Exchange rates and Balance of Payments

IB Economics - Global Economy - Exchange rates and Balance of Payments

Balance of Payments

The balance of payments is a record of payments between one country and the rest of the world

Accounts in the balance of payments

1) Current Account (CA)

2) Capital Account (KA)

3) Fincancial Account (FA)

Current Account (CA)

The sum of the balance of trade in goods and services, net investment income and net current transfers

CA = (X-M) + net income from abroad

Financial Account (FA)

The sum of direct investment, portfolio investment, changes in reserve assets and official borrowing

Components of the current account

1) Balance of trade in goods

2) Balance of trade in services

3) (Primary income) Net Investment Income

4) (Secondary income) Net Current Transfers

Components of the capital account

1) Capital transfers

2) Transactions in non-produced, non-financial assets

Components of the financial account

1) Foreign direct Investment (FDI)

2) Portfolio Investment

3) Reserve Assets

4) Official borrowing

Golden rule: The balance of payments must always balance

CA + KA + FA + E = 0 where E - net errors and emissions

Exchange rate

Value of one currency in terms of another currency

Floating exchange rate

The exchange rate is determined by forces of supply and demand with no central bank intervention

Fixed exchange rate

The value of a currency is maintained at a certain level against another currency through central bank intervention

Managed exchange rate

The exchange rate is generally determined by forces of supply and demand but the central bank will intervene to stop significant fluctuations

Appreciation/depreciation

Increase/decrease in the value of the currency in a floating exchange rate system

Revaluation/devaluation

Increase/decrease in the value of a currency in a fixed/managed exchange rate system due to central bank intervention

Factors that shift demand for a currency right

1) An increase in the demand for the country’s exports

2) An increase in foreign direct investment or portfolio investment into the country

3) “Hot money” inflows (short term capital flowing into the country)

4) Speculation that the currency will appreciate

5) If the central bankuses its foreign exhcange reserves to buy its own currency

Factors that shift supply of a currency right

1) An increase in demand for imports

2) An increase in FDI or portfolio investment going abroad

3) “hot money” outflows (short term capital flowing out of the country)

4) Speculation that the currency will depreciate

5) The central bank sells its own currency in the foreign exchange market and accumulates foreign exchange reserves