Topic 5 BOP

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Topic 4

The Balance of Payments and Exchange Rates

Outline:

A. Balance of PaymentB. Determinants of Import and Export

C. Demand and Supply of Foreign Exchange

D. Equilibrium Exchange Rate

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Section A: Balance of Payments (BOP)

BOP records a countrys transactions in goods, servicesand assets with the rest of the world.

BOP is also a record of a countrys sources (supply) and

uses (demand) of foreign exchanges. Usually recorded in local currency (at equivalent

amount of foreign currency).

1. Transactions that create earnings (supply) offoreign exchanges carry apositive sign.

2. Transactions that use up (demand) foreign

exchanges carry anegative sign.

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Current account

Exports of goods and services. (+)$XX

Imports of goods and services. (-) $XX

Balance of trade (+/-)$XX

Income (received/paid) on investments (e.g. dividends). (+/-) $XX

Transfer of funds (from/to) abroad (e.g., remittance). (+/-) $XX

Current account balance (+/-) $XX

Capital/Financial account (capital outflow/inflow)

(Increase/Decrease) in domestic ownership of foreign assets. (-/+)$XX

(Increase/Decrease) in foreign ownership of domestic assets. (+/-)$XX

Errors & omissions (e.g., unreported transactions) . (+/-)$XX

Capital account balance (+/-)$XX

Official settlement account

Changes in official reserves (sell(+)/buy(-) foreign currency (+/-)$XX

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Example:

A Hong Kong textile company sells USD 1m ofproducts to the US, then deposits the USD 1m revenue

in a New York bank

In HKs BOP:

Current A/C: export of goods and services +HKD 7.8m.

Capital A/C: increase in domestic ownership of foreign assets-HKD 7.8m.

Question:

If the HK company keeps the USD 1m in cash, does itchange the way in which the above transaction isrecorded in HKs BOP?

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Remark: The balances of these three accounts must besummed tozero.

Example: if HK has a trade deficit (e.g., imports exceeds

exports by HKD 3m) :

Spending of foreign exchange is larger than earning of foreign

exchange.

The trade deficit has to be financed by the capital account

surplus, e.g., selling government bonds to foreigners (increasein foreign ownership of domestic assets by HKD 3m).

Or, financed by the official reserves (the HK government

sells USD for HKD 3m).

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Notice that both the current account and capital account

concern with transactions of the private sector

Official settlement account concerns with transactions of the

government sector

Normally the BOP Balance is defined as the balance of the

private sector:

BOP Balance = Balance in the Current Account

+ Balance in the Capital Account

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Section B: The determinants of imports and exports

Major determinants of the demand for Imports (IM):

Domestic incomes rise (+ effect on IM)

Domestic prices rise relative to foreign prices (+ effect on IM)

Exchange rate of domestic currency rises (+ effect on IM)

Major determinants of the demand for Exports (EX):

Foreign incomes rise (+ effect on EX)

Domestic prices rise relative to foreign prices (- effect on EX)Exchange rate of domestic currency rises (- effect on EX)

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Remark:

Export and Import are parts of national incomes=>The economic performance of countries/economies

are interrelated through changes in exports and

imports

Example:

If the US has poor economic performance,

National income of the US will decrease.

Demand for import from overseas will decrease.

Demand for HKs exports will decrease.

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Section C: Demand and Supple of Foreign

Exchange

Definition of Exchange Rate: Price of foreign

currency in terms of domestic currency

Examples: USD1 = HKD7.75

HKD/USD = 7.75

USD/HKD = 0.129

Without government intervention, exchange

rate is determined by Demand and Supply.

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The demand for foreign currency

Consider the exchange rate between USD and HKD:

If the exchange rate of USD falls (in terms of HKD)

HK consumers buy more US goods, and thus buy more

USD (sell more HKD).

Quantity demanded for USD increases.

Demand curve for USD is downwardsloping.

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US$1 = HK$8 US$1 = HK$6

Price of US made sports shoes inUS$

US$50 US$50

Price of US made sports shoes in

HK$

HK$400 HK$300

Quantity demanded of US sportsshoes

20 28

Quantity demanded of US$ US$1,000 US$1,400

Example 1.1:

Review question: How is HKs trade balance affected by the

appreciation of HKD?

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Draw the Demand Curve for USD (Example 1.1)

HKD/USD

Q of USD

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US$1 = HK$8 US$1 = HK$6

Price of US made sports shoes inUS$

US$50 US$50

Price of US made sports shoes in

HK$

HK$400 HK$300

Quantity demanded of US sportsshoes

20 22

Quantity demanded of US$ US$1,000 US$1,100

Example 1.2:

Review question: How is HKs trade balance affected by theappreciation of HKD?

