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Balance of Payments. Chapter Three Eitman, Stonehill, and Moffett. Balance of Payments. Balance of Trade. Capital Account. Reserve account. Financial account. Cash flows. For example: the Balance of Trade (Current account) BOT = X – M. Exchange rate equilibirum. Demand for the dollar

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balance of payments

Balance of Payments

Chapter Three

Eitman, Stonehill, and Moffett

ESM Chapter 3 - Balance of Payments

balance of payments2
Balance of Payments

Balance of Trade

CapitalAccount

Reserve account

Financial account

ESM Chapter 3 - Balance of Payments

cash flows
Cash flows
  • For example: the Balance of Trade (Current account)
    • BOT = X – M

ESM Chapter 3 - Balance of Payments

exchange rate equilibirum
Exchange rate equilibirum
  • Demand for the dollar
    • all foreigners buying Canadian
    • all Canadians selling foreign assets
  • Supply of the dollar
    • Canadians buying foreign goods and services
    • foreigners selling Canadian assets
  • Where demand equals supply
    • Equilibrium price (Exchange Rate) and Quantity

ESM Chapter 3 - Balance of Payments

equilibrium
Equilibrium

S1

usd/cd

eo, 0, cd

D1

Qo, cd

Qcd

ESM Chapter 3 - Balance of Payments

demand for the dollar credits
Demand for the dollar(Credits)
  • Exports (X)
    • British buying Canadian goods
    • Germans vacationing in Newfoundland
  • Capital inflows – real assets (CI)
    • Walmart buying out Woolco
    • Toyota building a plant in
  • Financial inflows – financial assets (FI)
    • US investors buying Canadian Imperial, Vulcan
    • Germans buying NF CD denominated bonds

ESM Chapter 3 - Balance of Payments

supply of the dollar debits
Supply of the dollar (Debits)
  • Imports (I)
    • Buying Sonys
    • Spending a week at Disneyworld
    • Canadians spending six months of the year in Texas
  • Capital Outflows – real assets (CO)
    • Inco buying a property in Indonesia
    • Couple retiring to Florida buying a condo there
  • Financial Outflows - financial assets (FO)
    • Buying shares in Microsoft
    • Buying euro denominated bonds

ESM Chapter 3 - Balance of Payments

current account balance of trade bot
Current account – balance of trade (BoT)
  • goods
    • value of exports of goods - imports of goods
  • services (communications, information, financial)
    • value of exports of svcs - imports of svcs
  • net income transfers
    • interest & dividends pd on foreign investments
    • pensions pd to Canadians living overseas
    • transfers (sending checks to E. Europe)

ESM Chapter 3 - Balance of Payments

balance of trade
Balance of Trade

ESM Chapter 3 - Balance of Payments

capital account
Capital Account
  • transactions to non-financial and non-produced assets
  • debt forgiveness
  • transfer of goods and financial assets by migrants leaving or entering a country
  • transfer of ownership on fixed assets
  • transfer of funds received to the sale or acquisition of fixed assets
  • gift and inheritance taxes, death levies, patents, copyrights, royalties, and uninsured damage to fixed assets.

ESM Chapter 3 - Balance of Payments

financial account
Financial account
  • foreign direct investment
    • investment in real assets
  • portfolio investment
    • equities
    • debt
  • intangibles
    • patents, leases, goodwill
  • errors and omissions

ESM Chapter 3 - Balance of Payments

capital inflows capital outflows financial account
Capital inflows – capital outflowsFinancial Account
  • Capital inflows
    • Foreign direct investment in Canada
    • Foreign portfolio investment in Canada
    • Other investment in Canada
  • Capital outflows
    • Canadian foreign direct investment
    • Canadian foreign portfolio investment
    • Other foreign investment by Canada

ESM Chapter 3 - Balance of Payments

financial account13
Financial Account

ESM Chapter 3 - Balance of Payments

official reserves account
Official reserves account
  • Central Bank interventions in exchange markets
  • changes in official reserves by buying or selling
    • gold, silver
    • foreign currencies
    • Foreign denominated debt
    • Buy or sell options or futures in markets
    • SDRs (Special Drawing Rights at IMF)

ESM Chapter 3 - Balance of Payments

balance of payments15
Balance of payments
  • Assume BOP > 0
    • Canadians are selling more abroad than they are buying
      • Goods, services
      • Capital goods
      • Financial goods
  • If exchange rates are allowed to seek an equilibrium (floating exchange rates)
    • Supply of the Canadian dollar increases in exchange markets
    • The exchange rate will adjust to accommodate imbalance

