1 Lectures 33-39: BOP & Exchange Rate Systems Components of BOP Exchange rate and its determination.

1

Lectures 33-39: BOP & Exchange Rate Systems

Components of BOPExchange rate and its determination

2 Fall 2007 NU-FAST Zahid Siddique

BOP Accounts

• Balance of Payment is record of a country’s international transactions—sum of current and capital accounts

BOP = CA + KA– Current Account is record of a country’s international

trade in currently produced goods and services. Include: • X – M = NX, called trade or merchandise balance• Net investment income = Investment income earned

on foreign assets by home residents - Investment income paid to foreigners on home assets– earnings include interest payments, dividends or

royalties on bonds, stocks, patents or assets– also include Net Factor Payment (NFP)

• Unilateral Transfers include payments that do not involve purchase of goods, services or assets

CA = X – M + Net income from abroad + Unilateral Transfer


BOP Accounts

– Capital Account is record of a country’s international trade in existing assets, whether real or financial• If assets are traded among private individuals,

then it appears on private capital account– Includes

• Capital inflow: occurs when a resident of country sells an asset to someone in another country

• Capital outflow: occurs when a resident of country purchases an asset from abroad– both in shape of FDI and PFI

KA = Value of capital inflow – Value of capital outflow


BOP Accounts

– Official Reserve Transactions (ORT) or Official Settlement Balance is conducted by central bank• When buyer/seller of assets is central bank,

transaction appears on ORT account• Includes

– assets (other than domestic money or securities) that can be used in making international payments • e.g. gold, government securities of other

economies, foreign bank deposits or IMF created assets


Schematic representation of BOP

Accounts and Sub-accounts Cumulative Balance

Current Account (CA)

1) Merchandise

Services (Transportation, Tourism, Business & professional services)

Merchandise / Trade balance = Exports – Imports

2) Net investment income

BO goods & income = (X – M) + Investment income received on foreign assets by home residents - Investment income paid to foreigners on domestic assets

3) Unilateral transfer

• Government grants• Private remittances

CA Balance = X – M + Net income from abroad + Unilateral Transfers


Schematic representation of BOP

Accounts and Sub-accounts Cumulative Balance

Capital Account (KA)

1) Direct investment

2) Portfolio investment

• Long & short termKA Balance = Value of capital inflow – Value of capital outflow

Over all BOP = CA + KA

Official reserve transaction

1) Changes in foreign CB’s holding of domestic assets

2) Changes in home CB’s holding of foreign assets

• Gold, foreign exchange reserves , IMF credits


How to record transactions?

• The rule can be defined in two equivalent ways– transaction involving flow of funds into a country is a

credit item and entered with plus sign, and transaction that involves flow of funds out of a country is a debit item and entered with minus sign

– Alternatively, whatever leaves country is recorded as credit item and whatever enters is recorded as debit item

Exports Credit item with plus sign

Imports Debit item with minus sign

Sell of domestic assets Credit item

Purchase of foreign assetsDebit item (b/c claim to asset enters country)

Purchase of assets by home CB

Debit item


Relationship among three: The Balance

• By definition CA + KA + ORT ≡ 0

• This is due to Double Entry Book-keeping– Every complete economic transaction is recorded twice,

once as debit and once credit b/c each transaction involves something leaving the country in exchange for something entering (except for unilateral transfers)• Thus, every swap of goods/services has offsetting

effects on the sum of CA, KA and ORT• Since it is an accounting identity, it has not much

importance! The important statistics are (i) CA balance and (ii) BOP balance– The two statistics show whether a country is spending

beyond its means, and – whether there is net supply of, or demand for, its currency

• Consider an example

Identity, not equation



• Let BOP = 0 initially, and a Pakistani exports of worth $100– Pakistan is now running CA (and hence BOP) surplus

