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Chapter 28 Exchange rates and the balance of payments David Begg, Stanley Fischer and Chapter 28 Exchange rates and the balance of payments David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 9 th Edition, Mc. Graw-Hill, 2008 Power. Point presentation by Alex Tackie and Damian Ward ©The Mc. Graw-Hill Companies, 2008

Nominal Exchange Rates • The nominal exchange rate is the rate at which a Nominal Exchange Rates • The nominal exchange rate is the rate at which a person can trade the currency of one country for the currency of another. ©The Mc. Graw-Hill Companies, 2008

Nominal Exchange Rates • The nominal exchange rate is expressed in two ways: – Nominal Exchange Rates • The nominal exchange rate is expressed in two ways: – In units of foreign currency per one U. S. dollar. – And in units of U. S. dollars per one unit of the foreign currency. ©The Mc. Graw-Hill Companies, 2008

Nominal Exchange Rates • Assume the exchange rate between the Japanese yen and U. Nominal Exchange Rates • Assume the exchange rate between the Japanese yen and U. S. dollar is 80 yen to one dollar. – One U. S. dollar trades for 80 yen. – One yen trades for 1/80 (= 0. 0125) of a dollar. ©The Mc. Graw-Hill Companies, 2008

Nominal Exchange Rates • Appreciation refers to an increase in the value of a Nominal Exchange Rates • Appreciation refers to an increase in the value of a currency as measured by the amount of foreign currency it can buy. • Depreciation refers to a decrease in the value of a currency as measured by the amount of foreign currency it can buy. ©The Mc. Graw-Hill Companies, 2008

The foreign exchange market - the international market in which one national currency can The foreign exchange market - the international market in which one national currency can be exchanged for another. The exchange rate is the price at which two currencies exchange. Exchange rate ($/£) Suppose 2 countries: UK & USA SS SS 1 e 0 DD shows the demand for pounds by Americans wanting to buy British goods/assets. SS shows the supply of pounds by UK residents wishing to buy American goods/assets. Equilibrium exchange rate is e 0 e 1 DD Quantity of pounds If UK residents want more $ at each exchange rate, the supply of £ moves to SS 1 New equilibrium at e 1. ©The Mc. Graw-Hill Companies, 2008

Exchange rate regimes • In a fixed exchange rate regime – the national governments Exchange rate regimes • In a fixed exchange rate regime – the national governments agree to maintain the convertibility of their currency at a fixed exchange rate. • In a flexible exchange rate regime – the exchange rate is allowed to attain its free market equilibrium level without any government intervention using exchange reserves. ©The Mc. Graw-Hill Companies, 2008

Intervention in the forex market $/£ SS e 1 E A Suppose the government Intervention in the forex market $/£ SS e 1 E A Suppose the government is committed to maintaining the exchange rate at e 1. . . If the demand for pounds is DD 1 there is excess demand AC. C DD 1 DD DD 2 Quantity of £s The Bank of England must supply AC £s in return for $, which are added to reserves. The reverse occurs if demand is at DD 2. When demand is DD, no intervention is needed. . . there is a balance in transactions between the countries. ©The Mc. Graw-Hill Companies, 2008

The balance of payments • … a systematic record of all transactions between residents The balance of payments • … a systematic record of all transactions between residents of one country and the rest of the world • Current account – records international flows of goods, services, income and transfer payments • Capital account – records transactions involving fixed assets • Financial account – records transactions in financial assets ©The Mc. Graw-Hill Companies, 2008

The UK balance of payments, 1980 -2006 Source: Economic Trends Annual Supplement ©The Mc. The UK balance of payments, 1980 -2006 Source: Economic Trends Annual Supplement ©The Mc. Graw-Hill Companies, 2008

Balance of Payment • The interaction between the domestic agents with the foreign agents. Balance of Payment • The interaction between the domestic agents with the foreign agents. • 1. Current Account: Exports (+), Imports(), Take aid (+), Give aid (-), income coming from abroad (+), income going to abroad (-). • 2. Capital Account: Foreigners buying stocks (+), domestic buying foreign stocks (-), capital investment to abroad (-), foreign investment to Turkey (+). ©The Mc. Graw-Hill Companies, 2008

Balance of Payment • Current Account + Capital Account =0. ©The Mc. Graw-Hill Companies, Balance of Payment • Current Account + Capital Account =0. ©The Mc. Graw-Hill Companies, 2008