ESM Chapter 3 - Balance of Payments

effects of bop
Effects of BOP
  • Fixed exchange rates
    • CB uses FXB to bring BOP = 0
  • Floating exchange rates
    • CB ignores BOP
    • The exchange rate will adjust to accommodate imbalance
    • CB may intrude into the exchange market to reduce volatility

ESM Chapter 3 - Balance of Payments

exchange rate equilibrium
Exchange rate equilibrium
  • Demand for the dollar
    • all foreigners buying Canadian
    • all Canadians selling foreign assets
  • Supply of the dollar
    • Canadians buying foreign goods and services
    • foreigners selling Canadian assets
  • Where demand equals supply
    • Equilibrium price (Exchange Rate) and Quantity

ESM Chapter 3 - Balance of Payments

equilibrium18
Equilibrium

S1

usd/cd

eo, 0, cd

D1

Qo, cd

Qcd

ESM Chapter 3 - Balance of Payments

demand for the dollar credits19
Demand for the dollar(Credits)
  • Exports (X)
    • British buying Canadian goods
    • Germans vacationing in Newfoundland
  • Capital inflows – real assets (CI)
    • Walmart buying out Woolco
    • Toyota building a plant in
  • Financial inflows – financial assets (FI)
    • US investors buying Canadian Imperial, Vulcan
    • Germans buying NF CD denominated bonds

ESM Chapter 3 - Balance of Payments

supply of the dollar debits20
Supply of the dollar (Debits)
  • Imports (I)
    • Buying Sonys
    • Spending a week at Disneyworld
    • Canadians spending six months of the year in Texas
  • Capital Outflows – real assets (CO)
    • Inco buying a property in Indonesia
    • Couple retiring to Florida buying a condo there
  • Financial Outflows - financial assets (FO)
    • Buying shares in Microsoft
    • Buying euro denominated bonds

ESM Chapter 3 - Balance of Payments

bop surplus from the canadian perspective
BOP surplus from the Canadian perspective
  • US consumers buying more Canadian stuff
    • Demanding cd with which to buy Canadian stuff
  • free float allows a new equilibrium
      • usd price of the cd increases
        • cd appreciates
          • US goods lower in price to Canadians
        • usd depreciates
          • Canadian goods higher in price to the U.S.
      • Corrects BOP imbalance, so that BOP approaches 0

ESM Chapter 3 - Balance of Payments

excess demand for cd
Excess Demand for cd

S1

usd/cd

en, 0, cd

eo, 0, cd

D2

D1

Qo, cd

Qn, cd

Qcd

ESM Chapter 3 - Balance of Payments

bop deficit from us perspective
BOP deficit from US perspective
  • US consumers buying more Canadian stuff
    • Supplying usd into the market to buy cd
  • free float allows a new equilibrium
      • cd price of the usd decreases
        • cd appreciates
          • US goods lower in price to Canadians
        • usd depreciates
          • Canadian goods higher in price to the U.S.
      • Corrects BOP imbalance, so that BOP approaches 0

ESM Chapter 3 - Balance of Payments

excess supply of usd
Excess Supply of usd

S1

cd/usd

S2

eo, 0, usd

en, 0, usd

D1

Qo, usd

Qn, usd

Qusd

ESM Chapter 3 - Balance of Payments

benefits of floating exchange rates
Benefits of floating exchange rates
  • International prices adjust instantaneously
    • With Canadian dollar appreciation
      • Canadian stuff more expensive internationally
        • cd more expensive in terms of other currencies
    • International prices decrease for Canadians
  • In the future the BOP should approach zero
    • Foreign demand for Canadian stuff decreases
    • Domestic demand for foreign stuff increases

ESM Chapter 3 - Balance of Payments

depreciation
Depreciation
  • Negative aspects of depreciation
    • Creates image that the currency is weak
      • Canadian dollar has depreciated nearly 40% in the last decade
    • Imports become more expensive
  • Positive aspects of depreciation
    • Exports become cheaper to foreigners
  • Central bank may try to fix the exchange rate
    • Keep the trend line of the exchange rate flat

ESM Chapter 3 - Balance of Payments

appreciation
Appreciation
  • Negative aspects of appreciation
    • Impacts exports as exports are more expensive to foreigners
  • Positive aspects of appreciation
    • Imports become cheaper
  • Central bank may try to fix the exchange rate
    • Keep the trend line of the exchange rate flat

ESM Chapter 3 - Balance of Payments

trend volatility
Trend & volatility

e

T

ESM Chapter 3 - Balance of Payments

trend volatility29
Trend & volatility
  • The red line represents observed exchange rates
  • The brown line represents a minimum least squares regression of the observed exchange rates
  • Volatility is estimated by the standard error of estimate of the observed values from those predicted by the regression line

