III. Basic concepts from III. Basic concepts from international economicsinternational economics

III.1 Balance of Payments

International Transactions• Three types of transactions (omitting

details):– Transactions of current account, i.e. export

or import of goods and services– Transfers of wealth between countries,

recorded on capital account (relatively small)– Transactions, resulting from the purchase or

sale of financial assets – financial account

• BoP: sum of CA balance and of balance of other financial transactions

Double-entry bookkeeping

• All international transactions enter BoP twice– Whenever transaction results in a payment

into the country, enters as credit (+ sign)– Whenever transaction results in a payment

outside the country, enters as debit (- sign)

• Remember: every (international) transaction has 2 sides, as buying/selling from/to foreigner means (a) you pay/are being paid, (b) foreigner must spend or store the payment/must withdraw the money and convert it into “our” currency

Examples (1)

• Exporting Skoda car: (a) foreign importer pays to Skoda €20.000 → payment into the country, + sign; (b) Skoda’s agent abroad deposits €20.000 in a foreign bank → domestic subjects purchases claim on foreign entity, i.e. payment out of country, - sign

• In Austria, you buy a ski-lift ticket and pay with a credit card: (a) service is imported to CZ → payment out of country, - sign; (b) ski-lift company receives a claim (via credit card settlement system) on your bank account → foreign entity purchases claim on domestic entity, payment into the country, + sign

Examples (2)

• UBS trader in London buys CEZ’s shares for USD500.000: (a) foreigner buys domestic asset → payment into the country, + sign; (b) CEZ deposits the money with foreign bank, purchasing foreign asset → payment out of the country, - sign

• Many other examples, see textbooks

Two corollaries

1. Export/import of goods means payment into/outside the country (+/- sign); purchase/sale of financial assets means payment outside/into the country (-/+ sign)

2. Each transaction automatically means two offsetting entries into BoP:

Current account + capital account + financial account = 0

Balance of payments, CZ, 2010mil. CZK

Source: Czech National Bank

A. Current Account -139,192.1 Trade balance 53,954.4 Exports 2,410,623.1 Imports 2,356,668.7 Balance of services 66,069.0 Income balance -257,704.4 Current transfers -1,511.1

B. Capital Account 34,024.9

Total, Groups A plus B -105,167.2

C. Financial Account 182,129.3 Direct investment 97,006.2 Abroad -32,507.6 In the Czech Republic 129,513.8 Portfolio investment 157402.1 Assets 13,776.6 Liabilities 143,625.5 Financial derivatives -4,104.4 Assets 65,748.4 Liabilities -69,852.8 Other investment -68,174.6

Total, Groups A through C 76,962.1

D. Net errors and omissions, valuation changes -35,537.0

Total, Groups A through D 41,425.1

E. Change in reserves (-increase) -41,425.1

CA Deficit, % GDP, y-data

Change in reserves (Official Reserves Transaction)

• International (official) reserves: gold or foreign currency, held by central banks

• The reserves may change because of 2 reasons:– Flows, financing exports/imports of assets, must

include an exchange into domestic currency via domestic Central Bank, foreign Central Bank(s) and other lenders

– Central Bank itself may buy/sell international reserves (to influence macroeconomic conditions) - foreign exchange intervention

• Change in reserves: reflects how domestic Central Bank and foreign Central Banks and other lenders finance the CA deficit plus deficit from of the non-reserve flows on financial account

What is balance of payments?

Two confusing notions, but both valid:• BoP as a statistical account on macro-

level, a record of international transactions (sums up to zero)

• An usual interpretation (by economists, journalists, politicians):

BoP = CA balance + capital account balance + non-reserve part of financial account balance

• Also called Official Settlements Balance, equal to change in reserves (with sign reversed)

Statistical remark on „reserves“

• Official reserves transaction („change in reserves“) is an item from BoP statistics, but differs from another indicator:

• Change in „International Reserves“ – an item, published separately, usually within BoP statistics as well

International Investment Position• On of the interpretation of current account:

change in net foreign wealth (see LII.2)• Consequently, current account surplus/deficit

changes the level of country foreign wealth, i.e. difference between assets owned both by private and public entities abroad and assets owned by foreigners in domestic country

