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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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## 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

### 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.

### 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.

### 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.

### 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.

### 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

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.

### 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.

### 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 \$,

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.

### 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

### The UK balance of payments, 1980-2006

Source: Economic Trends Annual Supplement

### 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 (+).

### Balance of Payment

Current Account + Capital Account =0.

### 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

### 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.

### 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.

### Some Important Identities

• Assume a closed economy – one that does not engage in international trade:

Y = C + I + G

### 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).

### Some Important Identities

• Substituting S for Y - C - G, the equation can be written as:

S = I

### Some Important Identities

• National saving, or saving, is equal to:

S = I

S = Y – C – G

S = (Y – T – C) + (T – G)

### 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)

### 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)

### 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

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

### 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

### Relative prices and the nominal exchange rate, UK & USA

Relative price

(UK/USA)

Exchange rate (\$/£)

### The real £/\$ exchange rate

The real exchange rate is the nominal rate multiplied

by the ratio of domestic to foreign prices