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Chapter 28 Exchange rates and the balance of payments

Chapter 28 Exchange rates and the balance of payments. David Begg, Stanley Fischer and Rudiger Dornbusch, Economics , 9th Edition, McGraw-Hill, 2008 PowerPoint presentation by Alex Tackie and Damian Ward. Nominal Exchange Rates.

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Chapter 28 Exchange rates and the balance of payments

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  1. Chapter 28Exchange rates and the balance of payments David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 9th Edition, McGraw-Hill, 2008 PowerPoint presentation by Alex Tackie and Damian Ward

  2. Nominal Exchange Rates • The nominal exchange rate is the rate at which a person can trade the currency of one country for the currency of another.

  3. Nominal Exchange Rates • The nominal exchange rate is expressed in two ways: • In units of foreign currency per one U.S. dollar. • And in units of U.S. dollars per one unit of the foreign currency.

  4. Nominal Exchange Rates • Assume the exchange rate between the Japanese yen and U.S. dollar is 80 yen to one dollar. • One U.S. dollar trades for 80 yen. • One yen trades for 1/80 (= 0.0125) of a dollar.

  5. Nominal Exchange Rates • Appreciation refers to an increase in the value of a currency as measured by the amount of foreign currency it can buy. • Depreciation refers to a decrease in the value of a currency as measured by the amount of foreign currency it can buy.

  6. The foreign exchange market - the international market in which one national currency can be exchanged for another. DD shows the demand for pounds by Americans wanting to buy British goods/assets. Suppose 2 countries: UK & USA SS shows the supply of pounds by UK residents wishing to buy American goods/assets. SS SS1 e0 Exchange rate ($/£) Equilibrium exchange rate is e0 e1 If UK residents want more $ at each exchange rate, the supply of £ moves to SS1 DD New equilibrium at e1. Quantity of pounds The exchange rate is the price at which two currencies exchange.

  7. Exchange rate regimes In a fixed exchange rate regime the national governments agree to maintain the convertibility of their currency at a fixed exchange rate. In a flexible exchange rate regime the exchange rate is allowed to attain its free market equilibrium level without any government intervention using exchange reserves.

  8. Intervention in the forex market If the demand for pounds is DD1 there is excess demand AC. A C E The Bank of England must supply AC £s in return for $, which are added to reserves. DD1 The reverse occurs if demand is at DD2. DD2 Suppose the government is committed to maintaining the exchange rate at e1 ... SS $/£ e1 DD When demand is DD, no intervention is needed ... Quantity of £s there is a balance in transactions between the countries.

  9. The balance of payments … a systematic record of all transactions between residents of one country and the rest of the world Current account records international flows of goods, services, income and transfer payments Capital account records transactions involving fixed assets Financial account records transactions in financial assets

  10. The UK balance of payments, 1980-2006 Source: Economic Trends Annual Supplement

  11. Balance of Payment The interaction between the domestic agents with the foreign agents. 1. Current Account: Exports (+), Imports(-), Take aid (+), Give aid (-), income coming from abroad (+), income going to abroad (-). 2. Capital Account: Foreigners buying stocks (+), domestic buying foreign stocks (-), capital investment to abroad (-), foreign investment to Turkey (+).

  12. Balance of Payment Current Account + Capital Account =0.

  13. Components of the balance of payments The current account is influenced by: competitiveness domestic and foreign income The capital & financial accounts are influenced by: relative interest rates which affect international capital flows. Perfect capital mobility occurs when there are no barriers to capital flows, and investors equate expected total returns on assets in different countries

  14. Balance of Payments (Turkey_2007-2011)

  15. 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. Any current account imbalance is exactly matched by an offsetting balance in capital/financial accounts. If there is intervention, it is recorded as part of the financial account.

  16. Fixed Exhange Rate and Balance of Payments The central bank promises to keep the nominal exchange rate at a specified level. E.g. if exports<imports : need foreign currency. Foreign currency become more valuable, central bank should increase the dollar supply by using its reserves.

  17. Some Important Identities • Assume a closed economy – one that does not engage in international trade: Y = C + I + G

  18. Some Important Identities • Now, subtract C and G from both sides of the equation: Y – C – G =I • The left side of the equation is the total income in the economy after paying for consumption and government purchases and is called national saving, or just saving (S).

  19. Some Important Identities • Substituting S for Y - C - G, the equation can be written as: S = I

  20. Some Important Identities • National saving, or saving, is equal to: S = I S = Y – C – G S = (Y – T – C) + (T – G)

  21. The Meaning of Saving and Investment • National Saving • National saving is the total income in the economy that remains after paying for consumption and government purchases. • Private Saving • Private saving is the amount of income that households have left after paying their taxes and paying for their consumption. Private saving = (Y – T – C)

  22. The Meaning of Saving and Investment • Public Saving • Public saving is the amount of tax revenue that the government has left after paying for its spending. Public saving = (T – G)

  23. Saving, Investment, and Their Relationship to the International Flows • Net exports is a component of GDP: Y = C + I + G + NX • National saving is the income of the nation that is left after paying for current consumption and government purchases: Y - C - G = I + NX

  24. Domestic Investment Net Capital Outflow Saving = + S I = + NCO Saving, Investment, and Their Relationship to the International Flows • National saving (S) equals Y - C - G so: S = I + NX or

  25. International competitiveness The competitiveness of UK goods in international markets depends upon: the nominal exchange rate relative inflation rates. Overall competitiveness is measured by the real exchange rate which measures the relative price of goods from different countries when measured in a common currency. $/YTL Reel döviz kuru= e$/YTL *Ptr /Pabd

  26. Relative prices and the nominal exchange rate, UK & USA Relative price (UK/USA) Exchange rate ($/£)

  27. The real £/$ exchange rate The real exchange rate is the nominal rate multiplied by the ratio of domestic to foreign prices

  28. Real$/TLExchange Rate

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