BALANCE OF PAYMENT AND

EXCHANGE RATES

Open Economy phenomenon - Countries are involved in economic transaction:◦ international trade (i.e. buying and selling goods and

services) ◦ International buying and selling of physical and

financial assets◦ International borrowing and lending

Balance of Payment is a system of accounts, which measures all economic transactions between residents (Households, businesses and governments) and foreign residents (rest of the world)

Balance of Payment

Any transaction that leads to a PAYMENT by a country’s residents is a DEFICIT item, identified by negative sign (-)

Any transaction that leads to a RECEIPT by a country’s residents is a SURPLUS item, identified by plus sign (+)

RULE OF THUMB: “Follow the Cash Flows”

Balance of Payment (BOP)

A Chinese tourist purchases a Jewellary item (+) A heart patient went to U.S for his heart surgery (-) A Saudi student gets admission in Agha Khan Medical university

to do MBBS (+) Standard chartered in Pakistan repatriate profits to its parent in

U.S (-) PIA buys a hotel Roosevelt in New York (-) Pak. Government rented a building in Paris to open its embassy

(-) A Turkish hotel hired five Pakistani waiters (+) A Pakistani investor bought 5% shareholding in General Motors,

U.S. (-) A Saudi refinery buys a refining unit in Pakistan (FDI) (+) IMF gives a loan worth $ 200 million (+) on which Pakistan will

pay 10% annual interest (-)

Pakistan’s BOP – Some Examples

TRADE RECIPROCITY

(1)Current Account (CA)(i) Imports and Exports of goods(ii) Imports and exports of services(iii) Factor Income (investment income from direct & portfolio investment plus employee compensation)(iv) Unilateral transfers (grants, donations, workers’ remittances)

(2)Capital and Financial Account (KFA)(i) foreign direct investment(ii) foreign portfolio investment(iii) purchase and sale of assets

(3) Net Official Reserves

Components of BOP

Current Account – Surplus and Deficits

If you are running a current account deficit, you will have capital account surplus

Some economists reasoned U.S. current account deficit to huge capital inflows from rest of the world, mainly China and Middle east – Saving Glut

Asian and Latin American crises of late 1990s devastated investments and increased savings in poor countries

These countries now started sending their savings i.e. capital outflow towards U.S. due to its deep and sophisticated capital markets

This cheap money from abroad gave birth to “saving slut” which then fueled the housing bubble.

Saving Glut

9

BOP - COMPONENTSA. Current Account

A. Net exports/imports goods&services (Balance of Trade)B. Net Income (investment income from direct portfolio

investment plus employee compensationC. Net transfers (Donations, sums sent to back home by migrant

abroad)

B. Capital and Financial AccountCapital transfers related to purchase and sale of fixed assets such as real estate (OR opening accounts in foreign banks)

C. Financial AccountA. Net foreign direct investmentB. Net portfolio investment C. Other financial items

D. Net Errors and OmissionsMissing data (illegal activities) and statistical discrepencies

E. Reserves and Related ItemsChanges in official monetary reserves including gold and foreign exchange reserves

Σ (A:E) = Overall Balance

Basic Balance = A+B+C

Overall Balance = A+B+C+D

Pakistan BOP – FY 2013

Current Account + Capital and Financial Account = zero (if there is no government/central bank’s intervention)

Current Account + Capital and Financial Account = Change in Reserves (due to central bank’s intervention)

(Foreign) Reserves are assets, other than domestic money or securities, held by central bank, to make international payments (Foreign currencies, gold, SDRs)

Central bank can change the quantity of reserve assets by buying or selling them in open market

Cognitive Dissonance: when reserves rise, they are a net use of funds (you're spending money to buy reserves, just like you spend money to buy imports) and take a minus sign.  And when you draw on your reserves they are a net source of funds, and take a plus sign.

