Economics for Management GSB728 Topic 12: Balance of Payments and Exchange Rates 1
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Economics for Management
GSB728
Topic 12:
Balance of Payments and Exchange Rates
1
Note: This lecture note was prepared based on the teaching material provided
by the publisher of the textbook Principles of Economics.
2
Learning Objectives1. Balance of payments account – What is it?
2. Exchange rates – What causes exchange rates to change?
3. Exchange rates and the balance of payments – How do the exchange rates and balance of payments affect each other?
4. Globalisation and the problem of instability – Can governments do anything to create greater harmony in the world economy?
3
• The balance of payments records all flows of money between residents of a country and the rest of the world.
• Receipts of money from overseas are considered as credits and are entered in the accounts with a positive sign.
• Outflows of money from the country are considered as debits and are entered in the accounts with a negative sign.
• The balance of payments is composed by the current, capital and financial accounts.
Balance of Payments
4
• The current account:– The trade in goods account: records imports and
exports of physical goods.
– The trade in services account: records imports and exports of services (e.g.: transport, tourism and insurance).
– Income flows: wages, interest and profits flowing into and out of the country.
5
Balance of Payments (contd.)
Current Account
1. Trade in goods
Balance of trade in goods -14,688
2. Trade in services
Balance of trade in services -
10,618
3. Other income flows
Investment income balance -
44,264
Current Account Balance -40,194
6
Balance of Payments, Australia, 2011-12 ($m): Current Account
Source: Australian Bureau of Statistics (ABS) (2013).
• The capital account:– Net capital transfers: includes transfers of funds by
people moving into or out of the country, and the financing of capital project in developing countries.
– Net acquisition/disposal of non produced, non financial assets: intangible assets recorded in the capital account such as sales of patents, copyrights, trademarks and franchises.
Balance of Payments (contd.)
7
Capital Account
4. Net capital transfers -1,082
5. Net acquisition/disposal of non produced,
non financial assets -28 .
Capital Account Balance -1,110
Balance of Payments, Australia, 2011-12 ($m): Capital Account
8Source: Australian Bureau of Statistics (ABS) (2013).
• The financial account:– Net direct investment: purchase or sale of assets of
companies between overseas and in Australia.– Net portfolio investment: purchase and sale of land,
shares and other securities between Australian and foreign individuals and companies.
– Net financial derivatives: futures and forward contracts.
– Other net investments: non-tradable loans and deposits with banks, and trade credit provided by businesses to their customers.
– Reserves assets: RBA’s holdings of foreign currencies, gold and Special Drawing Rights (SDRs) position with the International Monetary Fund. 9
Balance of Payments (contd.)
Financial Account
6. Net direct investment 44,692
7. Net portfolio investment 46,373
8. Net financial derivatives -26,828
9. Other net investments -17,260
10. Reserve assets -5,908
Financial Account Balance41,069
Balance of Payments, Australia, 2011-12 ($m): Financial Account
10Source: Australian Bureau of Statistics (ABS) (2013).
The current account+ The capital account+ The financial account+ Net errors and omissions Total of all three accounts
• The three accounts together should balance exactly (credits equals to debits). If they were not equal, the rate of exchange will adjust until they were (or the government intervene, depending on the exchange rate system).
11
Balance of Payments (contd.)
• To maintain an overvalued exchange rate the government will need to purchase its own currency.
• To be able to do so, the government (usually the central bank or reserve bank) will need to hold foreign currency assets called international reserves (or simply reserves).
• Over the time the reserves available will vary!• The net decline in reserves over a year is
called balance of payments deficit.• The net increase in reserves over a year is
called balance of payment surplus.12
Balance of Payments (contd.)
Balance of Payments, Australia, 2011-12 ($m)
13Source: Australian Bureau of Statistics (ABS) (2013).
Exchange Rates
• The exchange rate indicates the amount at which one currency trades for another.
• Trade weighted index is a weighted average exchange rate expressed as an index, where the index was 100 in a given year. This index is used to get an impression of the overall movement in Australian exchange rates.
14
US
Dollar
UK
Pound Japanese Yen
Trade Weighted Index
(1970 = 100)
2000
0.51
0.36
63
49.7
2005 0.75 0.41 81 62.7
2008 0.92 0.55 83 72.0
2013
1.07 0.68 98 78.1
Australian Dollar Exchange Rates
15
Source: Sloman et al. (2014).
• Floating or flexible exchange rate system: the value of the currency is allowed to fluctuate according to the foreign exchange market.
• Fixed exchange rate system: set by government intervention.
• Managed exchange rate system: free exchange rate movement combined with government intervention to modify extreme swings.
Exchange Rate Systems
16
• Determination of the exchange rate in a free market:
• Determined by demand and supply.
• Equilibrium exchange rate.
Floating Exchange Rate
17
Ye
n p
er
$AU
Quantity of $AU
Determination of theYen/$AU Exchange Rate in a Floating System
80
100
$AU:DJapanese
$AU: SAustralians
b a
0
Yen/$AU equilibrium
Source: Sloman et al. (2014). 18
• Shifts in the currency demand and supply curves produce:
– Depreciation.