ESM Chapter 3 - Balance of Payments

reasons given for intervention
Reasons given for intervention
  • Alter the trend, reduce beta, long-run policy
    • Fix exchange rates in some fashion
      • Positive aspects
        • Maintain international prices relatively constant
        • Reduce the need to hedge exchange rate risk
        • Maintain “Strong Currency”
      • Negative aspects
        • Can only affect trend in the short run
        • Eventually results in a very steep adjustment
  • Reduce volatility
    • Reduces the cost of hedging, volatility and bid-ask spread are directly related
    • Short-run policy

ESM Chapter 3 - Balance of Payments

intervention
Intervention

S1

S2

usd/cd

B of C

buys usd

with cd

en, 0, cd

eo, 0, cd

D2

D1

Qo, cd

Qn, cd

Qcd

ESM Chapter 3 - Balance of Payments

intervention32
Intervention
  • If FXB = 0, then BOP > 0, exchange rates adjust
  • Bank of Canada accommodates
    • FXB = X – M + CI – CO + FI – FO,

pushes BOP toward 0

      • Buys up excess usd in the market, no change in exchange rate
    • Underlying cause for BOP surplus not fixed in short run
      • Canadian prices are still too low internationally
  • Domestic consequences
    • BOC has increased base money, inflationary pressure
  • Bank of Canada can chose to sterilize or not

ESM Chapter 3 - Balance of Payments

unsterilized intervention bank of canada balance sheet
gold

silver

cd denominated

t-bills

foreign currency denominated t-bills

cash

currency

chartered bank reserves held at the Bank of Canada

Unsterilized Intervention Bank of Canada balance sheet

Bof C buys US dollars

as an asset

Canadian dollar

liability increases

ESM Chapter 3 - Balance of Payments

domestic affects of an unsterilzed intervention
Domestic Affects of an Unsterilzed Intervention
  • Base money increases by amount of purchase
  • pressure exerted on prices to increase
    • Long-run, inflation in the economy
      • Canadian goods more expensive to Canadians
      • Canadian goods more expensive to foreigners
      • Long-run, balance of payments adjusts

ESM Chapter 3 - Balance of Payments

foreign affects of an unsterlized intervention
Foreign Affects of anUnsterlized Intervention
  • short run
    • exchange rate is not allowed to adjust
  • long run
    • higher Canadian inflation
      • US goods cost relatively less to Canadians
      • Canadian goods cost relatively more to US consumers
    • Long-run, Canadian prices adjust, BOP adjusts

ESM Chapter 3 - Balance of Payments

sterilized intervention bank of canada balance sheet
gold

silver

cd denominated t-bills

foreign currency denominated t-bills

cash

currency

chartered bank reserves held at the Bank of Canada

Sterilized Intervention Bank of Canada balance sheet

Bof C buys US

dollars as an asset

No increase in

B of C liabilities

B of C sells equal

value in other assets

ESM Chapter 3 - Balance of Payments

domestic affects of an sterilzed intervention
Domestic Affects of an Sterilzed Intervention
  • Base money remains constant
  • prices remain constant
    • Both domestic and foreign prices remain the same
  • BOP pressures exacerbated
    • Canadian prices too low in real terms
    • International prices too high in real terms
    • Canadian dollar undervalued
  • Continual intervention required by the Bank of Canada

ESM Chapter 3 - Balance of Payments

foreign affects of an sterlized intervention
Foreign Affects of anSterlized Intervention
  • short run
    • exchange rate is not allowed to adjust
    • From their point of view, BOP deficits continue
    • Interventions continue
  • long run
    • pressure continually increases on exchange rate to appreciate
      • BOT deficit remains
      • eventually the cd price of the usd will increase
    • Finally there is a large scale revaluation
      • Firms cannot adjust slowly to small price changes
      • Firms now must adjust to a large-scale price change

ESM Chapter 3 - Balance of Payments

depreciation39
Depreciation
  • Negative aspects of depreciation
    • Creates image that the currency is weak
      • Canadian dollar has depreciated nearly 40% in the last decade
    • Imports become more expensive
  • Positive aspects of depreciation
    • Exports become cheaper to foreigners
  • Central bank may try to fix the exchange rate
    • Keep the trend line of the exchange rate flat

ESM Chapter 3 - Balance of Payments

appreciation40
Appreciation
  • Negative aspects of appreciation
    • Impacts exports as exports are more expensive to foreigners
  • Positive aspects of appreciation
    • Imports become cheaper
  • Central bank may try to fix the exchange rate
    • Keep the trend line of the exchange rate flat

ESM Chapter 3 - Balance of Payments

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