation is the increase in the value of a currency by official by official government action under fixed exchange rate system If exchange rate is instead defined as units of foreign currency / one unit of domestic currency, the above definitions are reversed; that is depreciation would be called appreciation and so on

24 24 Fall 2007 NU-FAST Zahid Siddique Determination of floating exchange rate It is determined by demand for and supply of a currency The demand for, say $, arises when, say, Pakistani purchase US goods or assets Demand for a currency is negatively related to exchange rate –So b/c as exchange rate (Rs/$) increases, price of US goods in terms of Rs rises E.g. Suppose a US Cam = $1 and e nom = Rs 10/$. The camera costs Rs 10 to Pakistanis If e nom rises to Rs20/$, same camera costs Rs 20 –Pakistanis decrease imports demand from US, hence for its currency hence negative relation established 0 e nom Dollars D$D$

25 25 Fall 2007 NU-FAST Zahid Siddique Determination of floating exchange rate Supply of currency is positively related to exchange rate –So b/c as exchange rate increases, Pakistani exports become less expensive to US residents in terms of dollars E.g. Suppose a Pak Football = Rs10 and e nom = Rs 10/$. Then foot-ball would cost 1$ to US residents If, however, e nom increases to Rs 20/$, the same foot- ball will cost $0.5 now US order more export of foot-ball from Pakistan (hence more dollars supplied) ER is determined by the interaction of demand for and supply of foreign exchange Market exchange rate is e * and $ * dollars are traded in the international market 0 e nom Dollars D$D$ S$S$ e*e* $*$*

26 26 Fall 2007 NU-FAST Zahid Siddique Determination of floating exchange rate Factors that affect exchange rate are given below An Increase inCauses ER to BecauseIn Graph Domestic output (income), Y d FallHigher Y d raises demand for imports and increases supply of domestic currency S $ -curve shifts outward Foreign output (income), Y f RiseHigher Y f raises demand for domestic exports and increases demand for domestic currency D $ -curve shifts outward Domestic real interest rate, r RiseHigher real r makes domestic assets attractive and increases demand for domestic currency D $ -curve shifts outward Foreign real interest rate, r for FallHigher r for makes foreign assets more attractive and increases supply of domestic currency S $ -curve shifts outward

27 27 Fall 2007 NU-FAST Zahid Siddique Exchange rate and CA Factors that affect NX (or TB) are given below An Increase inCauses NX to Because Domestic output (income), Y d FallHigher Y d raises demand for imports hence decreases NX Foreign output (income), Y f RiseHigher Y f raises demand for our exports hence increases NX Domestic real interest rate, r FallHigher r appreciates exchange rate; domestic exports become expensive and imports from abroad become cheaper. Hence NX decrease Foreign real interest rate, r for RiseHigher r for depreciates exchange rate; domestic exports become cheaper while foreign imports expensive. Hence NX increase

28 28 Fall 2007 NU-FAST Zahid Siddique Determination of fixed exchange rate In a fixed ER system, government announces an official ER at which all trading take place This official ER may be above or below market (or fundamental value of) exchange rate This diagram shows that the official exchange rate is above the equilibrium one –In this case, the domestic currency ($) is overvalued. To keep ER at levels other than market ER, government becomes demander and supplier of its currency in foreign exchange market Here, supply of domestic currency (point b) in exceeds its private demand (point a) –hence excess supply (ab) 0 e nom Dollars D$D$ S$S$ e*e* $*$* eFeF b a

29 29 Fall 2007 NU-FAST Zahid Siddique Determination of fixed exchange rate Government can purchase excess currency in the amount ab against foreign reserve assets (e.g. gold, foreign bank deposits, assets created by IMF etc) However, central bank cant do it for long b/c it has limited supply of foreign reserve assets The process is even more difficult in case of speculative man one who buys currencies for arbitrage In case of undervalued fixed ER, country gains reserves at the cost of its trading partner (who is having overvalued currency) –It puts political pressure on the country to bring exchange rate at equilibrium rate 0 e nom Dollars D$D$ S$S$ e*e* $*$* eFeF b a


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