Copy of The Exchange Rate & the Balance of Payments

THE EXCHANGE RATE & BALANCE OF PAYMENTS

Balance of Payments

Balance of Payments Accounts

= result of international trading, lending and borrowing

-

+

- export-import, net interest income, net transfers

-

+

- foreign investments received - FI abroad

1) Current Account

2) Capital & Financial account

3) Official Settlements account

+/-

- change in official reserves of foreign currency

How Foreign Trade takes places...

Current Account Balance

SUM: 0

(zero)

A nation can be...

Net balances:

• Net exports: X-M
• Government sector balance: T-G
• Private Sector balance: S-I

• net borrower or net lender

(inflow of capital - outflow of capital)

• debtor nation or creditor nation

National Account (Y) = C+I+G+X-M = C+S+T

X-M = S-I + T-G

(historical accumulation)

Net exports = Private Sector Balance - Gov´t Sector Balance

Source: http://www.worldgameofeconomics.com/exchangerates.htm

Other observations on FEM movements:

Is the US like the PIIGS?

WORLD DEBT CLOCK:

http://www.economist.com/content/global_debt_clock

Basic Terms

1. A country with a large population will demand more currency from a country with a small population than vice versa.

2. People will demand more currency from another nation when they find its products to be more appealing.

3. Countries with high and rising incomes will demand more foreign currency than countries with low incomes or those that are in recession.

4. Relatively high domestic inflation in a country will curtail the demand for its currency.

5. If importers expect prices in the exporting country to rise in the future, they will demand more of that currency in the present to beat the price increases.

6. People will demand more of a foreign currency if they can get a higher rate of return on financial investments in that country.

7. On the other hand, if foreign investors expect that inflation will undermine the real return on their investments in a country, then they will get rid of that currency and move their money to another country.

8. If people expect a currency to appreciate in the future, they will demand more of that currency in the present.

9. Central banks will demand more of a foreign currency if they wish to depreciate their own.

http://earlywarn.blogspot.mx/2012/05/one-way-us-is-like-piigs.html

money of other countries

Exchange Rate Parities

place of exchanging currencies

arbitrage: the practice of buying and selling foreign currency for a higher price in another market

...always prevails

(if not: "carry trade")

Interest Rate Parity (IRP):

equal rates of return (on deposits)

(one of the most competitive markets!)

Purchasing Power Parity (PPP):

equal value of money (in goods)

...does not always prevail

Nominal Exchange Rate: the amount of one money that another money buys.

Thank you!

Real Exchange Rate: the relative price of a domestic product to a foreign product

e.g.: E=19 MXN/USD, 200usd=1 iPod in the US, 4400MXN in Mexico, RER=(19*200)/4400=0.86 => 1 US iPod=0.86 Mexican iPod

RER=(E*Pus)/Pmex

• E: exchange rate
• Pus: US price
• Pmex: Mexican price

The under (-) and over (+) valuation of the local currency against the dollar in %, by the Economist, 2004

Effects:

• in the short run: big changes in RER when NER changes (sticky prices, import/export)

• in the long run: real ER does not change when the nominal ER changes

Demand for one money is the supply of another money!

the price at which one currency is exchanged for another

Purchasing Power Parity of the US dollar in the World

Sources:

• Foreign Currency-
• Foreign Exchange Market-
• exchange rate -

Source:http://en.wikipedia.org/wiki/File:Big_Mac_index_50USD_2columns.png, Data based on the Big Mac index by The Economist -magazine January 2012

http://www.economist.com/content/big-mac-index

Source: http://en.wikipedia.org/wiki/Purchasing_power_parity

Demand & Supply

in the Foreign Exchange Market

On Purchasing Power Theory:

http://www.investopedia.com/terms/p/ppp.asp

Big Mac Index:

http://www.economist.com/content/big-mac-index

Exchange Rates:

http://www.banxico.org.mx/dyn/portal-mercado-cambiario/index.html

Salary Converter:

http://salaryconverter.nigelb.me/

PPP: http://knoema.es/atlas/maps/PIB-per-c%C3%A1pita-basado-en-la-PPA

Measuring well-being: http://www.economist.com/blogs/graphicdetail/2016/07/daily-chart-13

International Debt: http://www.economist.com/content/global_debt_clock

Law of Demand in FEM:

Exchange Rate Policy

3 types:

Law of Supply in FEM:

appreciation - a rise in exchange rate

- by demand/supply market laws, no gov´t intervention

the higher the exchange rate is, the lower the demand for that currency is in the FEM.

• flexible exchange rate

• fixed exchange rate

• crawling peg

- by government/Central Bank decision (market laws blocked)

(managed floating or "dirty" floating)

- follows a path of the gov´t/CB decision (target value, changed at intervals)

the higher the exchange rate is, the higher the supply for that currency is in the FEM.

depreciation - a fall in the exchange rate

two more details....

hard currency:

a currency that is used for storing value (saved by other countries) and easily traded for any other currency

("safe haven" or strong currency: long-term confidence in its PPP, e.g. USD, YEN, Euro, British pound)

(soft currency: no confidence in economic/political stability)

convertible currency:

globally and easily traded anywhere, liquid stored of value

(only major hard currencies with high int´l demand)

non-convertible currencies: Cuban peso & North Korean won

Expectations.....

(only on the black market can be exchanged, no official XRT)

Source: http://cpslearning.regis.edu/Multimedia_Exemplars/examples/4_5_5_foreign_exchange_exercise.html

Source: http://www.macrobasics.com/graphs/fe/examples/

http://www.banxico.org.mx/portal-mercado-cambiario/foreign-exchange-markets--exc.html

Source: http://www.colorado.edu/Economics/courses/econ2020/6550/readings/Mexico-currency.html

vs. Reality....

Determinants of Demand

for Mexican Pesos

Determinants of Supply

of Mexican Pesos

http://www.businessinsider.com.au/goldman-sachs-euro-parity-forecast-2015-3

• exchange rate
• world demand for Mexican exports (export effects)
• interest rates in Mexico
• the expected future exchange rate

• exchange rate
• Mexican demand for imports (import effect)
• interest rates in Mexico and other countries
• expected future exchange rate

Note: the difference between two countries interest rates is called interest rate differential

https://www.ecb.europa.eu/stats/exchange/eurofxref/html/eurofxref-graph-usd.en.html#