1. Chapter 2. Exchange Rate Determination
Balance of Payments (BOP) Approach
Managerial Significance of BOP Imbalances
International Parity Conditions
Interest Rates and Exchange Rates

2. Exchange Rate Determination

3. Generic BOP

4. CURRENT ACCOUNT BALANCE WITH IMF STANDARD
BALANCE ON GOODS
Trade Balance = Exports – Imports
BALANCE ON SERVICES
Selling Services = (Credits, +)
Purchasing Services = (Debits, -)
BALANCE ON INCOME
Investment Income = (Credits, +)
Compensation of Employees = (Debits, -)
BALANCE ON GOODS, SERVICES AND INCOME
Trade Balance – Services balance – Income Balance
BALANCE ON CURRENT TRANSFER
Payments for home migrants, workers abroad, fees payaments to students abroad
CURRENT ACCOUNT BALANCE
Trade Balance – Services Balance – Income Balance – Transfer Balance

5. BOP of USA in IMF Format

6. Balance of Payments, Turkey, billion USD.

7. BOP of North Cyprus (m. US $)
Source: State Planning Organization, TRNC.

8. USA

9. JAPAN

10. GERMANY

13. Balance of Payments in Comparison (% of GDP)

14. WORLD TRADE PROFILE

15. LATEST WORLD TRADE PROFILE
HW # 2
LATEST WORLD TRADE PROFILE
FOR
2016

16. Approaches in Balancing BOP
Exchange Rate Adjustments and Elasticity Approach
National Income Approach
Total Consumption (Absorption) Approach
Monetary Approach

17. Exchange Rate Adjustments and Elasticity Approach
Mostly related with Current Account Balance
When deficit in CA, excess supply of the domestic currency, so domestic currency is likely to depreciate
When surplus in CA, excess demand for domestic currency, so domestic currency is likely to appreciate
IF Ex + Em  1, then devaluation is BENEFICIAL
IF NOT, IT IS HARMFUL

18. National Income Approach
Y = C + I + G + (X – M) .....(Keynesian Theory)
Net Exports = Trade Balance
M = m(Y) m = MPI
M depends on Y
So which policy is to be adopted in case of a Deficit and a Surplus in BOP and when?

19. Fiscal Policy G  Taxes  So; C,I  and Y  and M 
In case of a Deficit:
G  Taxes  So; C,I  and Y  and M 
So net exports adjusts toward equilibrium, Deficit 
In case of a Surplus, the reverse will happen!!!

20. Monetary Policy Government follows Restrictive Monetary Policy:
In case of a Deficit:
Government follows Restrictive Monetary Policy:
MS  i  I  Y  and M 
Monetary policy is related with Capital Account Balance of BOP, not CA Balance
In case of Restrictive Monetary and Fiscal Policy, Unemployment will be SPEEDING UP, why?

21. Absoption Approach Y = C + I + G + (X-M) Y = A + (X-M)
where A means total domestic expenditures
and,
Y – A = X – M
If Y > A, excess production and a surplus trade balance
If Y < A, excess demand and a deficit in trade balance
When Y is increased, A will also increase but if Y > A (and MPS is positive), then devaluation will be beneficial in an underemployed economy.

22. Monetary Approach Real Demand for money: Md / P Md / P = f (y, i)
Money supply: MS = A ( D + R)
When D is driven to the economy:
Money supply increases
Consumption and investment-savings increase
Part of the investment goes to the foreign portfolios
There will be an outflow in capital account of balance of payments (BOP)
So, an increase in MS will damage BOP.
An increase in MS will have a negative effect on trade and capital balance of BOP, there will be a deficit.

23. Balance Of Payments

24. BOP IMBALANCES

25. Imbalances in Fixed Rate Countries

26. Relations in Parity Conditions

27. PPP

28. Relative PPP
PTurkey= 50%
PUSA= 10%

29. Relative PPP
PUSA > PJapan by 4 %

30. Indices

31. Exchange Rate Pass-Through
Complete Pass-Through
Both exchange rates and prices change proportionally (100%)
Partial Pass-Through
If the changes are not proportional, then it is Partial (<100%)

32. Example Assume: PEURBMW = EUR35,000 S1 = USD1.232/EUR P$BMW = $43,120
If EUR appreciates 5%, S2 = USD1.293/EUR, then P$BMW theoretically should be $45,255 (EUR35,000  USD /EUR). But P$BMW is only $44,000.
Then the degree of Pass-Through is only partial. P$BMW rose only 2.04% while SUSD/EUR increased by 5%.
Degree of pass through = 2.04%  5% = = 40.8%
The remaining 2.96% (5% – 2.04%) of the exchange rate change has been absorbed by BMW.

33. Price Elasticity vs Pass-Through
When BMW is Price Inelastic,
High degree of Pass-Through. When P , then little effect on Q, so TR will 
When BMW is Price Elastic,
Consumers would reduce the number of BMWs purchased,
so TR will 

34. FISHER EFFECT
i = r +  i = nominal interest rates r = real interest rates  = expected rate of inflation So; Real interest rates =  - i

35. International Fisher Effect
Example:
$ based investor buys a 10-year Yen bond earning 4%, compared with 6% interest available on $.
Investor expects Yen to appreciate against $ by at least 2% per year during 10 years.
If not, $ based investor will be better off.
If Yen appreciates by 3% during 10 years, $ based investor would earn 1% higher return of bonus.

36. Interest Rate Parity
IRP
Calculation of Forward Rates at IRP

37. IRP

38. CIA

39. IRP and Equilibrium

40. CIA