One way to reduce this cognitive dissonance is to look at "Overall balance“ instead of “change in reserves” (Refer to previous slide)

Relationship b/w CA and KFA

SURPLUS ITEMS DEFICIT ITEMSExport of merchandise Imports of merchandise

Private and governmental gifts from foreign residents

Private and governmental gifts to foreign residents

Foreign use of domestically operated travel and transportation services

Use of foreign operated travel and transportation services

Foreign tourist expenditures in this country U.S tourists’ expenditures abroad

Foreign military spending in this country Military spending abroad

Interest and dividend receipts from foreign entities

Interest and dividends paid to foreign individuals and businesses

Sales of domestic assets to foreign residents Purchase of foreign assets

Funds deposited in this country by foreign residents

Funds placed in foreign depository institutions

Sales of gold to foreign residents Purchases of gold from foreign resident

Sales of domestic currency to foreign residents

Purchase of foreign currency

Surplus and Deficit in BOP

Capital and Financial Account is a measure of capital inflows i.e. foreign savings that are available to finance domestic investment spending

Determinants of capital inflows:◦ Excess savings are “exported” from countries where it is

cheap/abundant to countries where it would be needed/expensive (i.e. interest rate consideration)

◦ Capital moves quickly to rapidly growing economies as these economies offer high returns to investors (e.g. flow of capital from Britain and EU to Argentina, Australia, Canada and U.S. from 1870-1914, known as golden age of capital flows)

◦ Two-way capital flows: Big individual investors often seek to diversify against risk by buying

stocks in number of countries Big corporations make strategic business decisions to buy and operate in

different countries Capital Flight: transfer by bearer (smuggling),, money

laundering (Swiss bank accounts, tax heavens, offshore zones)

CA and KFA - Capital Flows

Capital and Financial account signifies the differences in the supply of loanable funds from savings and the demand for loanable funds for investment lead to capital flows

Current account signifies the international difference in supply and demand of goods and services

What ensures that two accounts actually offset each other (CA – CFA = Zero): EXCHANGE RATE

BOP AND Exchange Rate

BOP shows surplus:◦ D > S for that currency. ◦ Allow currency value to increase,◦ Or accumulate foreign reserves.

BOP shows deficit:◦ S > D for that currency.◦ Devalue currency,◦ Or use official reserves to support currency.

What if….?

Goods, services, and assets produced in a country must be paid for in that country’s currency

Occasionally, sellers will accept payment in foreign currency, but they will then exchange that currency for domestic money

International transactions, then, require a market, foreign exchange market, in which currencies can be exchanged for each other

This market determines exchange rates, the prices at which currencies trade

This market is not located in one geographical spot – it is global electronic market that traders around the world use to buy and sell currencies

Understanding Exchange Rate

U.S. Dollars Yen Euros

1 U.S. $ exchanged for 1 76.6850 0.7412

1 Yen exchanged for 0.0130 1 0.0097

1 Euro exchanged for 1.3492 103.4596 1

Exchange RatesSep 24, 2011 @ 5:55 PM

• There are two ways to write any given exchange rate: $ 1 can be exchanged for 76.6850 Yen OR 1 Yen can be exchanged for 0.0130.

• There is no fixed rule – mostly, people tend to express the exchange rate as the price of a dollar in domestic currency.

When discussing movements in exchange rates, economists use specialized terms to avoid confusion.

When a currency becomes more valuable in terms of other currencies, currency appreciates

When a currency becomes less valuable in terms of other currencies, currency depreciates

For example, value of 1 euro went from 1 dollar to 1.25 dollars, which means that value of 1 dollar went from 1 Euro to 0.80 Euros (1/1.25=0.80).

In this case, we would say that euro appreciated and dollar depreciated

Depreciation and Appreciation

Movements in exchange rates affect the relative price of goods, services and assets in different countries.

For example, price of a hotel room in U.S. is $ 100 and price of a hotel room in a France is € 100.

If exchange rate is $1=€1, these rooms have same price If exchange rate is $1=€1.25, French room is cheaper than

American room (100/1.25=$80) If exchange rate is $1=€0.80, French room is expansive than

American room (100/0.80=$125) Local example: USD-PKR exchange rate is $1=Rs. 105. price

of Pakistani cotton shirt @ Rs. 1000 bought by an American would cost him (1000/105=$9.50)

USD-PKR exchange rate reduces to $1=Rs. 98. price of Pakistani cotton shirt @ Rs. 1000 bought by an American would cost him (1000/98=$10.20)

What determines exchange rates? Supply and Demand in exchange rate markets

Determining Exchange rates

Equilibrium Exchange Rate

DEMAND: If dollar appreciates, number of Euros needed to buy dollar rise so demand for dollar falls (as Europeans will buy less from U.S).If dollar depreciates, less Euros will be needed to buy dollars, so demand for dollars will increaseSUPPLY: if dollar appreciates, European products look cheap to Americans, who will demand more for them. This will require more dollars to be converted into Euros i.e. supply of dollars increases

The foreign exchange market matches up the demand for a currency from foreigners who want to buy domestic goods, services, and assets with the supply of a currency from domestic residents who want to buy foreign goods, services, and assets.

