Balance of payments and exchange rate

What is the BoP?

Value of all financial transactions made between consumers, firms and the government in one country with other nations

What is the current account?

the value of balance of trade, primary and secondary income

What is BoP made up of and describe the last two

current account

Capital account = records investment flows between countries (FDI)

financial account = transactions that result in change of ownership of fincnaisl assets and liabilities (FDI)

5 causes of current account deficit cyclical and structural

under investment

relatively low productivity

not enough R&D or innovation

boom in domestic demand

recession in export markets

Why is current account deficit bad?

slow real GDP growth

loss of jobs in the export sector

exchange rate weakness -> reduced living standards and higher yield on government debt

China has a trade surplus

• higher AD

• internationally competitive

• jobs

less variety of goods within China

demand pull inflation

vulnerable to economic shocks

results in more tariffs and protectionism → retaliation

What is expenditure switching?

change in the pattern of spending by either decreasing consumption of imports or increasing foreigners purchase off exports

What is portfolio investment?

buying financial assets rather than controlling firms like government bonds or shares

What determines the value of a currency in a freely floating exchange market?

supply and derived demand

Three factors that lead to currency appreciation

demand of exports (goods), higher interest rate, speculation

FDI vs portoflio

long vs short term

more stable vs volatile

What is a floating exchange rate?

the value of the currency depends on market forces of supply and demand

no target rate, no intervention

What is a managed exchange rate?

when the central bank may choose to intervene in FOREX markets to affect the value of a currency

evaluate managed

giving up control of interest rates (monetary policy) as it is used to control currency not the macroeconomy

Between 1990-1992 the UK managed the exchange rate. The UK £ was fixed at around 2.95DM. How was the currency managed in this system?

diagram

photo + bands

the government sees demand for the £ falling in value close to lower band due to falling UK exports.

The BoE can then use interest rates to defend their target of DM2.95. Demand falling to D2 increases interest rates so there is attraction of hot money as reward on assets has increased.

BoE can also use reserves to buy the £ therefore decreasing supply to S2 in the market to keep demand within the target

What does BoE do if demand is increasing too much above target?

decrease interest rates

sell £ by buying other currencies (what China has been doing as they have the largest US$ reserves in the world outside the USA)

Example of country with successful managed exchange rate

Singapore → high exports, flexibility to respond to shocks, maintain stability

Pakistan case study ( three economy figures, exports, BoT and current,weaknesses)

GDP per capita = $1500 (183rd)

Gini 0.33

HDI = 0.55 (170th)

low income country (at the top of band tho)

50% Textiles → comeptitiev

20% food → voltaile prices

2% refined copper → shows potential

BoT deficit → widening due to potential structural problems?

could use protectionism on infant industries/ attract FDI/ lower e/r/Borrow

75% depreciaton from 2017

This should be increasing exports but it is not

High dollar debt → need to attract FDI

inflation, weak currency, poor governance, decline in foreign reserves, low productivity

marshall lerner conditions

PED of exports and imports >1 then depreciation of currency will lead to improvement of BoT