• The person can use this $100 in following waysa) may import from US of worth $100– an export credit entry in CA will be offset by another

import debit entry in CA and BOP surplus will vanishCurrent Account

Exports + $100

Imports - $100

CA Balance 00Capital Account

No transaction

KA Balance 00

BOP 0



b) may buy US assets of $100• may be in the form of US currency account

– This involves capital outflow which implies KA deficit equal to CA surplus (KA = - CA), BOP = 0 and ORT = 0• This can be recorded as

Current Account

Exports + $100

Imports 0

CA Balance + + $100$100

Capital Account

Capital outflow - $100

KA Balance - $100- $100

BOP 0



c) If country is running CA surplus and private residents are not acquiring foreign assets—i.e. may decide to convert dollars with rupee through some bank• bank may loan it to an individual for US imports or

purchase of assets, then same as above happens• or central bank must be acquiring foreign assets• so country will have surplus on CA, and KA = 0• while ORT = - BOP

Current Account

Exports + $100

CA Balance + + $100$100

Capital Account

KA Balance 00

BOP + $100CB’s holding of foreign assets - $100

surplus both on CA and BOP

BOP = -ORT



• Thus, BOP shows net supply of foreign currency (or net demand for domestic currency) after the private sector has made all its desired CA and KA transactions– If BOP > 0, ORT must be negative which means CB is

adding to its foreign exchange reserves (or is supplying domestic currency that private agents demand in foreign market)

– If BOP < 0, ORT must be positive, means CB is selling foreign exchange reserves (or buying domestic currency that private agents want to sell in foreign market)

• This shows that ORT = - BOP, i.e., ORT is negative of the sum of items on BOP account– Therefore, ORT is termed as accommodating entry in BOP

accounts (b/c it always adjusts to keep BOP = 0) while the other (CA and KA) accounts are said to be autonomous


The issue of deficit

• CA deficit may be expressed as difference between value of exports and imports of goods and services

• To see this, begin from national income identity

– With slight rearrangements

– It says that• if output > domestic spending, NX > 0 (i.e., we

have trade surplus), and • if output < domestic spending, NX < 0 (i.e, we have

trade deficit) – CA deficit then means a country is importing more than

it is exporting—ignoring other small fractions in this total

MXGICY

SpendingDomesticOutputExportsNet

GICYNX

imports subtracted to find expenditures

only on domestic goods



• Another way to express deficit is the difference between national savings and investment

• Rearranging national income identity as

– LHS is national saving, SN

• To see this, note that SN = Sprivate + Spublic, where

• summing up we have LHS– so we have

– means trade surplus if (S – I) > 0, and deficit if (S – I) < 0

• Deficit now reflects low level of national savings relative to investment or a high rate of investment—or both

NXIGCY

TCYSprivate GTSpublic and

NXISN NXISN or

GTTCYSN



• CA deficit matters b/c amount flowing to foreigners is used to buy assets in domestic country—i.e. CA deficit is financed by selling domestic assets– stream of incomes on assets is paid to foreigners thus

limiting resources available for investment• If foreigners are not buying our assets, country faces

depreciation on its currency (to be discussed later)• Deficit is highly unjustified if it is in shape of ‘for

consumption goods’ (as is case for Pakistan) due to insolvency issues

• Bearable if borrowing are used to finance investment that has a higher marginal product than interest rate– problematic if private financing not available in future

• consumption, investment, and government expenditures must be curtailed to repay in short order its past borrowings


Exchange rate

• History of modern financial system evolution later, if possible• Nominal Exchange rate is relative price of two currencies

– Can be expressed in two ways

• measures how many units of domestic currency I can get in exchange for one unit of foreign currency

• measures how many units of foreign currency can be purchased by one unit of domestic currency

• US authors prefer first while Europeans prefer second definition– change in definition changes direction of movement of ER