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Factors that will shift the demand curve for

foreign currency

1. Relative price level between the domestic country and

foreign country

If US product pricesrise, the demand curve for USD

shifts to the left .

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Price of US made sportsshoes in US$

US$50 US$60

Exchange rate US$1 = HK$8 US$1 = HK$8

Price of US made sports

shoes in HK$

HK$400 HK$480

Quantity demanded of USsports shoes

20 15

Quantity demanded of US$ US$1,000 US$900

Example 1.3:

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Draw the Demand Curve for USD (Example 1.3)

HKD per

USD

Q of USD

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2. Interest rate

If US interest raterises

Investors buy more USD (sell more HKD) since

investment in US (e.g. bonds) becomes more attractive.

The demand curve for USD shifts to theright.

3. Domestic income

If HK national incomesrise

HK consumers buy more foreign goods.

The demand curve for USD shifts to theright.

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4. Expectation Expectation about future changes in relative price, interest

rate and income.

If investors expect a future appreciation of HKD (against

USD): The current demand curve for USD shifts to the left.

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The supply for foreign currency

If the exchange rate of USDfalls(in terms of HKD)

US consumers buy less HK goods, and thus buy less

HKD (sell less USD).

Quantity supplied of USDdecreases.

The supply curve for USD is upwardsloping.

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Price of HK madeclothing in HK$

HK$120 HK$120

Price of HK madeclothing in US$

US$15 US$20

Quantity demanded ofHK made clothing

30 20

Quantity supplied of US$ US$450 US$400

Example 2.1:

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Draw the Supply Curve of USD (Example 2.1)

HKD/USD

Q of USD

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Factors that will shift the supply curve for foreign

currency

1. Relative price level between the domestic country and

foreign country

If HK product pricesrise, the supply curve for USD

shifts to the left .

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Price of HK madeclothing in HK$

HK$120 HK$160


Price of HK madeclothing in US$

US$15 US$20

Quantity demanded ofHK made clothing

20 12

Quantity supplied of US$ US$300 US$240

Example 2.2:

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Draw the Supply Curve of USD (Example 2.2)

HKD per

USD

Q of USD

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2. Interest rate

If HK interest raterises.

Investors sell more USD (buy more HKD) since

investment in HK becomes more attractive.

The supply curve of USD shifts to theright.

3. Foreign income

If US national incomesrise. US consumers buy more HK goods.

The supply curve of foreign currency shifts to theright.

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4. Expectation

Expectation about future changes in relative price, interest

rate and income.

If investors expect a future appreciation of HKD:

The current supply curve of USD shifts to theright

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Summary

Price effect (shifts both demand and supply curves):

If domestic (HK) product prices rise

(IM rises) Demand for foreign currency (USD) increases. (EX falls) Supply of foreign currency (USD) decreases.

If foreign (US) product prices rise

(IM falls) Demand for foreign currency (USD) decreases. (EX rises) Supply of foreign currency (USD) increases.

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Summary

Interest rate effect (shifts both demand and supply curves):

If domestic (HK) interest rate rises

(Capital outflow falls) Demand for foreign currency (USD) decreases.(Capital inflow rises) Supply of foreign currency (USD) increases.

If foreign interest rate rises

(Capital outflow rises) Demand for foreign currency (USD) increases.(Capital inflow falls) Supply of foreign currency (USD) decreases.

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Summary

Income effect (shifts either demand or supply curve):

If domestic (HK) incomes rise

(IM rises) Demand for foreign currency (USD) increases.

If foreign (US) incomes rise

(EX rises) Supply of foreign currency (USD) increases.

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HKD per

USD

Quantity of USD available in the currency market

S1

D1

HKD7.75

D2

S2

Without government intervention, the equilibrium exchange rate is

determined by demand and supply.

Section D: Equilibrium Exchange Rate

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Managed exchange rate(e.g., Hong Kongs linkedexchange rate system)

Exchange rate is subject to demand and supply forces within

the trading band.

If the fluctuations are too large, central bank will intervene

the market.

If foreign currency appreciates too much (above the upper

bound), central bank will sell foreign currency to dampen the

appreciation.

If foreign currency depreciates too much (below the lower

bound), central bank will buy foreign currency to dampen the

depreciation.

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Managed exchange rate

HKD per

USDS

D

Upper bound

Lower bound

}Trading band

7.75

7.85

Quantity of USD available in the currency market

Topic 5 BOP

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