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Capital Flows, Balance of Payments, and the Foreign Exchange Market

Capital Flows, Balance of Payments, and the Foreign Exchange Market. Balance of Payments Accounts. Two Categories of Transactions. Current account – Sales & purchases, factor income, and transfers Balance of payments on goods & services – Exports minus imports of goods & services

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Capital Flows, Balance of Payments, and the Foreign Exchange Market

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  1. Capital Flows, Balance of Payments, and the Foreign Exchange Market

  2. Balance of Payments Accounts

  3. Two Categories of Transactions • Current account – Sales & purchases, factor income, and transfers • Balance of payments on goods & services – Exports minus imports of goods & services • Trade balance – Exports minus imports of goods only (more accurate & accessible) • Financial account – Sales & purchases of financial assets

  4. The Rule of Balance of Payments Current account (CA) + Financial account (FA) = 0 OR Positive entries on CA + positive entries on FA = Negative entries on CA + negative entries on FA

  5. Modeling the Financial Account • Financial account measures sales of assets to foreigners • For simplification, these are all shown in the form of loans – and only two countries are shown • Money flows from lenders to the country with the higher interest rate Let’s graph this…

  6. Effects of Capital Flows in the Loanable Funds Market • Capital inflows pushing rdown, capital outflows push r up • This can continue until the interest rates in two countries equalize – with a shortage of loanable funds in one country offset by a surplus of loanable funds in the other

  7. Underlying Determinants of Capital Flows • Differences in investment opportunities – Countries with rapid economic growth have higher demand for capital, so they offer higher returns • International differences in savings rates, including budget balance

  8. Two-Way Capital Flows Loanable funds model explains net capital flows, but in reality flows take place in both directions for a variety of reasons, such as: • International investors’ desire to diversify • International transactions as part of business model • International banking centers

  9. The Foreign Exchange Market • Goods produced within a country must be paid for with that country’s currency, so there is a market in which currencies are exchanged for one another • This market determines exchange rates • When a currency becomes more valuable in terms of other currencies, it appreciates • When a currency’s value falls, it depreciates • Exchange rates affect relative price, thus impacting trade

  10. Modeling Foreign Exchange Rates • FOREX is governed by supply and demand Let’s graph this… • Demand slopes downward because higher price means less money demanded (i.e., higher priced American products would mean fewer European purchasers) • Supply slopes upward because higher price means greater willingness to supply (i.e., relatively cheaper European goods will cause Americans to put more dollars on the market to exchange)

  11. Rationale: Americans will demand the less expensive German goods. To purchase the German goods, they need euros, so the demand for euros increases (shifts to the right). To buy euros, the Americans will supply U.S. dollars to the foreign exchange market, so the supply of U.S. dollars shifts to the right. The U.S. dollar depreciates (the exchange rate decreases). The euro appreciates (the exchange rate increases).

  12. Equilibrium Exchange Rate • Rate at which quantity demanded of a currency = quantity supplied • Demand shifts can cause the exchange rate to appreciate or depreciate • Any change in Financial account creates an equal and opposite reaction in the current account, maintaining CA + FA = 0 • Movements in the exchange rate ensure that FA and CA offset one another

  13. Inflation & Real Exchange Rate • Appreciation/depreciation can be exaggerated due to differences in inflation rates Real XR = XR (X per Y) ● Price LevelY/Price LevelX (i.e., Mexican pesos per $1U.S. X PLUS/PLMex) • Current account responds only to changes in Real XR, not nominal

  14. Purchasing Power Parity • PPP is the nominal exchange rate at which a given basket of goods would cost the same in two countries • Comparing PPP to XR over time reveals the impact of inflation • The relationship between PPP and exchange rate reveals the relative cost of living in each country

  15. Additional Terms to Know • Statistical discrepancy • Gross National Product (NOT GDP) • Tariffs • Import quotas

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