CurrencyForeignofUnitOneCurrencyDomesticofUnits

)1 nom e$1Rs10

CurrencyDomesticofUnitOneCurrencyForeignofUnits

)2 nom eRs1

$1.0


B

B

PakRs

240

USRs

120

Exchange rate

• Real Exchange rate is relative price of two countries goods; i.e. how many units of foreign good can I get in exchange of one unit of domestic good, also called terms of trade

• Consider an example– a burger costs Rs240 in Pakistan and $2 in US– to compare where it is cheaper, covert its price into a

common currency– if 1$ = Rs60, then USB costs Rs 120 which means that USB

costs one-half of a PakB; i.e. two USB can be exchanged with one of PakB

– algebraically,

B

B

PakRs

042

US$

2$Rs

60

reale

Cancel out

USPak

0.5 B

B

i.e. 1 USB = 0.5PakB same as

above

now in same currency unit


Exchange rate

• Putting formally,

– If real exchange rate is high, foreign goods are cheaper while domestic ones are expensive, and vice versa

• However, with $/Rs definition of ER, formula becomes

– Don’t get confused if you find different versions in different books

– Tip: refer to the definition of exchange rate for solution

d

f

Rs$nomReal PP

ee

goodforeignofPricegoodDomesticofPriceRateExchangeNominal

RateExchangeReal

f

d

$RsnomReal PP

ee


Purchasing Power Parity (PPP)

• Relation b/w nominal and real ER can be derived simply • Assume all countries producing one and same good

– None will exchange both goods but on one-to-one bases; i.e.

– idea that similar domestic and foreign goods should have same price in terms of same currency is called PPP—purchasing power of two currencies should be same across countries• an application of the law of one price at

international level due to the process of arbitrage• Above expression implies that

d

f

$Rsnom PP

e

1f

d

$RsnomReal

PP

ee

says that enom should equal ratio of foreign to domestic price



• If USB = $2 and PakB = Rs240, then

• Data shows PPP does not hold—neither in short nor long run– Many reasons account for it

• Countries don’t produce similar goods• Not all types of goods in a basket are freely traded• Transaction costs and barriers against trade matter

• To see the general relationship b/w enom and ereal, apply percentage change on ereal expression using log-rule

or

1 $120 Rs

2 $240 Rs

$Rsnom e for PPP to hold, 1$ = Rs120

f

f

d

d

nom

nom

Real

Real

PP

PP

ee

e

e

d

d

f

f

Real

Real

nom

nom

PP

PP

e

e

ee

Difference b/w foreign and domestic inflation



– so we have

– says that enom is affected by inflation in two countries. It depreciates if• real exchange rate decreases; or• rate of domestic inflation is higher than foreign

• If ereal is constant over time, then

• E.g. with USB = $2, PakB = Rs240 and if πf = 0 while πd = 10%– after one year, still USB = $2 but PakB = Rs264

– PPP predicts that enom should change to

– Similar result also holds for interest rate parity

df

ee

nom

nom

df

e

e

ee

Real

Real

nom

nom

1 $132 Rs

2 $264 Rs

$Rsnom e %Δenom is exactly 10%


Digression on terminologies

• Flexible exchange rate is one determined by the supply and demand conditions of a currency in the foreign exchange market (the market for international currencies)

• Fixed exchange rate is one determined by government at official level and is changed only by government actions

• Managed-floating exchange rate is one in which exchange rate responds to market conditions while central bank also intervenes to prevent undesirable movements in exchange rate

• Depreciation is a reduction in the value of a currency by market forces under flexible exchange rate system– increases in exchange rate means domestic currency

depreciates and foreign currency appreciates (when exchange rate is defined as ‘units of domestic currency / foreign currency’)


Digression on terminologies

• Appreciation is increase in the value of a currency due to market forces under flexible exchange rate system– decreases in exchange rate implies that domestic

currency appreciates and foreign currency depreciates• Devaluation is the reduction in the value of a currency

by official government action under fixed exchange rate system

• Revaluation is the increase in the value of a currency by official by official government action under fixed exchange rate system