– Appreciation.
19
Floating Exchange Rate (contd.)
Eu
ro p
er
$A
U
Quantity of $AU
Floating Exchange Rates: $AU Depreciates Against the Euro
0.70
0
S1 Australians
D1 EuropeansD2 Europeans
S2 Australians
Depreciation leads to new
Euro/$AU equilibrium
0.650.60
20Source: Sloman et al. (2014).
Eu
ro p
er
$A
U
Quantity of $AU
Floating Exchange Rates: $AU Appreciation Against the Euro
0.80
0
S2 Australians
D2 EuropeansD1 Europeans
S1 AustraliansAppreciation leads to new
Euro/$AU equilibrium
0.750.70
21Source: Sloman et al. (2014).
– Shifts in the currency demand and supply curves due to:
• Differences in interest rates.
• Differences in inflation rates.
• Change in domestic incomes relative to incomes abroad.
• Relative investment prospects.
• Speculation about the exchange rate.
22
Floating Exchange Rate (contd.)
Exchange Rates and the Balance of Payments
• No government or central bank intervention.
– Floating exchange rate:
• Automatic balancing of overall balance of payments.
• Current, capital and financial accounts may not separately balance, but when added they will balance.
23
• Government or central bank intervention.
– Reducing short-term fluctuations:• Using reserves.• Borrowing from abroad.• Changes in interest rates.
– Maintaining a fixed rate of exchange over the longer term:
• Contractionary policies.• Supply-side policies.• Controls on imports and/or foreign exchange dealings.
24
Exchange Rates and the Balance of Payments (contd.)
Exchange Rates: Fixed vs. Floating
• Advantages of fixed exchange rates– Certainty.– Prevents 'irresponsible' government policies.
• Disadvantages of fixed exchange rates– Exchange rate policy may conflict with the interests of
domestic business and the economy as a whole.– Competitive contractionary policies leading to world
depression.– Problems of international liquidity.– Inability to adjust to shocks.– Speculation.
25
• Advantages of free-floating exchange rates:– Automatic correction.– No problem of international liquidity and reserves.– Insulation from external economic events.– Governments are free to choose their domestic
policy.
Exchange Rates: Fixed vs. Floating (contd.)
26
• Disadvantages of free-floating exchange rates:– Unstable exchange rates.– Speculation.– Uncertainty for traders and investors:
• However, use of forward markets can assist in reducing uncertainty.
– Lack of discipline on the domestic economy.
Exchange Rates: Fixed vs. Floating (contd.)
27
• Exchange rates in practice:• Most countries have moved to floating exchange
rates over past 30 years.
• Intervention in floating exchange rates common.
• Increasing volatility in exchange rates:
– Huge growth in international financial markets.
– Abolition of capital movement controls.
– Speculation has increased.
28
Exchange Rates: Fixed vs. Floating (contd.)
Globalisation and the Problem of Instability
• Interdependence through trade:• International effects of changes in aggregate demand.
• Vulnerability of open economies.
• Financial interdependence:• Increase in the size of international financial flows.
• International effects of changes in interest rates.
29
• Need for international policy coordination!!– The search for policy co-ordination:
• Meetings of major industrial countries: attempts at policy harmonisation.
• Lack of convergence.
– Difficulties in achieving harmonisation:• Differences in budget deficits and debt.• Interest rate divergence.• Different internal structures of economies.
• Different rates of export growth.
• Politicians more concerned with domestic issues. 30
Globalisation and the Problem of Instability (contd.)
• Origins of the debt problem:– The oil shocks of the 1970s.
• The 1973/74 oil shock• The 1979/80 oil shock
– World recession Fall in export earnings.• Fall in commodity prices (exports).• High interest rates Cost of servicing debt.
– Borrowing to finance development.• Coping with debt: Rescheduling
– Rescheduling official loans.– Rescheduling commercial bank loans.
Debt and Developing Countries
31
• Dealing with debt:
– Structural reforms:• IMF structural adjustment programs.
– Tight fiscal policies to reduce budget deficits.
– Supply-side reforms.
– Open trade policy.
– Debt forgiveness:• Heavily indebted poor countries initiative (HIPC).
• Successes/failures to date.
• Pressure to cancel debts.32
Debt and Developing Countries (contd.)
ReferencesAustralian Bureau of Statistics (2013). Australian Balance
of Payments and International Investment Position. Retrieved from http://www.abs.gov.au/AUSSTATS/[email protected]/DetailsPage/5302.0Dec%202012?OpenDocument.
Morales, L. E., Simons, P. and Valle de Souza, S. (2014). GSB728: Economics for Management [Topic Notes]. Armidale, Australia: University of New England, Graduate School of Business.
Sloman, J., Norris, K and Garratt, D. (2014). Principles of Economics (4th ed.). French Forest, Australia: Pearson.33
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