Download Balance of Payments and Exchange Rates

Balance of Payments
and
Exchange Rates
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Introduction:
Open vs closed economy
Three kinds of openness:
• Free trade in goods and services
Restrictions:
,
etc.
• Free movements of capital (financial)
Restrictions:
• Free movements of factors: plants,
labor
Restrictions:
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Various Measurements of openness
• EXPORTS/GDP or IMPORTS/GDP
• (EXPORTS + IMPORTS)/GDP
• TRADABLES/GDP
Tradables are goods that compete with foreign goods
on either domestic or foreign markets e.g.
This last ratio (high for the US) reflects the fact that
if a country is competitive it does not need to
import much.
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X/GDP (in 2000)
US
UK
Belgium
Japan
China
11%
27%
84%
10%
23%
Some determinants of openness:
Geographical: how far a country is from specific
markets
Size: the extent of the range and choice of goods
produced domestically
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Differences between international
trade and international macro
International trade
•
•
•
•
Based on micro
Full employment of
factors
Total C = total Y each
year
Value of imports =
values of exports
Relative prices (T/T)
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International macro
•
•
•
•
Based on macro
Economy can be
_____ PPF
S
and b
at country level
Trade can be -balanced
Price ________
5
A
The Balance of Payments
• The national income accounts
revisited (econ 301)
• The balance of payments accounts
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National Income Accounts - Review
In principle
However
Because
Value of Production = Value of income
GNP ≠ National Income
•
GNP does not subtract economic depreciation
•
Income includes gifts from abroad
•
National income is based on prices producers receive
while GNP is based on prices purchasers pay
difference = indirect taxes
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GNP - Deprec + Net unilateral transfer - indirect taxes
= Natl Y
with: net unilateral transfer = gifts to us - gifts from us
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Gross domestic product vs
gross national product
• GDP is the value added ________ - ignoring who owns the
factors of production - i.e. income generated by activity
within the border
• GNP is the value added by __________ owned factors of
production - i.e. total income received by domestic
residents
GDP
less income on assets owned by foreigners in the country
plus income on assets owned by US residents abroad
equal GNP
If a country invests heavily abroad:
GNP
If a country uses a lot of foreign labor: GDP
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GDP
GNP
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GNP = GDP + Net receipts of factor income from ROW
GDP
US Res
+
Non US Res
in country
Includes income
generated by foreign
owned wealth and
foreign labor.
Res stands for residents
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GNP
US Res
Income
US Res
only
generated
abroad
US owned factor income
so includes income on
US wealth invested
abroad and
income to US workers
abroad
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The Balance of Payments
• Definition: Record of the transactions
between residents and
residents
a year.
• Double entry accounting:
– Credit entry: any transaction that gives rise to a
payments
(by the foreigners) and that is a
payment
+
– Debit entry: any transaction that gives rise to a
payments
(to the foreigners) and that is a
payment
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Characteristics of B/P
• 2 types of international transactions:
– Exports (sales) and imports (purchases) of goods & services
accounts CA
– Sales and purchases of assets
accounts FA
– Balance = sales - purchases
Note:
A section called the capital account was created recently to complement the shift from GNP to GDP
•
book keeping
–
–
–
2 sides to all transactions
one
entry (+) and one
entry (-)
so Sum of credits (+) + Sum of debits (-) = 0
i.e. BP = 0
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I Current Account
• Affects income ( as
)
• Measures direction and size of
CA > 0 S
- country is a
CA < 0 D
- country is a
So CA = ∆ in a country’s foreign assets (or debt)
C + I + G is absorption or
demand for
goods (produced at home or imported)
Y - (C + I + G) =
i.e. if a country consumes more than it produces, it
must
from abroad as it runs a CA
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Intertemporal interpretation
• Borrowers must repay their debt in the future
• A country with a CA deficit imports present
consumption and exports future consumption
Other interpretations
• Chronic CA deficits result in large foreign debt
and high interest payments on the debt which
further erode the CA
• Chronic surpluses could have inflationary effects
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National saving and the CA
By definition
Sn  Y - C - G
• Closed economy
as Y = C + I + G
in equil: Sn =

