Lecture International finance: An analytical approach (3/e): Chapter 3 - Imad A. Moosa

Chapter 3 - The balance of payments and the effective exchange rate. The objectives of this chapter are: The objectives of this chapter are: To define the balance of payments, to examine the australian balance of payments statistics, to illustrate the relation between the balance of payments and the foreign exchange market,...

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Chapter 3

The Balance of Payments and the

Effective Exchange Rate

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PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa

Slides prepared by Afaf Moosa 3-2

Objectives

• To study the structure of the balance of payments

• To illustrate how the BOP is related to the FX market

• To introduce the concept of the effective exchange rate

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• The balance of payments (BOP) is a systematic

record of all economic transactions between the

residents of the reporting country and the rest of the world over a specified period of time.

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Important elements in the

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Important elements in the

definition (cont.)

• The BOP records changes in assets and liabilities

• Figures may or may not be seasonably adjusted

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Slides prepared by Afaf Moosa

Structure of the BOP

• The BOP consists of the current account and the

financial account

3-6

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Components of the current account

• Merchandise account (trade balance)

• Net services

• Current transfers

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The financial account

• Records official and non-official net financial flows

• A balancing item is added to account for errors and omissions

3-8

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The Australian BOP: Current

account

(AUD Million)

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The Australian BOP: Financial

account

(AUD Million)

3-10

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The Australian BOP: Balancing item (AUD Million)

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The BOP and FX market

• The BOP is related to the FX market because

transactions involving trade and capital flows give

rise to the demand for and supply of currencies

• The demand for foreign currency is the supply of

domestic currency, and vice versa

3-12

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Derivation of the demand and

supply curves

• The demand for foreign exchange is equivalent to

import expenditure

• The demand curve is derived from the supply and

demand for imports

(cont.)

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Derivation of the demand and

supply curves (cont.)

• The supply of foreign exchange is equivalent to

export revenue.

• The supply curve is derived from the supply of and demand for exports.

3-14

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The demand side equations

The following equations are used to derive the demand curve:

m

m Q P

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The supply side equations

The following equations are used to derive the supply curve:

x

*

x Q P

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The demand for and supply of

foreign exchange curves

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Factors affecting the current

account

• Economic growth: A country with a higher growth

rate than its trading partners will experience

deterioration in the current account.

(cont.)

3-18

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m e P

*

x x

Q  

(cont.)

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account (cont.)

• Inflation: A country that has a higher inflation rate

than its trading partners will experience deterioration

in the current account.

(cont.)

3-20

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Improving current account

(zero domestic inflation)

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Deteriorating current account

(high domestic inflation)

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account (cont.)

• Trade restrictions: One reason for imposing trade

restrictions, such as tariffs and quotas, is the desire

to protect the current account.

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Factors affecting the financial

account

• Taxes: Taxes that are imposed on capital gains

and/or income from dividends and interest payments may adversely affect the financial account This is

because foreign investors no longer find it attractive

to invest in the underlying country’s securities

(cont.)

3-24

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account (cont.)

• Capital controls: Capital controls are imposed

typically to deal with a chronic weakness in the

balance of payments

(cont.)

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account (cont.)

• The expected change in the exchange rate: If a

currency is expected to appreciate, the expected rate

of return on investment in securities denominated in that currency will be higher, attracting capital flows Thus, a country’s financial account will improve if

that country’s currency is expected to appreciate.

3-26

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The effective exchange rate

• The effective exchange rate is an index of a

weighted average of the nominal exchange rates

against the currencies of major trading partners.

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The EER equations

The following equations are used to calculate the EER:

i

w t i

m i t

m

i i i t t

V E

V w E

) (

Π

∑

, 1

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The EER equations (cont.)

The following equations are used to calculate the

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What does the RBA do in practice?

• The RBA calculates a nominal effective exchange

rate called the trade-weighted index (TWI)

(cont.)

3-30

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What does the RBA do in practice? (cont.)

• As the name implies, the index is calculated on the

basis of the (bilateral) trade shares of Australia’s

major trading partners

(cont.)

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What does the RBA do in practice? (cont.)

• Until October 1988 the TWI was calculated as an

arithmetic weighted average, but since then the RBA has shifted to using a geometric weighted average

• Major trading partners are those accounting for at

least 90 per cent of Australia’s trade (exports plus

imports)

3-32

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The weights used by the RBA to

calculate the TWI

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The RBA’s trade-weighted index,

January (1970 = 100)

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The real exchange rate

• The real exchange rate is the nominal exchange rate adjusted for differences in prices or inflation rates:

x

y

P

P y

x S y

x

Q ( / ) ( / )

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The real effective exchange rate

• The real effective exchange rate can be calculated from the real bilateral exchange rates:

i

w

, i

t, i

m i t

, i

t, i m

i i t

Q

Q Q

Q

Q w

Q

0 1

∑

3-36

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