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Business Environment

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  1. Business Environment Lecture 19(L6/S2) Global Financial Environment MilenaMalinowska

  2. Definitions • The balance of payments is a form of state book keeping, where monetary inflows and outflows are recorded • The number of transaction depends heavily on the exchange rate • The exchange rate might be floating (based on S&D) or fixed • Demand for a currency dependents on investment prospects in the home country

  3. Balance-of-Payments (BoP) • It is a record of a country’s all international monetary transactions over a specific period of time • Includes both private and government transactions • Inflows of money are recorded as credit (+) • Outflows of money are recorded as debit (–) • Every transaction is recorded twice • BoP should be balanced, but in reality this rarely happens • BoP is calculated quarterly and annually

  4. BOP Components • Current Account * Unilateral transfers, where one party benefits economically and provides nothing in return

  5. BOP Components (2) • Capital Account

  6. BOP Components (3) • Financial Account *Buying home currency at the foreign exchange market is considered a (–) from the reserve account, but a (+) in the BoP

  7. Recording transactions • Export of goods from UK • UK granting government aid (goods) • BG government loan ($) from IMF

  8. Balance of BoP • Current Account + Capital Account + Financial Account + Net Errors and Omissions = 0 • Net Errors and Omissions stem from statistical mistakes, which are fixed before final calculation • Current Account deficit = M > X • To balance the deficit, governments can: • Borrow • Draw from reserves • Sell assets abroad • Raise the interest rate

  9. Trade deficit

  10. Trade deficit

  11. Exchange rate (floating) • Exchange rate is the price at which one currency trades for another • In free exchange rate system, the price of the currency is defined by S & D • When the exchange rate of the £ (vs. X) is high, people will be selling £ • Too much £ (c-d) will cause depreciation of the currency • When the exchange rate of the £ (vs. X) is low, people will be buying £ • Too few £ (a-b) will cause appreciation of the currency • Eventually there will be an equilibrium €

  12. BoP and exchange rate ? • When the exchange rate of the pound is high, imports are cheaper – pounds are going to be in excess on the market: • When the exchange rate is low, exports are cheaper – pounds are going to be in shortage on the market: • The exchange rate should helpBoP balance

  13. Shift in S & D for a currency Causes for depreciation: • Fall in interest rates • Rise of inflation at home, compared to inflation abroad • Rise in incomes at home, compared to incomes abroad • Better business climate abroad, compared to climate at home • Speculation € S1 D1 S2 D2 1.40 1.20 Q of £

  14. Fixed exchange rate • Some governments prefer to stick to a fixed exchange rate, because: • There is more certainty • There is less speculation • When the market price falls below the fixed one the difference is financed by: • Borrowing – foreign currency loan to buy out excess pounds • Drawing from reserves – use own currency reserves to buy out excess pounds • Raising interest rates – to raise the demand for the currency

  15. Drawbacks of a fixed exchange rate • Do not work during economic recession – high interests rates reduce aggregate demand and hamper economic activity • Fail in times of economic shock – during an oil crises, oil importing countries face pressure to devaluate their currencies – paying for the difference become too expensive • Cannot resist massive speculation – if demand for the currency is too low for too long, financing becomes impossible

  16. Intermediate regimes • Adjustable peg – fixed in the short term, adjusted in several years • Crawling peg – is adjusted frequently by small amount • Joint float – group of currencies, using adjustable peg among each other and jointly float vis-à-vis other currencies (ERM) • Exchange rate band – fluctuate within limits • Managed float – free rate, but governments intervene to buy and sell in turbulent times

  17. Currency board • In a CB, the exchange rate is completely fixed to a reserve (anchor) currency • The country maintains a reserve of 110-115% equivalent to the whole monetary base • The government cannot print money • BG adopted a CB in 1997, after experiencing hyperinflation • Initially the lev was pegged to the DM, later on the the Euro • IMF financed the CB

  18. The Euro – a panacea? By adopting the euro MS enjoyed following advantages: • No more conversion costs • No uncertainty, stemming from floating currencies • Lower inflation (strong confidence), guaranteed by ECB • Increased investment coming in the EU

  19. Sources • Lecture is based on: The global financial environment in Sloman, J. and Jones, E. (2011) Economics and the Business Environment (3rd ed) UK: Pearson