In previous figure, the equilibrium in the market for dollars is at point E, corresponding to an equilibrium exchange rate of €0.95 per $1.00.

The equilibrium exchange rate is the exchange rate at which the quantity of a currency demanded in the foreign exchange market is equal to the quantity supplied.

Equilibrium Exchange Rate

Equilibrium Foreign Exchange – A Hypothetical Example

At equilibrium exchange rate, total quantity of U.S $ Europeans want to buy is equal to the total quantity of U.S $ Americans want to sell.

Capital flows from Europe to U.S increases, for some reason

This is resulted in increased demand for U.S $ in FOREX market because European investors convert Euros into dollar to fund their investment in U.S.

As a result, U.S $ appreciates against Euro IN BOP, this rise in KFA (surplus) must be matched by

a decline in CA (deficit) What caused decline in CA? Appreciation of U.S $: rise

in number of Euros per dollar leads American to buy more European goods and services and Europeans to buy fewer American goods and services

Thus, movements in exchange rate ensures that changes in CA and KFA offsets each other

Effect of CA and KFA Surplus/deficit on exchange rate

Effect of CA and KFA Surplus/deficit on exchange rate

To take account of the effects of differences in inflation rates, economists calculate real exchange rates.

Real exchange rates are exchange rates adjusted for international differences in aggregate price levels.

In 1993, $1 exchanged for 3.1 Mexican Pesos In 2011, $1 exchanged for 12.4 Mexican Pesos i.e. peso

depreciated by 75% Did price of Mexican products expressed in terms of $ also

declined by 75%. No, because Mexico had much higher inflation than U.S. over

these years So, let PUS and PMex be indexes of aggregate price level in U.S

and Mexico. Real Exchange rate = Mexican Pesos per U.S. $ × PUS /PMex

To distinguish, exchange rates unadjusted for aggregate price levels (just like we were talking till now) is called Nominal Exchange Rate

Inflation and Real Exchange Rate

Peso depreciates against $, with exchange rate going from 10pesos/$ to 15 peso/$ i.e. a 50% change

Prices of everything in Mexico, measured in pesos, also increased by 50%, so Mexican price index went from 100 to 150

Prices of everything in U.S. remains same, so U.S price index remains at 100

Peso per $ before depreciation × PUS /Pmex

10 × 100/100 = 10 Peso per $ after depreciation × PUS /Pmex

15 × 100/150 = 10 Peso depreciated substantially in terms of $, but real

exchange rate remain unchanged, if it is adjusted against aggregate price level

Real Exchange Rate - Example

USD-PKR exchange rate went from $1=Rs. 80 to $1=Rs. 100 i.e. 25% depreciation of PKR

Aggregate price level in Pakistan rises by 15% whereas aggregate price level in U.S rises by 5%

PKR per $ before depreciation × PUS /Ppak

80 × 100/100 = 90 PKR per $ after depreciation × PUS /Ppak

100 × 105/115 = 91 PKR depreciated substantially in terms of $ (25%), but real

exchange rate remain unchanged, if it is adjusted against aggregate price levels in both countries

Thus, country’s products become cheaper/expensive to foreigners only when country’s currency depreciates/appreciates in real terms

As a result, economists who are analyzing movements in exports and imports of goods and services focus on real exchange rate, not the nominal exchange rate

Real Exchange Rate - Example

Real vs. Nominal Exchange Rates

Between 1990 and 2007, the price of a dollar in Mexican pesos increased dramatically. But because Mexico had higher inflation than the United States, the real exchange rate, which measures the relative price of Mexican goods and services, ended up roughly where it started.

The purchasing power parity between two countries’ currencies is the nominal exchange rate at which a given basket of goods and services would cost the same amount in each country.