• However, there are other factors, influencing current value of assets, either at home or abroad– e.g. fall of stock prices during recent crisis

• Resulting indicator: International investment position

Statistical remark: IIP and external debt

• Two different indicators, but with similar dynamics

• Again: both published within BoP statistics

International Investment Position and External Debt, CZ, mil. CZK

III.2 Floating exchange rate

Definition• Price of one currency in terms of other

currency, 1€ = 24 CZK, 1$ = 18 CZK– Direct and indirect quotation, here always

direct

• ExR – enables to compare domestic and foreign prices and to determine and compare values of various assets in other country’s currency– 1 Octavia in CZ: 552,000 CZK– 1 Passat in D: 25,000 €– value of exported Octavia in D: 23.000 €– Octavia cheaper

Depreciation and appreciation

• Depreciation of domestic currency against a foreign one is a fall of the price of domestic currency in terms of units of foreign currency– Remark!!! – using direct quotation, the numerical

value of ExR increases: e.g., between 1998 and 2000, depreciation of CZK against $ from 1 $ = 28 CZK to 1 $ = 40 CZK

• Appreciation is an increase of the price of domestic currency in terms of units of foreign currency– The numerical value of ExR decreases: in past 6

years CZK appreciated against € from approx. 1 € = 30 CZK to 1 € = 24 CZK

Foreign Exchange Market• ExR – relative price of two currencies and like

any price, it is determined by demand and supply foreign currencies

• What generates supply and demand for forex? Three factors:– Flow of exports and imports (transactions on current account)– Intention to invest wealth into foreign assets, i.e. speculation on

higher yields abroad than at home– Hedging

• Participants: commercial banks, corporations, non-bank financial institutions, central banks

• Characteristics of today’s forex market: integrated, electronic, global trading (almost “ideal” market)

• Different measures of ExR (see bellow)• Notation: (nominal) exchange rate E

Arbitrage

• There can be no different prices in different places, application for forex market:

• If, e.g., € is cheaper in New York than in Frankfurt and elsewhere, then the profit can be made by buying in N.Y. and selling elsewhere, but this increases demand for € in N.Y. and drives its price there up in general, quick leveling of ExR on all markets

• Remark: do understand well the concept of arbitrage, it will apply – in different situations - again and again

Different exchange rates

• Immediate trading, value date (2 days)– Published ExR – for wholesale

transactions (over 1 MUSD)– Retail: bank fees, retail spread

• Forward rates, different time horizons

• Futures, options

Nominal ExR: USD/EUR, d-data

26.10.2000

15.7.2008

27.10.2008

13.12.2009

9.6.2010

13.10.2011

Nominal ExR: CZK/USD, m-data27.10.200042,13

22.7.200814,45

17.2.200923,33

30.9.201117,83

Nominal ExR: CZK/EUR, m-data

12.5.200037,04

22.7.200823,01

30.9.201124,56

Nominal Effective ExR• Market (nominal) ExR above: price of unit of foreign

currency in terms of units of domestic currency– Reflects just market situation, relations between the two

economies, probably many other facts, speculation, etc.– In our definition above: numerical increase = depreciation,

numerical decrease = appreciation• Nominal Effective Exchange Rate: price of unit of a

domestic currency in terms of a basket of main foreign currencies– it is price of unit of domestic currency (i.e. numerical

increase means appreciation, decrease depreciation)– Numerically: weighted (usually geometric) average of

different nominal exchange rates, where weights are the trade shares (with main trading partners), constructed as an index (base year = 100)

– Increase (appreciation) means loss of competitiveness of domestic economy compared to main trading partners, decrease (depreciation) vice versa

Nominal Effective ExRm-data, I/2003 = 100

III.3 Asset approach to ExR and forex market

Forex market• Not the only approach, see bellow

• Floating ExR – price of currency, determined by supply and demand

• Basic logic: foreign exchange is an asset that people (institutions) can invest in– There are other reasons why people

demand forex, but the investment is the prevailing one

Demand for foreign currency assets

• Why there is larger or smaller demand?– Investment, rate of return, real rate of return,

domestic and foreign interest rate (r, r*)– Risk, liquidity – not considered here (later)

