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Unit 10

Unit 10. Open Macroeconomy The Balance of Payments Capital Flow Exchange Rate. Balance of Payments. Balance of Payments. A record of international transactions between residents of one country and the rest of the world.

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Unit 10

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  1. Unit 10 Open Macroeconomy The Balance of Payments Capital Flow Exchange Rate

  2. Balance of Payments Balance of Payments • A record of international transactions between residents of one country and the rest of the world. • International transactions include exchanges of goods, services or assets. • “Residents” means businesses, individuals and government agencies, including citizens temporarily living abroad but excluding local subsidiaries of foreign corporations.

  3. Balance of Payments Double-entry accounting in the BOP • All transactions are either debit or credit transactions • Each credit transaction has a balancing debit transaction, and vice versa, so the overall balance of payments is always in balance

  4. Structure of the Balance of Payments Current account • Merchandise trade • Exports • Imports • Balance • Services • Transportation & travel receipts, net • Other services, net • Balance on goods and services • Income receipts and payments • Investment income, net • Compensation of employees • Balance • Unilateral transfer, net • Balance on current account • All purchases or sales of assets, including: • Direct investment • Securities (debt) • Bank claims and liabilities • Official settlements transactions Capital and financial account

  5. Current account Current account surplus and deficit • Current account and capital & financial account balance each other; when one is in surplus the other must be in deficit. • Current account surplus means exports of goods and services, investment income and transfers exceed imports and outflows. • Current account deficit means imports of goods and services, and outflows are greater than exports and inflows; must be financed by borrowing (capital account inflows). Is current account deficit a problem? • Current account deficit has little to do with foreign trade practices or competitiveness. • Determined mostly by domestic macro-economic conditions that cause demand to exceed supply and increase imports (paid for with borrowing). • Whether a current account deficit is good or bad depends on whether the borrowed funds are used to pay for consumption or investment.

  6. Malaysia: Balance of Payments (2002)

  7. Balance of Payments • Calculate the Balance of Current Account • Calculate the Balance on Capital and Financial Accounts • Calculate the Overall Balance • Calculate the amount of exports

  8. Balance of Payments (i) The amount of exports = Merchandise Trade Balance + Imports = RM 72,117 + RM 286,387 = RM 358,504 • Current Account Balance = Merchandise Trade Balance + Services Balance + Income Balance + Current Transfers = RM 72,117 + (RM -5,996) + (RM -25,061) + RM(- 10,566) = RM 30,494 • The Balance of Capital and Financial Account = Balance of Capital Account + Balance of Financial Account = RM 0 + (RM -11,941 ) = RM -11,941 • Overall Balance = Current Account Balance + Capital and Financial Accounts Balance + Errors and Omissions = RM 30,494 + (RM -11, 941) + (RM -4,362) = RM 14,191

  9. Capital Flow Capital Flow • Capital inflows involves either: • An increase in foreign assets in the nation i.e. a Japanese resident purchases a U.S. stock • A reduction in the nation’s assets abroad i.e. a US resident sells a Japanese stock • Capital outflows involves either: • A reduction in foreign assets in the nation i.e. a US resident purchases a German stock • An increase in the nation’s assets abroad i.e. a German firm sells a US stock

  10. Capital Flow Factors Determining Capital Flow • Real interest rate on foreign assets • Real interest rate on domestic assets • Economic & political risks abroad • Government policies on foreign ownership Example: r foreign bond↑, investment abroad ↑, capital outflow ↑ r foreign bond↓, investment abroad ↓, capital outflow ↓ r domestic bond ↑, domestic investment ↑, capital outflow ↓ r domestic bond↓, domestic investment ↓, capital outflow ↑

