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 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
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
Exchange rate ($/£)
Equilibrium exchange rate is e0
If UK residents want more $
at each exchange rate, the
supply of £ moves to SS1
New equilibrium at e1.
The exchange rate is the price at which two currencies exchange.
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.
If the demand for pounds is DD1
there is excess demand AC.
The Bank of England must
supply AC £s in return for $,
which are added to reserves.
The reverse occurs if
demand is at DD2.
Suppose the government is
committed to maintaining the
exchange rate at e1 ...
When demand is DD, no
intervention is needed ...
Quantity of £s
there is a balance in transactions between the countries.
… a systematic record of all transactions between residents of one country and the rest of the world
records international flows of goods, services, income and transfer payments
records transactions involving fixed assets
records transactions in financial assets
Source: Economic Trends Annual Supplement
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 (+).
Current Account + Capital Account =0.
The current account is influenced by:
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
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.
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.
Y = C + I + G
Y – C – G =I
S = I
S = I
S = Y – C – G
S = (Y – T – C) + (T – G)
Private saving = (Y – T – C)
Public saving = (T – G)
Y = C + I + G + NX
Y - C - G = I + NX
Net Capital Outflow
S = I + NX
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
Exchange rate ($/£)
The real exchange rate is the nominal rate multiplied
by the ratio of domestic to foreign prices