1 lectures 33-39: bop & exchange rate systems components of bop exchange rate and its...
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Lectures 33-39: BOP & Exchange Rate Systems
Components of BOPExchange rate and its determination
2 Fall 2007 NU-FAST Zahid Siddique
BOP Accounts
• Balance of Payment is record of a country’s international transactions—sum of current and capital accounts
BOP = CA + KA– Current Account is record of a country’s 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 Fall 2007 NU-FAST Zahid Siddique
BOP Accounts
– Capital Account is record of a country’s 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 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 Fall 2007 NU-FAST Zahid Siddique
Schematic representation of BOP
Accounts and Sub-accounts Cumulative 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 Fall 2007 NU-FAST Zahid Siddique
Schematic representation of BOP
Accounts and Sub-accounts Cumulative Balance
Capital Account (KA)
1) Direct investment
2) Portfolio investment
• Long & short termKA Balance = Value of capital inflow – Value of capital outflow
Over all BOP = CA + KA
Official reserve transaction
1) Changes in foreign CB’s holding of domestic assets
2) Changes in home CB’s holding of foreign assets
• Gold, foreign exchange reserves , IMF credits
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
Exports Credit item with plus sign
Imports Debit item with minus sign
Sell of domestic assets Credit item
Purchase of foreign assetsDebit item (b/c claim to asset enters country)
Purchase of assets by home CB
Debit item
8 Fall 2007 NU-FAST Zahid Siddique
Relationship among three: The Balance
• By definition CA + 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 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 waysa) 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 vanishCurrent Account
Exports + $100
Imports - $100
CA Balance 00Capital Account
No transaction
KA Balance 00
BOP 0
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
Imports 0
CA Balance + + $100$100
Capital Account
Capital outflow - $100
KA Balance - $100- $100
BOP 0
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 assets—i.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$100
Capital Account
KA Balance 00
BOP + $100CB’s holding of foreign assets - $100
surplus both on CA and BOP
BOP = -ORT
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 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 exporting—ignoring other small fractions in this total
MXGICY
SpendingDomesticOutputExportsNet
GICYNX
imports subtracted to find expenditures
only on domestic goods
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, SN
• To see this, note that SN = Sprivate + Spublic, 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 investment—or both
NXIGCY
TCYSprivate GTSpublic and
NXISN NXISN or
GTTCYSN
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 country—i.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 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
CurrencyForeignofUnitOneCurrencyDomesticofUnits
)1 nom e$1Rs10
CurrencyDomesticofUnitOneCurrencyForeignofUnits
)2 nom eRs1
$1.0
17 Fall 2007 NU-FAST Zahid Siddique
B
B
PakRs
240
USRs
120
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 USB costs Rs 120 which means that USB
costs one-half of a PakB; i.e. two USB can be exchanged with one of PakB
– algebraically,
B
B
PakRs
042
US$
2$Rs
60
reale
Cancel out
USPak
0.5 B
B
i.e. 1 USB = 0.5PakB same as
above
now in same currency unit
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 $/Rs definition of ER, formula becomes
– Don’t get confused if you find different versions in different books
– Tip: refer to the definition of exchange rate for solution
d
f
Rs$nomReal PP
ee
goodforeignofPricegoodDomesticofPriceRateExchangeNominal
RateExchangeReal
f
d
$RsnomReal PP
ee
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
d
f
$Rsnom PP
e
1f
d
$RsnomReal
PP
ee
says that enom should equal ratio of foreign to domestic price
20 Fall 2007 NU-FAST Zahid Siddique
Purchasing Power Parity (PPP)
• If USB = $2 and PakB = Rs240, then
• Data shows PPP does not hold—neither in short nor long run– Many reasons account for it
• Countries don’t 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 enom and ereal, apply percentage change on ereal expression using log-rule
or
1 $120 Rs
2 $240 Rs
$Rsnom e for PPP to hold, 1$ = Rs120
f
f
d
d
nom
nom
Real
Real
PP
PP
ee
e
e
d
d
f
f
Real
Real
nom
nom
PP
PP
e
e
ee
Difference b/w foreign and domestic inflation
21 Fall 2007 NU-FAST Zahid Siddique
Purchasing Power Parity (PPP)
– so we have
– says that enom is affected by inflation in two countries. It depreciates if• real exchange rate decreases; or• rate of domestic inflation is higher than foreign
• If ereal is constant over time, then
• E.g. with USB = $2, PakB = Rs240 and if πf = 0 while πd = 10%– after one year, still USB = $2 but PakB = Rs264
– PPP predicts that enom should change to
– Similar result also holds for interest rate parity
df
ee
nom
nom
df
e
e
ee
Real
Real
nom
nom
1 $132 Rs
2 $264 Rs
$Rsnom e %Δenom is exactly 10%
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 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 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 USCam = $1 and enom = Rs 10/$. The camera costs Rs 10 to Pakistanis
• If enom rises to Rs20/$, same camera costs Rs 20
– Pakistanis decrease imports demand from US, hence for its currency—hence negative relation established 0
en
om
Dollars
D$
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 PakFootball = Rs10 and enom = Rs 10/$. Then foot-ball would cost 1$ to US residents
• If, however, enom 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 $* dollars are traded in the international market 0
en
om
Dollars
D$
S$
e*
$*
26 Fall 2007 NU-FAST Zahid Siddique
Determination of floating exchange rate
• Factors that affect exchange rate are given below
An Increase in Causes ER to
Because In Graph
Domestic output (income), Yd
Fall Higher Yd raises demand for imports and increases supply of domestic currency
S$-curve shifts outward
Foreign output (income), Yf
Rise Higher Yf raises demand for domestic exports and increases demand for domestic currency
D$-curve shifts outward
Domestic real interest rate, r
Rise Higher real r makes domestic assets attractive and increases demand for domestic currency
D$-curve shifts outward
Foreign real interest rate, rfor
Fall Higher rfor makes foreign assets more attractive and increases supply of domestic currency
S$-curve shifts outward
27 Fall 2007 NU-FAST Zahid Siddique
Exchange rate and CA
• Factors that affect NX (or TB) are given below
An Increase in Causes NX to
Because
Domestic output (income), Yd
Fall Higher Yd raises demand for imports hence decreases NX
Foreign output (income), Yf
Rise Higher Yf raises demand for our exports hence increases NX
Domestic real interest rate, r
Fall Higher r appreciates exchange rate; domestic exports become expensive and imports from abroad become cheaper. Hence NX decrease
Foreign real interest rate, rfor
Rise Higher rfor depreciates exchange rate; domestic exports become cheaper while foreign imports expensive. Hence NX increase
28 Fall 2007 NU-FAST Zahid Siddique
Determination of fixed exchange rate
• In a fixed ER system, government announces an official ER at which all trading take place
• This official ER may be above or below market (or fundamental value of) exchange rate
• This diagram shows that the official exchange rate is above the equilibrium one– In this case, the domestic currency ($) 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
en
om
Dollars
D$
S$
e*
$*
eF
ba
29 Fall 2007 NU-FAST Zahid Siddique
Determination of fixed exchange rate
• Government can purchase excess currency in the amount ab against foreign reserve assets (e.g. gold, foreign bank deposits, assets created by IMF etc)
• However, central bank can’t do it for long b/c it has limited supply of foreign reserve assets
• The process is even more difficult in case of speculative man—one who buys currencies for arbitrage
• In case of undervalued fixed ER, country gains reserves at the cost of its trading partner (who is having overvalued currency)– It puts political pressure
on the country to bring exchange rate at equilibrium rate 0
en
om
Dollars
D$
S$
e*
$*
eF
ba