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Chapter 28 Exchange rates and the balance of payments David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 9th Edition, McGraw-Hill, 2008 PowerPoint presentation by Alex Tackie and Damian Ward ©The McGraw-Hill Companies, 2008 Nominal Exchange Rates • The nominal exchange rate is the rate at which a person can trade the currency of one country for the currency of another. ©The McGraw-Hill Companies, 2008 Nominal Exchange Rates • The nominal exchange rate is expressed in two ways: – In units of foreign currency per one U.S. dollar. – And in units of U.S. dollars per one unit of the foreign currency. ©The McGraw-Hill Companies, 2008 Nominal Exchange Rates • Assume the exchange rate between the Japanese yen and U.S. dollar is 80 yen to one dollar. – One U.S. dollar trades for 80 yen. – One yen trades for 1/80 (= 0.0125) of a dollar. ©The McGraw-Hill Companies, 2008 Nominal Exchange Rates • Appreciation refers to an increase in the value of a currency as measured by the amount of foreign currency it can buy. • Depreciation refers to a decrease in the value of a currency as measured by the amount of foreign currency it can buy. ©The McGraw-Hill Companies, 2008 The foreign exchange market - the international market in which one national currency can be exchanged for another. The exchange rate is the price at which two currencies exchange. Exchange rate ($/£) Suppose 2 countries: UK & USA SS SS1 e0 DD shows the demand for pounds by Americans wanting to buy British goods/assets. SS shows the supply of pounds by UK residents wishing to buy American goods/assets. Equilibrium exchange rate is e0 e1 DD Quantity of pounds If UK residents want more $ at each exchange rate, the supply of £ moves to SS1 New equilibrium at e1. ©The McGraw-Hill Companies, 2008 Exchange rate regimes • In a fixed exchange rate regime – the national governments agree to maintain the convertibility of their currency at a fixed exchange rate. • In a flexible exchange rate regime – the exchange rate is allowed to attain its free market equilibrium level without any government intervention using exchange reserves. ©The McGraw-Hill Companies, 2008 Intervention in the forex market SS e1 E A Suppose the government is committed to maintaining the exchange rate at e1 ... If the demand for pounds is DD1 there is excess demand AC. C DD1 DD DD2 Quantity of £s The Bank of England must supply AC £s in return for $, which are added to reserves. The reverse occurs if demand is at DD2. When demand is DD, no intervention is needed ... there is a balance in transactions between the countries. ©The McGraw-Hill Companies, 2008 The balance of payments • … a systematic record of all transactions between residents of one country and the rest of the world • Current account – records international flows of goods, services, income and transfer payments • Capital account – records transactions involving fixed assets • Financial account – records transactions in financial assets ©The McGraw-Hill Companies, 2008 £ billion at current prices The UK balance of payments, 1980-2006 50 40 30 20 10 0 -10 -20 -30 -40 -50 1980 1983 1986 1989 1992 1995 1998 2003 Current Capital Financial Err & om Source: Economic Trends Annual Supplement ©The McGraw-Hill Companies, 2008 Balance of Payment • The interaction between the domestic agents with the foreign agents. • 1. Current Account: Exports (+), Imports(), Take aid (+), Give aid (-), income coming from abroad (+), income going to abroad (-). • 2. Capital Account: Foreigners buying stocks (+), domestic buying foreign stocks (-), capital investment to abroad (-), foreign investment to Turkey (+). ©The McGraw-Hill Companies, 2008 Balance of Payment • Current Account + Capital Account =0. ©The McGraw-Hill Companies, 2008 Components of the balance of payments • The current account is influenced by: – competitiveness – domestic and foreign income • The capital & financial accounts are influenced by: – relative interest rates • which affect international capital flows. • Perfect capital mobility – occurs when there are no barriers to capital flows, and investors equate expected total returns on assets in different countries ©The McGraw-Hill Companies, 2008 Balance of Payments (Turkey_2007-2011) ©The McGraw-Hill Companies, 2008 ©The McGraw-Hill Companies, 2008 ©The McGraw-Hill Companies, 2008 Floating exchange rates and the balance of payments • If the exchange rate is free to move to its equilibrium, there is no need for intervention. • Any current account imbalance is exactly matched by an offsetting balance in capital/financial accounts. • If there is intervention, it is recorded as part of the financial account. ©The McGraw-Hill Companies, 2008 Fixed Exhange Rate and Balance of Payments • The central bank promises to keep the nominal exchange rate at a specified level. • E.g. if exports<imports : need foreign currency. Foreign currency become more valuable, central bank should increase the dollar supply by using its reserves. ©The McGraw-Hill Companies, 2008 Some Important Identities • Assume a closed economy – one that does not engage in international trade: Y=C+I+G ©The McGraw-Hill Companies, 2008 Some Important Identities • Now, subtract C and G from both sides of the equation: Y – C – G =I • The left side of the equation is the total income in the economy after paying for consumption and government purchases and is called national saving, or just saving (S). ©The McGraw-Hill Companies, 2008 Some Important Identities • Substituting S for Y - C - G, the equation can be written as: S=I ©The McGraw-Hill Companies, 2008 Some Important Identities • National saving, or saving, is equal to: S=I S=Y–C–G S = (Y – T – C) + (T – G) ©The McGraw-Hill Companies, 2008 The Meaning of Saving and Investment • National Saving – National saving is the total income in the economy that remains after paying for consumption and government purchases. • Private Saving – Private saving is the amount of income that households have left after paying their taxes and paying for their consumption. Private saving = (Y – T©The–McGraw-Hill C) Companies, 2008 The Meaning of Saving and Investment • Public Saving – Public saving is the amount of tax revenue that the government has left after paying for its spending. Public saving = (T – G) ©The McGraw-Hill Companies, 2008 Saving, Investment, and Their Relationship to the International Flows • Net exports is a component of GDP: Y = C + I + G + NX • National saving is the income of the nation that is left after paying for current consumption and government purchases: Y - C - G = I + NX ©The McGraw-Hill Companies, 2008 Saving, Investment, and Their Relationship to the International Flows • National saving (S) equals Y - C - G so: S = I + NX or Domestic Net Capital Saving = + Investment Outflow S = I + NCO ©The McGraw-Hill Companies, 2008 International competitiveness • The competitiveness of UK goods in international markets depends upon: – the nominal exchange rate – relative inflation rates. • Overall competitiveness is measured by the real exchange rate – which measures the relative price of goods from different countries when measured in a common currency. – $/YTL Reel döviz kuru= e$/YTL *Ptr /Pabd ©The McGraw-Hill Companies, 2008 1.1 2.5 Relative price 1 (UK/USA) 0.9 2 0.8 $/£ 3 1.5 Exchange rate ($/£) 0.7 0.6 1 0.5 0.5 Relative price (UK/USA) Relative prices and the nominal exchange rate, UK & USA 0.4 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 ©The McGraw-Hill Companies, 2008 The real £/$ exchange rate The real exchange rate is the nominal rate multiplied by the ratio of domestic to foreign prices 2.5 2 £/$ 1.5 1 0.5 19 72 19 74 19 76 19 78 19 80 19 82 19 84 19 86 19 88 19 90 19 92 19 94 19 96 19 98 20 00 20 02 0 ©The McGraw-Hill Companies, 2008 Real $/TL Exchange Rate Reel $/TL döviz kuru (1995=100) 300 250 200 150 100 50 0 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 reel döviz kuru 30 ©The McGraw-Hill Companies, 2008