For example, a basket of goods and services that costs $100 in U.S costs 1,000 Pesos in Mexico

PPP is 10 Pesos per $ i.e. at this exchange rate, 1000 Pesos = 100 dollars, so the market basket costs same both countries

PPP is estimated for buying cost of a broad market basket, from automobiles to groceries to houses.

The Economist, once every year, publishes a list of PPP based on cost of buying a market basket which contains only one item – McDonald’s Big Mac

Purchasing Power Parity

Country Big Mac Price Local Currency per $

In local currency

In U.S. $ Implied PPP

Actual Exchange

rate

India Rupee 84.0 1.6642 20.7 50.475

China Yuan 14.7 2.289 3.6 6.422

Mexico Peso 32.00 2.2988 7.87 13.9205

Britain £ 2.39 3.7233 0.59 0.6419

U.S. $4.07 4.07 - 1

Japan ¥320 4.2503 78.7 77.103

EU €3.44 4.6032 0.85 0.74

Brazil Real 9.50 5.1271 2.34 1.8529

Switzerland SFr 6.5 7.1539 1.6 0.9086

PPP and Price of Big Mac

The Big Mac index looks at the price of a Big Mac in local currency and computes the following: ◦ the price of a Big Mac in U.S. dollars using the prevailing

exchange rate.◦ the exchange rate at which the price of a Big Mac would

equal the U.S. price. If purchasing power parity held, the dollar price of

a Big Mac would be the same everywhere – which is not the case shown in previous Table.

PPP = price of good ‘A’ in currency 1/price of good ‘A’ in currency 2 (e.g. 84 Indian rupees / $4.7 = 20 PPP)

PPP and Price of Big Mac

Nominal exchange rates are almost always different from PPP.

Some of these differences are systematic: in general, aggregate price levels are lower in poor than in rich countries because services tend to be cheaper in poor countries

But even among countries at roughly same level of economic development, nominal exchange rates vary quite a lot from PPP.

Comparison of PPP and Nominal exchange rate between Canadian dollar and US $ from 1990 to 2011

PPP vs. Nominal Exchange Rate

PPP vs. Nominal Exchange Rate

The purchasing power parity between US and Canada—the exchange rate at which a basket of goods and services would have cost the same amount in both countries—changed very little over the period shown, staying near C$1.20 per US$1. But the nominal exchange rate fluctuated widely.

Does exchange rate matter for business decisions? And How? Why were European automakers, such as Volvo and BMW,

flocking to America? To some extent because they were being offered special

incentives. But the big factor was the exchange rate. In the early 2000s one euro was, on average, worth less

than a dollar; by the summer of 2008 the exchange rate was around €1 = $1.50.

This change in the exchange rate made it substantially cheaper for European car manufacturers to produce in the United States than at home.

Automobile manufacturing wasn’t the only U.S industry benefiting from weak $ - across the board, U.S exports surged after 2006 while imports fell

Business Case

U.S. Net Exports 1947-2008

After a long period of decline, US net exports—exports minus imports—increased sharply after 2006 as the dollar depreciated against other major currencies, making US-produced goods more attractive to foreign buyers.

Exchange Rate is the price of a country’s money, in terms of another country’s money

Nominal exchange rate is very important price for many countries as it determines price of imports and exports

Economies where imports and exports are large percentages of GDP, movements in exchange rate can have major impact on aggregate output and price level

What governments do with their power to influence this price? ….it depends

At different times and in different places, governments have adopted a variety of exchange rate regimes.

Exchange Rate Policy

An exchange rate regime is a rule governing policy toward the exchange rate.

There are two main kinds of exchange rate regimes:1. A country has a fixed exchange rate when the

government keeps the exchange rate against some other currency at or near a particular target. E.g. Hong Kong has an official policy of setting an exchange rate @ HK$7.80 per 1 U.S.$

2. A country has a floating exchange rate when the government lets the exchange rate go wherever the market takes it. E.g. Britain, Canada, U.S. follows floating exchange rate regime

3. Fixed and Floating are not the only possibilities: At various times, countries adopted compromise policies that lie somewhere between fixed and floating exchange rates. Such regime is known as “managed float” or “dirty float”.

Exchange Rate Policy

Exchange rates are fixed at any given time but are adjusted frequently OR

Exchange rates that are not fixed but are “managed” by the government to avoid wide swings OR

Exchange rates that float within a “target zone” but are prevented from leaving that zone.