• If exchange rate is instead defined as ‘units of foreign currency / one unit of domestic currency’, the above definitions are reversed; that is depreciation would be called appreciation and so on


Determination of floating exchange rate

• It is determined by demand for and supply of a currency• The demand for, say $, arises when, say, Pakistani purchase

US goods or assets• Demand for a currency is negatively related to exchange rate

– So b/c as exchange rate (Rs/$) increases, price of US goods in terms of Rs rises

• E.g. Suppose a USCam = $1 and enom = Rs 10/$. The camera costs Rs 10 to Pakistanis

• If enom rises to Rs20/$, same camera costs Rs 20

– Pakistanis decrease imports demand from US, hence for its currency—hence negative relation established 0

en

om

Dollars

D$



• Supply of currency is positively related to exchange rate– So b/c as exchange rate increases, Pakistani exports

become less expensive to US residents in terms of dollars

• E.g. Suppose a PakFootball = Rs10 and enom = Rs 10/$. Then foot-ball would cost 1$ to US residents

• If, however, enom increases to Rs 20/$, the same foot-ball will cost $0.5 now

• US order more export of foot-ball from Pakistan (hence more dollars supplied)

• ER is determined by the interaction of demand for and supply of foreign exchange

• Market exchange rate is e* and $* dollars are traded in the international market 0

en

om

Dollars

D$

S$

e*

$*



• Factors that affect exchange rate are given below

An Increase in Causes ER to

Because In Graph

Domestic output (income), Yd

Fall Higher Yd raises demand for imports and increases supply of domestic currency

S$-curve shifts outward

Foreign output (income), Yf

Rise Higher Yf raises demand for domestic exports and increases demand for domestic currency

D$-curve shifts outward

Domestic real interest rate, r

Rise Higher real r makes domestic assets attractive and increases demand for domestic currency

D$-curve shifts outward

Foreign real interest rate, rfor

Fall Higher rfor makes foreign assets more attractive and increases supply of domestic currency

S$-curve shifts outward


Exchange rate and CA

• Factors that affect NX (or TB) are given below

An Increase in Causes NX to

Because

Domestic output (income), Yd

Fall Higher Yd raises demand for imports hence decreases NX

Foreign output (income), Yf

Rise Higher Yf raises demand for our exports hence increases NX

Domestic real interest rate, r

Fall Higher r appreciates exchange rate; domestic exports become expensive and imports from abroad become cheaper. Hence NX decrease

Foreign real interest rate, rfor

Rise Higher rfor depreciates exchange rate; domestic exports become cheaper while foreign imports expensive. Hence NX increase


Determination of fixed exchange rate

• In a fixed ER system, government announces an official ER at which all trading take place

• This official ER may be above or below market (or fundamental value of) exchange rate

• This diagram shows that the official exchange rate is above the equilibrium one– In this case, the domestic currency ($) is overvalued.

• To keep ER at levels other than market ER, government becomes demander and supplier of its currency in foreign exchange market

• Here, supply of domestic currency (point b) in exceeds its private demand (point a)– hence excess supply (ab) 0

en

om

Dollars

D$

S$

e*

$*

eF

ba


Determination of fixed exchange rate

• Government can purchase excess currency in the amount ab against foreign reserve assets (e.g. gold, foreign bank deposits, assets created by IMF etc)

• However, central bank can’t do it for long b/c it has limited supply of foreign reserve assets

• The process is even more difficult in case of speculative man—one who buys currencies for arbitrage

• In case of undervalued fixed ER, country gains reserves at the cost of its trading partner (who is having overvalued currency)– It puts political pressure

on the country to bring exchange rate at equilibrium rate 0

en

om

Dollars

D$

S$

e*

$*

eF

ba

1 Lectures 33-39: BOP & Exchange Rate Systems Components of BOP Exchange rate and its determination.

Documents

assets ca

assets slide

capital accounts bop

ca balance0 capital

imports0 ca balance

us assets

private capital account

ca surplus ka