David Begg, Foundations of Economics , Third Edition McGraw-Hill, 2006

1. Foundations of Economics David Begg, Foundations of Economics, Third Edition McGraw-Hill, 2006 Power Point presentation by Peter Smith Adapted for the Third Edition by Lester C Hunt, UniS.

2. Chapter 12Exchange rates and thebalance of payments

3. 12.1 Exchange rates and thebalance of payments By the end of this section, you should understand: ◆ The forex market ◆ Balance of payments accounting ◆ Internal and external balance

4. Open economy macroeconomics • The openness of the economy of a country is the extent to which it trades with the rest of the world • exports and imports are influenced by exchange rates and international competitiveness • trade flows influence financial flows and hence monetary and fiscal policy • When an economy is very open to foreign trade, the exchange rate, international competitiveness, and the trade balance with foreigners become major policy issues

5. The foreign exchange market 1 • Foreign exchange (forex) market • exchanges one national currency another • Exchange rate • price at which two currencies exchange • Fixed exchange rate regime • Where the governments, acting through their central banks, will buy or sell as much of the currency as people want to exchange at the fixed rate • Foreign exchange reserves • the foreign currency holdings of the domestic central bank • Devaluation • a fall in the fixed exchange rate • Revaluation • A rise in the fixed exchange rate

6. The foreign exchange market 2 • Floating exchange rate regime • where the exchange rate is allowed to find its free market equilibrium without any intervention using the foreign exchange reserves • Appreciation • Where the exchange rates rises • E.g. a higher $/£ rate • Depreciation • Where the exchange rates falls • E.g. a lower $/£ rate • Dirty floating • means some intervention in the short run but allowing the exchange rate to find its equilibrium level in the longer run

7. The foreign exchange market 3 DD shows the demand for pounds by Americans wanting to buy British goods/assets SS shows the supply of pounds by UK residents wishing to buy American goods/assets SS A Exchange rate ($/£) e1 Equilibrium exchange rate is e1 DD Quantity of pounds

8. The foreign exchange market 4 If the US demand for UK goods or assets rises, the demand for £ shifts right to DD1 The equilibrium $/£ exchange rate appreciates (point B) If the US demand for UK goods or assets falls, the demand for £ shifts left right to DD2 The equilibrium $/£ exchange rate depreciates (point D) SS B A Exchange rate ($/£) e1 E DD1 D DD DD2 Quantity of pounds

9. Fixed exchange rate regime 1 If the fixed exchange rate is e1, the free market equilibrium rate, then the market clears unaided But if the demand for pounds increases to DD1 then in a free market there would be a new equilibrium at B with the £ appreciating against the $. At the fixed exchange rate e1 there is an excess demand AC for £ To meet this, the Bank prints AC extra £ and sells them in exchange for [e1xAC] of $ which are added to the UK foreign exchange reserves. SS B A Exchange rate ($/£) C e1 DD1 DD Quantity of pounds

10. Fixed exchange rate regime 2 But if the demand for pounds decreases to DD1 then in a free market there would be a new equilibrium at C with the £ depreciating against the $. At the fixed exchange rate e1 there is an excess supply EA for £ To defend the fixed exchange rate the Bank buys EA £s, paid for by selling [e1xEA] of $ from the foreign exchange reserves. SS A Exchange rate ($/£) e1 E D DD DD2 Quantity of pounds

11. Fixed exchange rate regime 3 • If the demand for £ on average is DD2, the Bank on average is reducing the UK forex reserves to support the £ at e1 • The £ is overvalued • As reserves run out, the government may try to borrow foreign exchange reserves from the International Monetary Fund [IMF], an international body that lends to governments in short-term difficulties • But at best this is a temporary solution • Unless the demand for £ rises in the long run, it will be necessary to devalue the pound

12. Floating exchange rate regime With no intervention the exchange rate is allowed to adjust to its free market level. Starting at A if demand increases to DD1the exchange rate appreciates to B But if it falls to DD2 it depreciates to D SS B A Exchange rate ($/£) e1 DD1 D DD DD2 Quantity of pounds

13. The balance of payments 1 • Balance of payments • records all transactions between a country and the rest of the world • Current account • records international flows of goods, services, income and transfer payments • Visible trade • exports and imports of goods (cars, food, steel) • Invisible trade • exports and imports of services (banking, shipping, tourism). • Capital account • shows international flows of transfer payments relating to capital items

14. The balance of payments 2 • Financial account • records international purchases and sales of financial assets • Balancing item • a statistical adjustment • would be zero if all previous items had been correctly measured • reflects a failure to record all transactions in the official statistics. • Official financing • This is always of equal magnitude and opposite sign to the balance of payments • measures the international transactions that the government must take to accommodate all the other transactions in the balance of payments accounts

15. The balance of payments 3

16. Floating exchange rates and the balance of payments • If the exchange rate is free to move to its equilibrium, there is no need for intervention and forex reserves are constant • the exchange rate equates the supply and demand for pounds • a current account surplus (deficit) is exactly matched by a capital account deficit (surplus) and vice versa

17. Fixed exchange rates and the balance of payments • With a fixed exchange rate the balance of payments can be in deficit or surplus • to maintain the exchange rate the central bank must sell foreign currency to buy pounds to cover a deficit and vice versa to cover a surplus. • This is the official financing

18. The current account • Imports depend upon income • exports depend upon the incomes of our customers abroad and international competitiveness • international competitiveness depends upon exchange rates and countries’ relative inflation

19. The capital account • Capital flows are affected by countries’ relative interest rates and exchange rates • perfect capital mobility occurs when interest rate differentials are offset by exchange rate differences

20. Internal and external balance • Internal balance • a situation for a country when aggregate demand equals potential output • External balance • a situation for a country when the current account of the balance of payments is zero • The combination of internal and external balance is the long-run equilibrium for the economy.

21. 12.2 Monetary policy in open economies By the end of this section, you should understand: ◆ Monetary policy with fixed exchange rates ◆ The impact of devaluation ◆ Monetary policy with floating exchange rates

22. Monetary policy underfixed exchange rates 1 • With perfect capital mobility, monetary policy is powerless • Domestic interest rates must match foreign interest rates • this means that fiscal expansion will not bid up domestic interest rates

23. Monetary policy underfixed exchange rates 2 • Devaluation • Is a fall in the fixed exchange rate; • in the short-run if prices and wages adjust slowly, the short run effect of devaluation is to slowly improve international competitiveness • in the medium run, internal balance may be restored but inflationary pressure may require a fiscal response • In the long run, wages and prices adjust fully and the economy returns to equilibrium.

24. Monetary policy underfloating exchange rates • Domestic and foreign monetary policies determine domestic and foreign prices • In the short-run the exchange rate may display instability in relation to the rate required to achieve current account balance • Fiscal policy is less powerful in the short-run; the fiscal stance will induce interest rate changes that in turn affect the exchange rate • Under fixed exchange rates, domestic monetary policy was powerless; under floating exchange rates, the converse is true