The Balance of Payments and the Effective Exchange Rate Chapter 3 The Balance of Payments and the Effective Exchange Rate

Objectives To study the structure of the balance of payments To illustrate how the BOP is related to the FX market To introduce the concept of the effective exchange rate

Definition The balance of payments (BOP) is a systematic record of all economic transactions between the residents of the reporting country and the rest of the world over a specified period of time.

Important elements in the definition Rest of the world Economic transactions Resident Flows versus stocks

Important elements in the definition (cont.) The BOP records changes in assets and liabilities Figures may or may not be seasonably adjusted

Structure of the BOP The BOP consists of the current account and the financial account

Components of the current account Merchandise account (trade balance) Net services Current transfers

The financial account Records official and non-official net financial flows A balancing item is added to account for errors and omissions

The Australian BOP: Current account (AUD Million)

The Australian BOP: Financial account (AUD Million)

The Australian BOP: Balancing item (AUD Million)

The BOP and FX market The BOP is related to the FX market because transactions involving trade and capital flows give rise to the demand for and supply of currencies The demand for foreign currency is the supply of domestic currency, and vice versa

Derivation of the demand and supply curves The demand for foreign exchange is equivalent to import expenditure The demand curve is derived from the supply and demand for imports (cont.)

Derivation of the demand and supply curves (cont.) The supply of foreign exchange is equivalent to export revenue. The supply curve is derived from the supply of and demand for exports.

The demand side equations The following equations are used to derive the demand curve:

The supply side equations The following equations are used to derive the supply curve:

The demand for and supply of foreign exchange curves

Factors affecting the current account Economic growth: A country with a higher growth rate than its trading partners will experience deterioration in the current account. (cont.)

Factors affecting the current account (cont.) The exchange rate: The effect of the exchange rate depends on the elasticities of demand for exports and imports. (cont.)

Factors affecting the current account (cont.) Inflation: A country that has a higher inflation rate than its trading partners will experience deterioration in the current account. (cont.)

Improving current account (zero domestic inflation)

Deteriorating current account (high domestic inflation)

Factors affecting the current account (cont.) Trade restrictions: One reason for imposing trade restrictions, such as tariffs and quotas, is the desire to protect the current account.

Factors affecting the financial account Taxes: Taxes that are imposed on capital gains and/or income from dividends and interest payments may adversely affect the financial account. This is because foreign investors no longer find it attractive to invest in the underlying country’s securities. (cont.)

Factors affecting the financial account (cont.) Capital controls: Capital controls are imposed typically to deal with a chronic weakness in the balance of payments. (cont.)

Factors affecting the financial account (cont.) The expected change in the exchange rate: If a currency is expected to appreciate, the expected rate of return on investment in securities denominated in that currency will be higher, attracting capital flows. Thus, a country’s financial account will improve if that country’s currency is expected to appreciate.

The effective exchange rate The effective exchange rate is an index of a weighted average of the nominal exchange rates against the currencies of major trading partners.

The EER equations The following equations are used to calculate the EER: (cont.)

The EER equations (cont.) The following equations are used to calculate the weights:

What does the RBA do in practice? The RBA calculates a nominal effective exchange rate called the trade-weighted index (TWI). (cont.)

What does the RBA do in practice? (cont.) As the name implies, the index is calculated on the basis of the (bilateral) trade shares of Australia’s major trading partners. (cont.)

What does the RBA do in practice? (cont.) Until October 1988 the TWI was calculated as an arithmetic weighted average, but since then the RBA has shifted to using a geometric weighted average. Major trading partners are those accounting for at least 90 per cent of Australia’s trade (exports plus imports).

The weights used by the RBA to calculate the TWI

The RBA’s trade-weighted index, January (1970 = 100)

The real exchange rate The real exchange rate is the nominal exchange rate adjusted for differences in prices or inflation rates:

The real effective exchange rate The real effective exchange rate can be calculated from the real bilateral exchange rates: