1. definitions the balance of payments is a form of state book keeping, where monetary inflows and...
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DefinitionsThe balance of payments is a form of state
book keeping, where monetary inflows and outflows are recorded
The number of transaction depends heavily on the exchange rate
The exchange rate might be floating (based on S&D) or fixed
Demand for a currency dependents on investment prospects in the home country
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Balance-of-Payments (BoP)It is a record of a country’s all international
monetary transactions over a specific period of time
Includes both private and government transactions
Inflows of money are recorded as credit (+)Outflows of money are recorded as debit (–)Every transaction is recorded twiceBoP should be balanced, but in reality this rarely
happensBoP is calculated quarterly and annually
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BOP ComponentsCurrent Account
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Item Debit Credit
Balance on trade (goods & services)
Imports (–) Exports (+)
Net income flows (wages, investment income e.g. profit, interest, dividends)
Outflows (–)
Inflows (+)
Net current transfers *(government contribution and aid & personal transfers e.g. remittances)
Outflows (–)
Inflows (+)
* Unilateral transfers, where one party benefits economically and provides nothing in return
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BOP Components (2)Capital Account
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Item Debit Credit
Net transfers of capital (acquisition or sale of fixed assets e.g. land, funds of migrants, government funds for capital projects (CAP & Cohesion)
Outflows (–)
Inflows (+)
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BOP Components (3)Financial Account
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Item Debit Credit
Direct Investment Outflows (–)
Inflows (+)
Portfolio Investment (shares, bonds, government securities)
Outflows (–)
Inflows (+)
Other short-term investment (trade credit, loans, bank deposits & currency)
Outflows (–)
Inflows (+)
Reserves * Adding (–) Drawing (+)
*Buying home currency at the foreign exchange market is considered a (–) from the reserve account, but a (+) in the BoP
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Recording transactionsExport of goods from UK
UK granting government aid (goods)
BG government loan ($) from IMF
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Debit Credit
Merchandise exports (current account) £ 125 000
Short term investment (financial account)
£ 125 000
Debit Credit
Unilateral transfer (current account) 10 million
Merchandise exports (current account) 10 million
Debit Credit
Loan (financial account) 50 million
Reserves (financial account) 50 million
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Balance of BoPCurrent Account + Capital Account + Financial
Account + Net Errors and Omissions = 0Net Errors and Omissions stem from statistical
mistakes, which are fixed before final calculation
Current Account deficit = M > XTo balance the deficit, governments can:BorrowDraw from reserves Sell assets abroadRaise the interest rate
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Trade deficit
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Trade deficit
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Exchange rate (floating) Exchange rate is the price at
which one currency trades for another
In free exchange rate system, the price of the currency is defined by S & D
When the exchange rate of the £ (vs. X) is high, people will be selling £
Too much £ (c-d) will cause depreciation of the currency
When the exchange rate of the £ (vs. X) is low, people will be buying £
Too few £ (a-b) will cause appreciation of the currency
Eventually there will be an equilibrium
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€
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BoP and exchange rate ?When the exchange rate of the pound is high,
imports are cheaper – pounds are going to be in excess on the market:
When the exchange rate is low, exports are cheaper – pounds are going to be in shortage on the market:
The exchange rate should help BoP balance12
Trade deficit Trade deficit Value of poundValue of pound
Trade surplus Trade surplus Value of poundValue of pound
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Shift in S & D for a currencyCauses for depreciation:Fall in interest rates Rise of inflation at home, compared to inflation abroadRise in incomes at home, compared to incomes abroadBetter business climate abroad, compared to climate at homeSpeculation
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1.40
1.20
€
Q of £
S1D1
S2D2
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Fixed exchange rateSome governments prefer to
stick to a fixed exchange rate, because:
There is more certainty There is less speculation
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Ex. rate
Price Cost Profit
£1=$1.50
$ 1.50 80p 20p
£1=$2 $ 1.50 80p – 5 p
• When the market price falls below the fixed one the difference is financed by:
Borrowing – foreign currency loan to buy out excess pounds
Drawing from reserves – use own currency reserves to buy out excess pounds
Raising interest rates – to raise the demand for the currency
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Drawbacks of a fixed exchange rateDo not work during economic recession –
high interests rates reduce aggregate demand and hamper economic activity
Fail in times of economic shock – during an oil crises, oil importing countries face pressure to devaluate their currencies – paying for the difference become too expensive
Cannot resist massive speculation – if demand for the currency is too low for too long, financing becomes impossible
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Intermediate regimesAdjustable peg – fixed in the short term,
adjusted in several yearsCrawling peg – is adjusted frequently by
small amountJoint float – group of currencies, using
adjustable peg among each other and jointly float vis-à-vis other currencies (ERM)
Exchange rate band – fluctuate within limits Managed float – free rate, but governments
intervene to buy and sell in turbulent times
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Currency board In a CB, the exchange rate is completely fixed
to a reserve (anchor) currencyThe country maintains a reserve of 110-115%
equivalent to the whole monetary baseThe government cannot print moneyBG adopted a CB in 1997, after experiencing
hyperinflationInitially the lev was pegged to the DM, later
on the the EuroIMF financed the CB
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The Euro – a panacea?By adopting the euro MS enjoyed following advantages:No more conversion costsNo uncertainty, stemming from floating currenciesLower inflation (strong confidence), guaranteed by ECBIncreased investment coming in the EU
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SourcesLecture is based on:The global financial environment in Sloman, J. and Jones, E. (2011) Economics and
the Business Environment (3rd ed) UK: Pearson
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