• Open economy
as Y = C + I + G + CA
in equil: Sn =

Open economy saves by building capital stock (I)
by investing abroad (if CA >0)
(A country can invest more than its saving by borrowing from abroad thus
running a CA deficit)
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Private and government saving: The twin deficit
• Sp 
and Sg 
by definition
and national saving Sn  Sp + Sg = Y - C - G
• In equilibrium
Sn = I + CA
Sp + Sg = I + CA
Sp = I + CA - Sg = I + (EX - IM) + (G - T)
So private saving can
1. Finance private investment
2. Allow the country to invest abroad
3. Finance the budget deficit
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Current Accounts Breakdown
• Exports and imports of goods and services
– Exports are
– Imports are
entries ( )
entries ( )
• Services are sometimes called
» Insurance - banking services - shipping
• Investment income received ( ) and paid ( )
– Interest etc.
– Net = investment income received less inv. inc. paid
• Unilateral Transfers (net)
– One sided transaction: Gifts to us ( ) and gifts from us ( )
– Net = Gifts to us - gifts from us
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Various balances
• Exports of goods less imports of goods:
the balance on goods
so-called the
trade balance
• Exports of services less imports of services:
the balance on services
• Exports of goods and services less imports of
goods and services:
the balance of
( or net exports)
• Balance of trade + net investment income +
net unilateral transfer:
the balance on
or
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II Capital and Financial Account
A Capital Account
•
capital transfers (migrant labor financial
transfers and debt forgiveness)
•
transactions in non-produced and nonfinancial assets (transfer of ownership in
natural resources, intellectual property
rights, franchises and leases)
Total amount is not very large.
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B Financial account
• Correspond to
in stock of assets - so they
are
(thus consistent with current accts).
• Some are
and other are
accounts.
• Some are
term and some are
term type of
assets.
• Some are
and some are government
transactions;
– the government transactions can be broken down
further into Central Bank and non Central Bank .
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Financial Account summary
• US owned assets abroad (net changes)
– Increase is a US
– So a financial
– So a
(-)
of foreign stocks/bonds
• Foreign owned assets in the US (net changes)
– Increase is a
of US assets to foreigners
– So a financial
– So a
(+)
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Financial Account detail
• US owned assets abroad (increase is (-))
– US official reserves assets (net)
• Gold - SDR - foreign currencies
– US government assets
– US private assets
• Direct investment (FDI)
• Foreign securities
• Credit balance in foreign bank and non-bank
institutions
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• Foreign owned assets in the US (increase is
(+))
– Foreign official assets in the US (net)
• US Treasury Securities - bank balances
– Other foreign assets in the US (as above)
• FDI
• US Treasury securities (gov’t bonds)
• Other stocks and bonds
• US currency
• Bank balances in US bank and non-bank
institutions
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• Net capital account transactions
+ {net increase in foreign owned assets in the US
less abs. value1 of net increase in US owned
assets abroad}
= Capital and financial account balance FA
1.
Because they are entered as a minus in BoP
• Statistical discrepancy
{ - [Current account balance + Capital and financial account
balance]}
If there was no mistakes or underreporting, the sum of the 2
balances should be equal to zero.
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Overall Interpretation
• CA balance measures
in country’s net
foreign assets (e.g. a surplus - CA > 0 corresponds to lending to ROW)
• So this will be reflected in the FA balance
where purchases of foreign assets will be
________ than sales of foreign assets.
• In sum a positive CA balance will be
matched by a
FA balance of same
absolute value
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Examples of US balance of payments
entries
Alitalia buys a Boeing 747 and pays with a
check from Banco di Lavoro
– Credit:
of Boeing (3)
accounts
– Debit:
in US owned private asset
abroad or in US claims reported by US
banks (54)
accounts
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The US government sends food as relief
to famine stricken Mali
– Credit:
– Debit:
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of food (3)
accounts
(gift from us) (36)
accounts
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A French citizen buys shares of
Microsoft and pays by drawing his
account at the Key Bank
– Credit:
in foreign owned private
assets in the US (64)
accounts
– Debit:
in US liabilities reported
by US banks (69)
accounts
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B
Exchange Rates
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Various Exchange Rates
Nominal exchange rate - E
• Definition: the price of the foreign currency in
terms of the domestic currency so it is quoted as
________ of units of domestic currency
in ____ unit of foreign currency
• It fluctuates overtime
– Appreciation of the domestic currency:
units
are needed to buy 1 unit of the foreign currency
– Depreciation of the domestic currency:
units
are needed to buy 1 unit of the foreign currency
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Examples of ER fluctuation
•
•
•
•
•
January 1999
$1.17/€
September 2000
$0.85/ €
May 2002
$0.91/ €
May 2003
$1.14/ €
September 2007
$1.41/€
The euro depreciated by some 27%
against the dollar in its first 18 months and
appreciated by some 25% from 2002 to
2003. The euro has continued to appreciate
steadily since.
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Law of One Price
2 countries - each produces one good
– Switzerland produces calculator - price: 100SF
– US
produces book
- price: $25
– Nominal exchange rate: E = $.50/SF
• So price of Swiss calculator in $ is 100 * .50 = $50
– The real exchange rate RER is:

Pr iceofSwissgoodin $ 50
RER 

2
Pr iceofUSgood ($)
25
PSinSF * E $ /SF 100SF * .50$ /SF
RER 

2
PUSin$
$25
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Real Exchange Rate
• The real exchange rate is a relative price of 2
goods (calculator and book) indicating that
Swiss calculator =
US books
i.e.
US books can be exchanged for (or buy)
Swiss calculator
• With more than one good, the meaning will be
slightly different. We will need to use the
aggregate price of a basket of goods (the price
level or CPI) in each country and the RER will
become the relative price of the 2 baskets.
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RER cont.
• We now have
PS * E $ /SF
EP *
RER   =
or  
PUS
P
• The meaning is similar: the RER indicates how
many (units of a) US basket(s) can be
 exchanged for 1 foreign basket (P* is the
foreign price level).
• If either E or P or P* change, we will have a
real appreciation or a real depreciation.
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Real appreciation and depreciation
• When the RER drops, we have a real
i.e. the US needs to give up
US baskets to
acquire
foreign basket. This is a real
depreciation from the point of view of the other
country.
*
• Since
EP
=
P
A real appreciation can be caused by:
a nominal
(E drops)
or/and an
in the domestic price level (P incr)

or/and a
in the foreign price level (P* drops)
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Effect of the real appreciation on trade
• Swiss goods become
expensive for Americans
(less than 2 US baskets to buy one Swiss basket)
– So demand for Swiss good
- US Imports
• US goods become
expensive for the Swiss
(one Swiss basket buy fewer US baskets)
– So demand for US goods
- US Exports
• So the US the balance of trade (exports less
imports)
but the Swiss balance of
trade
because they experience a real
depreciation).
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In Sum:
Effect of the real appreciation on trade:
• imports are ________ and exports ___________
• the balance of trade will __________
• this results in a _______ in the country’s
international competitiveness
A real depreciation has the opposite effect as
more domestic baskets are needed to buy one
foreign basket and the balance of trade improves:
• this results in an _______ in the country’s
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international competitiveness
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Illustration
• Between 1959 and 1985, inflation in
Switzerland or Germany has not been as high as
in France, so France (the French Franc)
experienced a real appreciation with respect to
these 2 currencies. However in the long run
(over the years), the nominal exchange rate
(F/DM or F/SF) also depreciated to account for
these relative price changes.
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Multilateral or trade weighted ER
Up to now we only considered bilateral exchange
rate i.e. the relative price of 2 currencies.
However one specific currency may appreciate
with respect to another currency and depreciate
with respect to a third currency: in one instance
there will be a deterioration in its international
competitiveness and in the other an
improvement.
We need to develop a way to get the whole picture.
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Construction of a trade weighted ER
• The are constructed by the IMF - but there is
more than one way to do it.
• The basic approach is
– To transform each bilateral ER into an
(indeed you can’t add ER as they are expressed in
different units)
– Decide on a
year set as 100 and calculate an
index series over time for each bilateral ER.
– Use a
scheme to aggregate the various
indices - usually the importance of trade with a
specific country as a ratio of total trade.
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Calculation of a trade weighted index
for the $ using pound and euro
Yr 0 index wght
Yr 1
.70
100
.30
.75
107
.30
€/$ 1.15
100
.70
1.10
95
.70
£/$
index wght
TW
index
The dollar appreciates w/ respect to the pound and depreciates w/
respect to the euro, but overall the dollar depreciates. Note that w/
T-W exchange rates, an increase is an appreciation.
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Real multilateral or trade weighted ER
Evidently, it is also possible to calculate a real
multilateral or trade weighted exchange rate.
It suffices to calculate the original bilateral indices
with the real bilateral exchange rates.
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