  11. Foreign-exchange market (Forex market) Exchange Rate • Refers to the organizational setting within which individuals, businesses, governments, and banks buy and sell foreign currencies and other debt instruments. • Only a small fraction of daily transactions in foreign exchange actually involve trading of currency. • Most foreign exchange transactions involve the transfer of bank deposits. • Foreign exchange market is the Largest and most liquid market in the world • No central market - key markets in several cities around the world • London, New York, Tokyo, Hong Kong. • Participating banks and brokers are in constant contact via phone and computer • Three general types of transaction • Between banks and their customers • Domestic interbank market conducted through brokers • Trading with overseas banks

  12. Exchange Rate Foreign exchange quotations • Exchange rate is the price of one currency in terms of another • One country’s currency has depreciated when more of it is needed to buy a unit of a foreign currency (is worth less relative to the other currency) • A currency has appreciated when less of it is needed to buy a foreign currency (is worth more relative to the other currency)

  13. Exchange Rate Exchange rate determination What determines the equilibrium exchange rate in a free market? The supply and demand conditions

  14. Exchange Rate Nominal & Real Exchange Rate • A problem arises when interpreting changes in nominal exchange rate index when prices are not constant. • When prices of goods & services are changing in either the home or foreigh country (or both), one does not know the change in the relative price of foreign goods and services by simply looking at changes in the nominal exchange rate and failing to consider the new level of prices within both countries. • As a result, economists calculate the real exchange rate, which embodies the changes in prices in the countries in the calculation.

  15. Exchange Rate Real interest rates • Short term real interest rate differences influence international capital movements • Real interest rate is nominal minus inflation • Low short term rates lead to less demand for the currency and depreciation • High rates lead to greater demand for the currency and appreciation

  16. Exchange Rate Factors influencing exchange rates • Market fundamentals • Bilateral trade balances • Real income • Real interest rates • Inflation rates • Consumer preferences for domestic or foreign products • Productivity changes affecting production costs • Profitability and risk of investments • Product availability • Monetary policy and fiscal policy • Government trade policy Market expectations • News about future market fundamentals • Speculative opinion about future exchange rates

  17. Exchange Rate Bilateral trade balances • An increase in the net export - An appreciating currency • An increase in net import - A depreciating currency Real income differentials • A country with faster economic growth than the rest of the world will have a depreciating currency (other things being equal) • Imports rise faster than exports, so demand for foreign currency rises faster than its supply • Real income changes can also reflect other processes, which might lead to rising exports

  18. Exchange Rate Inflation rate, Purchasing power parity and Exchange rate • The simplest concept of purchasing power parity (PPP) is the law of one price. • Law of one price: In theory, a good should cost the same in all countries (aside from tariffs or transportation costs) • As a result, exchange rates should end up making prices equal across countries • By this theory, if two countries have different inflation rates, exchange rates will move in the opposite direction to keep prices the same • The theory is useful in predicting and managing the exchange the exchange rate of a country. • The theory may be more useful for predicting long-term trends than short-run fluctuations

  19. Exchange Rate Relative Purchasing Power Parity • According to the theory of relative purchasing power parity, changes in relative national price levels determine changes in exchange rates over the long run. • The theory predicts that the foreign-exchange value of a currency tends to appreciate or depreciate at a rate equal to the difference between foreign and domestic inflation. • The theory of relative PPP is useful in forecasting the appropriate levels to which currency values should be adjusted • It is useful in predicting long-run exchange rates. • According to PPP, Letting 0 be the base period and 1 represent period 1. S0 = the equilibium exchange rate existing in the base period S1 = the estimated target at which the actual rate should be in the future P0 & P1 = Price index of the home country Pf0 & Pf1 = Price index of the foreign country

  20. Exchange Rate • For example, let the price indexes of the US and Switzerland and • the equilibrium exchange rate be as follows: • Between one period and the next, the US inflation rate rose 100 %, whereas Switzerland’s inflation rate remained unchanged. • Maintaining PPP between the dollar and the franc requires the dollar to depreciate against the franc by an amount equal to the difference in the percentage rates of inflation in the US and Switzerland.

  21. THANK YOU

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