EXCHANGE RATE AND BALANCE OF PAYMENTS

After studying this unit, you will be able to: Describe the foreign exchange market, define the exchange rate, and distinguish between the nominal exchange rate and the real exchange rat

International Finance

Lecture 3 EXCHANGE RATE AND BALANCE OF PAYMENTS

After studying this unit, you will be able to:

Describe the foreign exchange market, define the

exchange rate, and distinguish between the nominal exchange rate and the real exchange rate

Calculate the real exchange rate

Explain how the exchange rate is determined day by day

Explain the factors that influence the demand for

and supply of rand

Show the demand for and supply of rand graphically, and indicate equilibrium in the foreign exchange

market

Evaluate the effect of changes in the demand for

and supply of rand on the equilibrium exchange rate, and show it graphically

After studying this unit, you will be able to:

Discuss the long-run trends in the exchange rate and explain interest rate parity and purchasing power

parity

Discuss the balance of payments accounts and

explain what causes an international deficit

Calculate the various balances of the balance of

payments

Compare the alternative exchange rate policies and explain their long-run effects

Themes of this unit:

1.Currencies and Exchange Rates

2.The Foreign Exchange Market

3.Changes in Demand and Supply: Exchange Rate Fluctuations4.Financing International Trade

5.Exchange Rate Policy

Currencies and Exchange Rates

Foreign currency is obtained in exchange for domestic

currency in the foreign exchange market

The nominal exchange rate is the value of one currency in terms of another currency

The Foreign Exchange Market

Exchange Rates

Economic agents who supply or demand foreign

– They operate in the foreign currency market in order to make profit by

buying and selling the foreign exchange.

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Exchange rate regimes

• Copeland identifies three broad categories:

– Floating rates

– fixed rates and

– managed floats

• The International Monetary Fund classifies exchange rate

arrangements into eight categories:

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Exchange rate arrangements in the 185

IMF member countries

No Exchange rate arrangement 2007 2008

1 No separate legal tender 5.32 5.32

IMF (2009), Annual Report of Exchange rate arrangement and exchange rate restrictions, International

Monetary Fund, Washington, D.C. 8

Exchange Rate regimes since 1940

Exchange Rate Structure

Attributes of the ideal regime

• The best regime ought to have three important

attributes, this is usually described as the “impossible trinity”:

– Exchange rate stability

– Full financial integration

– Monetary independence

• The forces at play in economics do not allow the

simultaneous attainment of all three goals.

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Fixed versus floating

• A country’s choice of exchange rate regime depends

on national priorities such as:

Fixed versus floating

• Countries will go for a fixed rate regime for the following

reasons:

– Stability in international prices

– Inherent anti-inflationary nature of fixed prices

• Fixed regime:

– Need for central bank to maintain large quantities of hard

currencies and gold to defend the fixed rate.

– Fixed rates may be maintained at rates that are out of tune with economic fundamentals.

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Nominal and Real Exchange Rates

The real exchange rate is the relative price of

foreign-produced goods and services to locally foreign-produced goods and services

The Effective Exchange Rate

The effective exchange rate is the average exchange rate

of the rand against a basket of currencies

Questions About the Exchange Rate

The Foreign Exchange Market

Demand and supply in the foreign exchange market

determine the exchange rate

The Demand for One Money Is the Supply of Another MoneyDemand in the Foreign Exchange Market

The exchange rate

World demand for South African exports

Interest rates in South Africa and other countries

The expected future exchange rate

The Law of Demand for Foreign Exchange

Exports Effect

Expected Profit Effect

Demand Curve for South African Rand

Supply in the Foreign Exchange

Market

The exchange rate

South African demand for

imports

Interest rates in South

African and other countries

The expected future

exchange rate

Demand Curve for South African Rand

The Law of Supply of

Foreign Exchange

Imports Effect

Expected Profit Effect

Supply Curve for South

African Rand

Market Equilibrium

The equilibrium exchange rate makes the quantity of rand demanded equal the quantity of rand supplied

Changes in Demand and Supply: Exchange Rate Fluctuations Changes in the Demand for South African Rand

 World Demand for

South African Exports

 South African Interest

Rate Relative to the

Foreign Interest Rate

 The Expected Future

Exchange Rate

Changes in the Supply of South African Rand

 South African Demand

for Imports

 South Africa’s Interest

Rate Relative to the

Foreign Interest Rate

 The Expected Future

Exchange Rate

Changes in the Exchange Rate

An Appreciating South African Rand: 2002–2006

A Depreciating Rand: 1999–2001

Financing International Trade

International trade, borrowing, and lending are financed by using foreign currency

A country’s international transactions are recorded in its balance

of payments

Balance of Payments Accounts

The balance of payments consists of a:

An Individual’s Balance of Payments Accounts

Borrowers and Lenders

Debtors and Creditors

Current Account Balance

Net Exports

The current account balance is similar to net exports and is determined by the government sector balance plus the private sector balance

Where Is the Exchange Rate?

Exchange Rate Policy

An exchange rate can be flexible, fixed, a crawling peg

To achieve a fixed or a

crawling exchange rate, a

central bank must intervene in the foreign exchange market

Flexible Exchange Rate

Fixed Exchange Rate

Crawling Peg

The People’s Bank of China in the Foreign Exchange MarketWhy Does China Fix Its Exchange Rate?