We’ll elaborate only fixed and floating.

Managed/Dirty Float Policy

How it is possible for governments to fix the exchange rate when the exchange rate is determined by supply and demand?

Let’s consider a hypothetical country, Genovie, which fixed its currency, Geno for U.S $ 1.50

Obvious problem is that U.S $ 1.50 per Geno may not be equilibrium exchange rate; it might be either below or above equilibrium exchange rate

Fixed Exchange Rate

Fixed Exchange Rate

In both panels the imaginary country of Genovia is trying to keep the value of its currency, the geno, fixed at US$1.50.In panel (a), there is a surplus of genos on the foreign exchange market. To keep the geno from falling, the Genovian government can buy genos and sell U.S. dollars. In panel (b), there is a shortage of genos. To keep the geno from rising, the Genovian government can sell genos and buy U.S. dollars.

There are three mechanisms through which governments/central banks try to maintain fixed exchange rate regime:

1. Exchange market intervention2. Changing Monetary Policy3. Foreign exchange controls

Maintaining fixed Exchange Rate

One way to keep geno at fixed rate is to buy and sell currencies

Government purchases or sales of currency in the foreign exchange market are exchange market interventions.

To buy genos in FOREX market, Genovian government must have US $ to exchange for genos

Thus, most countries maintain Foreign exchange reserves which are the stocks of foreign currency that governments maintain to buy their own currency on the foreign exchange market.

Recall capital flows in BOP, now we can see why governments sell foreign assets: they are supporting their currency through exchange market intervention

1. Exchange Market Intervention

Governments try to shift supply and demand curves for their currencies in FOREX market

Government usually do this by changing the monetary policy

For example, to support PKR, SBP might increase interest rate. This will increase capital inflows into Pakistan, increasing the demand for PKR.

At the same time, it reduces capital flows out of Pakistan, reducing the supply of PKR.

So, other things equal, an increase in country’s interest rate will increase the value of its currency

2. Changing the Monetary Policy

A government can support its currency by reducing its supply in FOREX market.

It can do so by requiring residents who want to buy foreign currency to get a license

They give license only to those people who engage in approved transactions e.g. purchase of imported goods that government thinks are essential

Foreign exchange controls are licensing systems that limit the right of individuals to buy foreign currency.

Other things equal, foreign exchange controls increase the value of a country’s currency

3. Foreign Exchange Control

We discussed a situation when government is trying to prevent a depreciation of its currency.

Instead, if equilibrium exchange rate is above the target or fixed exchange rate (panel b on slide 39), there is shortage of local currency

Thus, government will apply same three mechanisms in reverse direction:1.Forex Market intervention to sell its currency and to acquire US $ which it can add to its foreign exchange reserves2. Reduction of interest rates to increase supply of its currency and reduce the demand3. Imposition of foreign exchange controls that limit the ability of foreigners to buy local currency

Similar mechanisms for shortage

Choice of exchange rates regime poses a dilemma for policy makers, because fixed and floating exchange rates each have both advantages and disadvantages

Uncertainty about value of our goods/services/assets in terms of foreign currencies has deterring effect on trade between countries. So one benefit of fixed exchange rate is certainty about future value of a currency

Thus, there are economic payoffs to stable exchange rates, but the policies used to fix the exchange rate have costs.

◦ Exchange market intervention requires large reserves on hand, usually a low-return investment

◦ Foreign exchange controls, like quotas and tariffs, distort incentives for importing and exporting goods and services

If monetary policy is used to help fix the exchange rate, it isn’t available to use for domestic policy (particularly, price stability and inflation control)

Exchange Rate Regime Dilemma

Should a country let its currency float, which leaves monetary policy available for macroeconomic stabilization BUT creates uncertainty for businesses? OR

Should it fix the exchange rate, which eliminates the uncertainty but means giving up monetary policy, adopting exchange controls, or both?

Different countries reach different conclusions at different times: most of European economies, except Britain, which do most of their trade with each other, believe that exchange rate should be fixed (transition towards Euro) whereas Canada is satisfied with floating exchange regime despite of most of its trade with U.S.

