# International Finance Lecture 3 EXCHANGE RATE AND BALANCE OF PAYMENTS.

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International Finance Lecture 3 EXCHANGE RATE AND BALANCE OF PAYMENTS

After studying this unit, you will be able to: Describe the foreign exchange market, define the exchange rate, and distinguish between the nominal exchange rate and the real exchange rate Calculate the real exchange rate Explain how the exchange rate is determined day by day Explain the factors that influence the demand for and supply of rand Show the demand for and supply of rand graphically, and indicate equilibrium in the foreign exchange market Evaluate the effect of changes in the demand for and supply of rand on the equilibrium exchange rate, and show it graphically

After studying this unit, you will be able to: Discuss the long-run trends in the exchange rate and explain interest rate parity and purchasing power parity Discuss the balance of payments accounts and explain what causes an international deficit Calculate the various balances of the balance of payments Compare the alternative exchange rate policies and explain their long-run effects

Themes of this unit: 1.Currencies and Exchange Rates 2.The Foreign Exchange Market 3.Changes in Demand and Supply: Exchange Rate Fluctuations 4.Financing International Trade 5.Exchange Rate Policy

Currencies and Exchange Rates Foreign currency is obtained in exchange for domestic currency in the foreign exchange market. The nominal exchange rate is the value of one currency in terms of another currency. The Foreign Exchange Market Exchange Rates

Economic agents who supply or demand foreign exchange Exporters –Suppliers of goods to foreign buyers receive payments in foreign currency that they exchange for local currency thus they tend to supply foreign currency onto the local foreign exchange market. Importers –These require foreign exchange to pay for the goods that are acquired from elsewhere in overseas. Foreign investors –Foreign investors buy SDG in other to acquire assets such as buildings in the Sudan or shares in Sudanese businesses. Speculators –They operate in the foreign currency market in order to make profit by buying and selling the foreign exchange. 6

Exchange rate regimes Copeland identifies three broad categories: –Floating rates –fixed rates and –managed floats The International Monetary Fund classifies exchange rate arrangements into eight categories: 7

Exchange rate arrangements in the 185 IMF member countries No.Exchange rate arrangement20072008 1No separate legal tender5.32 2Currency board6.91 3Conventional peg33.532.45 4Peg with horizontal band2.661.60 5Crawling band0.531.06 6Crawling peg3.194.26 7Managed floating25.5323.4 8Independently floating18.6221.28 IMF (2009), Annual Report of Exchange rate arrangement and exchange rate restrictions, International Monetary Fund, Washington, D.C. 8

Exchange Rate regimes since 1940 Source: People’s Bank of China, 2009 9

Exchange Rate Structure Unitary Dual Multiple –Most countries are moving towards a unitary exchange rate market for sake of market efficiency among others. 10

Attributes of the ideal regime The best regime ought to have three important attributes, this is usually described as the “impossible trinity”: –Exchange rate stability –Full financial integration –Monetary independence The forces at play in economics do not allow the simultaneous attainment of all three goals. 11

Fixed versus floating A country’s choice of exchange rate regime depends on national priorities such as: –Inflation –Unemployment –Interest rate –Trade balances and –Economic growth 12

Fixed versus floating Countries will go for a fixed rate regime for the following reasons: –Stability in international prices –Inherent anti-inflationary nature of fixed prices Fixed regime: –Need for central bank to maintain large quantities of hard currencies and gold to defend the fixed rate. –Fixed rates may be maintained at rates that are out of tune with economic fundamentals. 13

Nominal and Real Exchange Rates The real exchange rate is the relative price of foreign- produced goods and services to locally produced goods and services.

The Effective Exchange Rate The effective exchange rate is the average exchange rate of the rand against a basket of currencies. Questions About the Exchange Rate

The Foreign Exchange Market Demand and supply in the foreign exchange market determine the exchange rate. The Demand for One Money Is the Supply of Another Money Demand in the Foreign Exchange Market  The exchange rate  World demand for South African exports  Interest rates in South Africa and other countries  The expected future exchange rate  The Law of Demand for Foreign Exchange  Exports Effect  Expected Profit Effect

Demand Curve for South African Rand Supply in the Foreign Exchange Market  The exchange rate  South African demand for imports  Interest rates in South African and other countries  The expected future exchange rate

Demand Curve for South African Rand The Law of Supply of Foreign Exchange  Imports Effect  Expected Profit Effect Supply Curve for South African Rand

Market Equilibrium The equilibrium exchange rate makes the quantity of rand demanded equal the quantity of rand supplied.

Changes in Demand and Supply: Exchange Rate Fluctuations Changes in the Demand for South African Rand  World Demand for South African Exports  South African Interest Rate Relative to the Foreign Interest Rate  The Expected Future Exchange Rate

Changes in the Supply of South African Rand  South African Demand for Imports  South Africa’s Interest Rate Relative to the Foreign Interest Rate  The Expected Future Exchange Rate

Changes in the Exchange Rate An Appreciating South African Rand: 2002–2006 A Depreciating Rand: 1999–2001

Financing International Trade International trade, borrowing, and lending are financed by using foreign currency. A country’s international transactions are recorded in its balance of payments. Balance of Payments Accounts The balance of payments consists of a:  current account  capital transfer account  financial account  change in net gold and other foreign reserves.

An Individual’s Balance of Payments Accounts Borrowers and Lenders Debtors and Creditors Current Account Balance

Net Exports The current account balance is similar to net exports and is determined by the government sector balance plus the private sector balance.

Where Is the Exchange Rate? Exchange Rate Policy An exchange rate can be flexible, fixed, a crawling peg. To achieve a fixed or a crawling exchange rate, a central bank must intervene in the foreign exchange market. Flexible Exchange Rate Fixed Exchange Rate

Crawling Peg The People’s Bank of China in the Foreign Exchange Market Why Does China Fix Its Exchange Rate?

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