Components of the balance of payments • The current account is influenced by: – Components of the balance of payments • The current account is influenced by: – competitiveness – domestic and foreign income • The capital & financial accounts are influenced by: – relative interest rates • which affect international capital flows. • Perfect capital mobility – occurs when there are no barriers to capital flows, and investors equate expected total returns on assets in different countries ©The Mc. Graw-Hill Companies, 2008

Balance of Payments (Turkey_2007 -2011) ©The Mc. Graw-Hill Companies, 2008 Balance of Payments (Turkey_2007 -2011) ©The Mc. Graw-Hill Companies, 2008

©The Mc. Graw-Hill Companies, 2008 ©The Mc. Graw-Hill Companies, 2008

©The Mc. Graw-Hill Companies, 2008 ©The Mc. Graw-Hill Companies, 2008

Floating exchange rates and the balance of payments • If the exchange rate is Floating exchange rates and the balance of payments • If the exchange rate is free to move to its equilibrium, there is no need for intervention. • Any current account imbalance is exactly matched by an offsetting balance in capital/financial accounts. • If there is intervention, it is recorded as part of the financial account. ©The Mc. Graw-Hill Companies, 2008

Fixed Exhange Rate and Balance of Payments • The central bank promises to keep Fixed Exhange Rate and Balance of Payments • The central bank promises to keep the nominal exchange rate at a specified level. • E. g. if exports

Some Important Identities • Assume a closed economy – one that does not engage Some Important Identities • Assume a closed economy – one that does not engage in international trade: Y=C+I+G ©The Mc. Graw-Hill Companies, 2008

Some Important Identities • Now, subtract C and G from both sides of the Some Important Identities • Now, subtract C and G from both sides of the equation: Y – C – G =I • The left side of the equation is the total income in the economy after paying for consumption and government purchases and is called national saving, or just saving (S). ©The Mc. Graw-Hill Companies, 2008

Some Important Identities • Substituting S for Y - C - G, the equation Some Important Identities • Substituting S for Y - C - G, the equation can be written as: S=I ©The Mc. Graw-Hill Companies, 2008

Some Important Identities • National saving, or saving, is equal to: S=I S=Y–C–G S Some Important Identities • National saving, or saving, is equal to: S=I S=Y–C–G S = (Y – T – C) + (T – G) ©The Mc. Graw-Hill Companies, 2008

The Meaning of Saving and Investment • National Saving – National saving is the The Meaning of Saving and Investment • National Saving – National saving is the total income in the economy that remains after paying for consumption and government purchases. • Private Saving – Private saving is the amount of income that households have left after paying their taxes and paying for their consumption. Private saving = (Y – T – C) ©The Mc. Graw-Hill Companies, 2008

The Meaning of Saving and Investment • Public Saving – Public saving is the The Meaning of Saving and Investment • Public Saving – Public saving is the amount of tax revenue that the government has left after paying for its spending. Public saving = (T – G) ©The Mc. Graw-Hill Companies, 2008

Saving, Investment, and Their Relationship to the International Flows • Net exports is a Saving, Investment, and Their Relationship to the International Flows • Net exports is a component of GDP: Y = C + I + G + NX • National saving is the income of the nation that is left after paying for current consumption and government purchases: Y - C - G = I + NX ©The Mc. Graw-Hill Companies, 2008

Saving, Investment, and Their Relationship to the International Flows • National saving (S) equals Saving, Investment, and Their Relationship to the International Flows • National saving (S) equals Y - C - G so: S = I + NX or Domestic + Net Capital Saving = Investment Outflow S = I + NCO ©The Mc. Graw-Hill Companies, 2008

International competitiveness • The competitiveness of UK goods in international markets depends upon: – International competitiveness • The competitiveness of UK goods in international markets depends upon: – the nominal exchange rate – relative inflation rates. • Overall competitiveness is measured by the real exchange rate – which measures the relative price of goods from different countries when measured in a common currency. – $/YTL Reel döviz kuru= e$/YTL *Ptr /Pabd ©The Mc. Graw-Hill Companies, 2008

Relative prices and the nominal exchange rate, UK & USA Relative price (UK/USA) Exchange Relative prices and the nominal exchange rate, UK & USA Relative price (UK/USA) Exchange rate ($/£) ©The Mc. Graw-Hill Companies, 2008

The real £/$ exchange rate The real exchange rate is the nominal rate multiplied The real £/$ exchange rate The real exchange rate is the nominal rate multiplied by the ratio of domestic to foreign prices ©The Mc. Graw-Hill Companies, 2008

Real $/TL Exchange Rate 30 ©The Mc. Graw-Hill Companies, 2008 Real $/TL Exchange Rate 30 ©The Mc. Graw-Hill Companies, 2008