Sally Meek [email protected] Revised by Lori Leachman [email protected].

CONNECTIONS: BALANCE OF PAYMENTS,

FOREX MARKETS, LOANABLE FUNDS

MARKETS

Sally [email protected]

Revised byLori Leachman

[email protected]

Open Economy Topics (from College Board’s Course Description)

VII. Open Economy: International Trade and Finance

Balance of Payments Accounts

Foreign Exchange Market

Net Exports and capital flows

Links to financial and goods markets

Key Ideas

(Handout page 1) The exchange rate is the price of one country’s money

in terms of another- there are 2 ways to report: E= foreign price of a dollar= #FC units/$1 e=dollar price of foreign currency=$1/#FC units

Focus on money coming in as a credit (sell) and money going out as a debit (buy) – or alternatively one person’s buy is another person’s sell

2 major accounts: Current account and financial account

(Handout page 2)BP = Current Account (CA) + Financial Account(FA) = 0If BP≠0, then there is an official change in foreign currency

reserves (this role of official reserves is critical in fixed exchange rate systems) so really

BP= CA + FA + ∆ off reserves = 0

Current account deficits must be offset by financial account surpluses (increasing capital inflows)

(CA‹0)=( FA›0) so BP=0

Current account surpluses must be offset by financial account deficits (increasing capital outflows)

(CA›0) = (FA‹0) so BP=0

(Handout page 2)

All transactions impact foreign currency markets of the participants – because to buy or sell foreign goods or asset you must exchange currency

Financial account transactions impact the loanable funds market of the participants:

Capital inflows will increase the supply of loanable funds (as foreigners buy bonds)

Capital outflows will decrease the supply of loanable funds( as foreigners and domestic investors sell bonds)

Department of Commerce

www.bea.gov – International Transactions

Examples of current articles (relatively)

Bloomberg - March 19, 2009

WSJ – September 11, 2008

WSJ- Feb. 16, 2010

Balance of Payments – An Activity (Handout pages 3 – 10)

2 groups (countries)

Classifying transactions as current account or financial/capital account

Classifying transactions as inflows of money or outflows of money

Creating forex models to illustrate transactions impact on currency value

Creating loanable funds markets to illustrate impact on real interest rates from financial/capital account transactions

1.

increase D$=increase SFC; E rises or e falls

Practice Questions: (page 11)

Euros/$=E

Q USD

S$

D$

SEuros

DEuros

$/Euro=e

QEuros

D1

S1

USD appreciates and the Euro depreciates

2.

Increase S$ = increase DSGD; E falls or e rises

Practice Questions: (page 11)

SGD/$ =E

Q USD

S$

D$

SSGD

DSGD

$/SGD =e

QSGD

D1

S1

USD depreciates and the SGD appreciates

3.

Practice Questions: (page 11)

Peso/$

Q USD

S$

D$

SPeso

DPeso

$/Peso

QPeso

D1

S1

USD depreciates and the Peso appreciates

4.

Practice Questions: (page 11)

Yen/$

Q USD

S$

D$

SYen

DYen

$/Yen

QYen

D1

S1

USD appreciates and the Yen depreciates

5.

Practice Questions: (page 11)

Real Interest

rate

Q Loanable Funds

SLF

DLF

S1

Capital flows into the US (increased demand for dollars), increasing the supply of loanable funds and decreasing the real interest rate.

The US dollar would appreciate as more dollars are demanded in order to purchase US government bonds.

6.

Practice Questions: (page 11)

Real Interest

rate

Zambia’s Loanable Funds Market

Q

SLF

DLF

S1

Capital flows out of Zambia, decreasing the supply of loanable funds and increasing the real interest rate.

Zambia’s currency would depreciate as the currency is used to purchase other currencies.