Note: often believed – demand for forex assets because of international trade (cash, deposits). Today less important, level of demand – given the global business – determined by portfolio investment

• Basic rule (assumption): people always hold assets with the highest expected real rate of return

Exchange rate and asset return

• 1 (M) CZK investment into domestic bonds– At interest r, one year return 1+r

• The same amount invested into € bonds – more steps:– CZK into € - investing (1/E) €– 1 year return at foreign interest r* (in €) :

– 1 year return in CZK at expected exchange rate :

*r1E1

eE e* Er1E1

Equilibrium on the forex market

• Equilibrium: assets (deposits) of all currencies offer the same expected real rate of return

• Formally:• Approximately:

• In words:– Expected rate of return, expressed in domestic

currency, on foreign deposits is approximately equal to foreign interest rate plus the rate of expected depreciation of domestic currency against a foreign one

– In equilibrium, both rate of return (in domestic currency) must be equal equilibrium E0 determined

e* Er1E1r1

E

EErr

e*

Adjustment towards equilibrium (1)

• If E > E0 → return on domestic assets larger → people try to sell foreign and buy domestic assets, but nobody is ready → larger amount of foreign currency per unit of domestic one offered → E (appreciation)

• If E < E0 – vice versa

E

E

EEr

e*

Expected return on foreigndeposits inversely relatedto today’s exchange rate

Expected returnsr

Return on domestic deposits

E0

E1

E2

Adjustment towards equilibrium (2)

III.4 Monetary approach to ExR and forex market (PPP)

Law of one price• Starting concept: if prices (and ExR) quickly

adjust and there are no barriers to trade, no transportation and other costs, then arbitrage erases any price differences between different geographical locations (when prices converted to the same currency)

• If we consider Octavia and Passat to be the same product (VW Group car of the same class), then price of Octavia could not remain 552,000 CZK too long:– Arbitrage: Germans would travel to CZ, buying

Passats and Octavias here → increasing the price from 552,000 CZK

Purchasing Power Parity• Suppose that markets (both domestic and

foreign) are fully competitive and prices quickly adjust

• Than prices, when converted into same currency, must be equal, i.e. PPPxP*=P or

PPP = P/P*

• This definition: absolute PPP• Changes in PPP solely determined by changes in

relative price levels: faster domestic inflation → depreciation, faster foreign inflation → appreciation

• Not approved by reality, even in the long run (when prices adjust)– In literature (Mankiw or Krugman&Obstfeld), see

anecdotic evidence, based upon the so-called Big Mac index

Relative PPP• Absolute PPP – not workable concept →

weaker version for PPP definition of ExR• On the absolute levels PPP is far from

everyday reality, but it may still apply when we consider changes in prices and exchange rates

• Relative PPP: percentage change in the ExR between two currencies is equal the difference in percentage changes in national price levels

• Formally– Where inflation

• Remark: the expression is good approximation for small inflation values

*1-1- π-πEE-E 1-1- PP-Pπ

Why PPP?• Empirically, exchange rates are very far

from ratio of price levels, i.e. absolute PPP can not be considered as a proper representation of exchange rate– Even relative PPP performs empirically

badly

• Reasons:– Trade barriers and non-tradables– Non-competitive markets– Different consumer baskets and difference

in inflation measurements– Important starting point for other concepts

III.5 Real exchange rate

Relative prices of goods

• Nominal ExR: relative price of two currencies, its level on the forex market

• International trade: people make decisions, comparing relative prices of comparable goods, that can be purchased either on domestic market or in a foreign country, provided that prices are allowed to adjust

• Problem on macroeconomic level, when comparing two countries: each country has different basket of commodities that are purchased

• Back to starting example: suppose that CZ and D produce only Octavias and Passats

Octavia vs. Passat Again

• Price of foreign goods in terms of domestic goods, how to construct?