Exchange Rate Regime Dilemma

China’s spectacular success as an exporter led to a rising surplus on current account.

At the same time, non-Chinese private investors became increasingly eager to shift funds into China, to take advantage of its growing domestic economy.

As a result of the current account surplus and private capital inflows, at the target exchange rate, the demand for Yuan exceeded the supply.

To keep the rate fixed, China had to engage in large-scale exchange market intervention—selling Yuan, buying up other countries’ currencies (mainly U.S. dollars) on the foreign exchange market, and adding them to its reserves.

China fixed the Yuan

The fact that modern economies are open to international trade and capital flows adds a new level of complication to analysis of macroeconomic policy

Let’s look at three policy issues raised by open-economy macroeconomics:1. devaluation and revaluation of fixed exchange rates2. monetary policy under floating exchange rates3. international business cycles

Exchange Rate and Macroeconomic Policy

Historically, fixed exchange rates haven’t been permanent; some countries switch to floating regime AND some countries change target rate from time to time

A devaluation is a reduction in the value of a currency that previously had a fixed exchange rate – a devaluation is a depreciation that is due to a revision in a fixed exchange rte target◦ Devaluation makes domestic goods cheaper in terms of

foreign currency, which leads to higher exports.◦ Devaluation makes foreign goods expansive in terms of

domestic currency, which reduces imports◦ Thus, net effect of devaluation is to increase the BOP on CA

Devaluation of Fixed Exchange Rates

A revaluation is an increase in the value of a currency that previously had a fixed exchange rate.◦ Revaluation makes domestic goods more

expensive in terms of foreign currency, which reduces exports

◦ Revaluation makes foreign goods cheaper in terms of domestic currency, which increases imports

◦ Thus, net effect of revaluation is to reduce the BOP on CA

Revaluation of Fixed Exchange Rates

Devaluation and Revaluation serves two purposes under fixed exchange rates:◦ They can be used to eliminate shortage or surpluses in

the FOREX market. E.g. economists and politicians around the world were urging china to revalue Yuan as they believed that China’s fixed exchange rate policy unfairly aided Chinese exports (subsidizing effect of devaluation)

◦ Devaluation and revaluation can be used as macroeconomic policy tools.

Devaluation, by increasing exports and reducing imports, increased aggregate demand – fill the recessionary gap i.e. aggregate output < potential output

Revaluation, by reducing exports and increasing imports, reduces aggregate demand – eliminate inflationary gap i.e. aggregate output > potential output

Devaluation and Revaluation

Under floating exchange rates, expansionary monetary policy works in part through the exchange rate: ◦ Reduction in domestic interest rate leads foreigner to

have less incentive to move funds into your country and residents have more incentive to move funds out of country due to low interest rates

◦ As a result, they want to exchange more local currency for U.S $, so supply of local currency increased which leads to depreciation

◦ Depreciation of local currency result in higher exports and lower imports, which increases aggregate demand.

Contractionary monetary policy has the reverse effect.

Monetary Policy under Floating Exchange Rates

The fact that one country’s imports are another country’s exports creates a link between the business cycle in different countries.

However, extent of this link depends on exchange rate regime: Recession in U.S reduces demand for Canadian exports. Reduction in foreign demand for Canadian goods and services is also a

reduction in demand for Canadian dollar in FOREX market In case of fixed regime, Canada might respond to this decline with exchange

market interventions In case of floating regime, Canadian dollar will depreciate

Such depreciation, under floating regime, makes Canadian goods cheaper to foreigners, and foreign goods expensive for Canadians - leading to increase in exports and decrease in imports.

Both effects limit the decline in aggregate demand compared to what it would have been under a fixed regime

International Business Cycles

One of the virtues of floating exchange rate is that they help insulate countries from recessions originating abroad.

This theory looked pretty goods in early 2000s: Britain, with floating exchange rate, managed to stay out of a recession that affected rest of Europe.

However, GFC of 2007-08 that began in U.S. led to a recession in virtually every country.

International linkages among financial markets were much stronger than any insulation from overseas disturbances provided by floating exchange rate.

International Business Cycles

Lecture 5 (Slides and chapter 5) Lecture 6 (slides) Lecture 7 (slides and chapter 7) Lecture 8 (slides and chapter 8, 9 & 11)

2ND MID EXAM - Course