• Example (nom.ex.rate 1 € = 24 CZK):• CZ Octavia 552,000 CZK• D Passat 25,000 €• Price of Passat in terms of Octavia?

– Price of Passat in CZK: 25,000x24=600,000 CZK

– In terms of 1 Octavia: 600,000/552,000=1.09– “Real ex.rate” between Passat and Octavia:

1 P =1.09 O

Real ExR - Definition• Generalization to the economy-wide level

– Problem of “comparable good”: price over standard (reference, typically purchased) basket of purchases in both countries in a given period of time (e.g. a week, months, year, etc.)

– Important: when constructing price indexes, relatively larger weight on commodities, produced (and consumed) domestically

• Formally (see example on Octavia and Passat above):

e=(E.P*)/P– Direct quotation again: price (expressed in domestic

currency) of a reference basket (considered as one unit) in a foreign country relative to the reference basket in domestic country (again considered as one unit)

• Real appreciation, e decreases• Real depreciation, e increases

Real exchange rate and price level (1)

• Alternative interpretation: e = E.(P*/P) - ratio of foreign and domestic price levels, when both expressed in domestic currency– Real ExR evaluates the purchasing power of domestic

currency over foreign goods

• If e < 1, then foreign price level relatively lower than domestic one, domestic goods relatively more expensive, so less competitive

• if e > 1, then foreign price level relatively higher than domestic one, domestic goods relatively cheaper, so more competitive

• Real depreciation: fall of purchasing power of domestic currency over the goods in foreign country

• Real appreciation: increase of purchasing power over foreign goods

Real exchange rate and price level (2)

Changes in real ExR:• Change in nominal ExR: nominal

depreciation (appreciation) → real depreciation (appreciation)

• Change in relative price levels:– increase in relative domestic inflation → real

appreciation, domestic goods relatively more expensive

– increase in relative foreign inflation → real depreciation, domestic goods relatively cheaper

Real Effective Exchange Rate (REEF)

• In reality, country trades with many foreign counterparts

• For a given country’s trade, usually a limited number of other countries decisive– E.g. CZ: Euro zone, SK

• REEF: weighted average of real ExRs with these decisive trading partners– Weighs: shares of trade with particular

country on total trade with the group of decisive countries

REER: CZK, EURI/2005=100, m-data

III.5 Fixed exchange rate

Definitions

• So far: exchange rate assumed as completely flexible, ready for immediate adjustment floating exchange rate– Perfect floating – theoretical concept only (almost)

• In reality – different level of central banks’ (state) interventions– Managed floating (today) – technically is ExR

floating, but central banks try to intervene to moderate the movements of exchange rates

– Fixed exchange rate – central bank fixes the exchange rate in various ways

Different ways of fixing ExR

• Full fix: central banks are prepared to trade any amount of currencies at given fixed rate

• Regional currency arrangements, in the past or today’s Euro

• Policies for developing countries or countries in transition, different types of fixing (for more detailed discussion of following concepts see later Lectures):– Pegging to other currencies, horizontal bands,

crawling peg, crawling bands, currency boards

Fixed ExR and supply of money (1)

• LII: brief discussion of money supply• Fixed ExR – how does Central Bank maintain

the fix?• Through open market operations

– When market pressure towards devaluation (market selling domestic currency, i.e. excess supply), Central Bank buys assets, denominated in domestic currency (increasing demand for it, offsetting excess supply)

– When market pressure towards revaluation (excess demand), Central Bank sells assets, denominated in domestic currency (increasing its supply, offsetting excess demand)

Fixed ExR and supply of money (2)

• Consequence of the fix: supply of money (monetary policy) is not fully independent, but must follow market pressures towards domestic currency

• Will be discussed more in detail in later Lectures– But this basic finding will be needed

already in Lecture IV, when discussing gold standard

Literature to Lecture III

• Krugman, P.R., Obstfeld, M.: International Economics, Theory and Policy, Pearson, Addison Wesley, Boston 2006 (7th ed.), Ch. 13 and Ch. 15

• Mankiw, Ch. 7, pp. 205-220

and references there