The Exchange Rate and the Balance of Payments

The Exchange Rate and the Balance of Payments

Currency Exchange and Objectives

The chapter aims to explain:
- The foreign exchange market and exchange rate determination.
- Trends and fluctuations in exchange rates.
- Interest rate parity and purchasing power parity.
- Alternative exchange rate policies and their effects.
- Balance of payments accounts and international deficits.

Introduction

In October 2000, $1 USD bought 1.17 euros.
By July 2008, $1 USD bought only 0.63 euros, indicating a dollar depreciation against the euro.

The Foreign Exchange Market

Definition

The foreign exchange market is where currencies are traded.
Foreign currency includes foreign bank notes, coins, and bank deposits.

Trading

Foreigners exchange their currency for U.S. dollars, and vice versa.

Exchange Rates

The foreign exchange rate is the price of one currency in terms of another.
Currency depreciation: A fall in the value of one currency relative to another.
Currency appreciation: A rise in the value of one currency relative to another.

Exchange Rate as a Price

Exchange rates are determined in the foreign exchange market.
The market is competitive due to numerous traders and minimal restrictions.

Demand and Supply

The demand for one currency is the supply of another.
Factors influencing the demand for U.S. dollars also affect the supply of other currencies (e.g., Canadian dollars, euros, yen).

Demand in the Foreign Exchange Market

The quantity of U.S. dollars demanded depends on:
1. The exchange rate.
2. World demand for U.S. exports.
3. Interest rates in the U.S. and other countries.
4. The expected future exchange rate.

The Law of Demand for Foreign Exchange

Demand for dollars is derived from the need to buy U.S. goods, services, or assets.
The higher the exchange rate, the smaller the quantity of U.S. dollars demanded.

Influences on Demand

Exports Effect: Lower exchange rates increase U.S. exports, raising demand for U.S. dollars.
Expected Profit Effect: Lower exchange rates increase the potential profit from holding U.S. dollars, increasing demand.

Demand Curve

The demand curve for U.S. dollars illustrates the inverse relationship between the exchange rate and the quantity of dollars demanded.
A rise in the exchange rate decreases the quantity of U.S. dollars demanded.
A fall in the exchange rate increases the quantity of U.S. dollars demanded.

Supply in the Foreign Exchange Market

The quantity of U.S. dollars supplied depends on:
1. The exchange rate.
2. U.S. demand for imports.
3. Interest rates in the U.S. and other countries.
4. The expected future exchange rate.

The Law of Supply of Foreign Exchange

The higher the exchange rate, the greater the quantity of U.S. dollars supplied.

Influences on Supply

Imports Effect: Higher exchange rates increase U.S. imports, increasing the supply of U.S. dollars.
Expected Profit Effect: Lower current exchange rates increase the expected profit from holding U.S. dollars, decreasing the supply.

Supply Curve

The supply curve for U.S. dollars illustrates the direct relationship between the exchange rate and the quantity of dollars supplied.
A rise in the exchange rate increases the quantity of U.S. dollars supplied.
A fall in the exchange rate decreases the quantity of U.S. dollars supplied.

Market Equilibrium

The exchange rate is determined by the equilibrium between demand and supply.
A surplus of U.S. dollars drives the exchange rate down.
A shortage of U.S. dollars drives the exchange rate up.

Exchange Rate Fluctuations

Changes in Demand

Changes in world demand for U.S. exports, U.S. interest rate differentials, and expected future exchange rates shift the demand curve.
An increase in demand shifts the curve rightward; a decrease shifts it leftward.

Changes in Supply

Changes in U.S. demand for imports, U.S. interest rate differentials, and expected future exchange rates shift the supply curve.
An increase in supply shifts the curve rightward; a decrease shifts it leftward.

Impact on Exchange Rate

Increase in demand, no change in supply: exchange rate rises.
Decrease in demand, no change in supply: exchange rate falls.
Increase in supply, no change in demand: exchange rate falls.
Decrease in supply, no change in demand: exchange rate rises.

Fundamentals, Expectations, and Arbitrage

Exchange rate changes are influenced by expectations, which are driven by:
- Interest rate parity.
- Purchasing power parity.

Interest Rate Parity

Return on currency = interest rate + expected rate of appreciation.
Interest rate parity: equal returns on two currencies when exchange rate changes are considered.
Market forces quickly achieve interest rate parity.

Purchasing Power Parity

Currency value is linked to the goods and services it can buy.
Purchasing power parity: equal value of money in terms of goods and services.

Instant Exchange Rate Response

Exchange rates react immediately to news affecting demand and supply.
Example: Anticipated interest rate hike by the Bank of Japan leads to expectations of yen appreciation and dollar depreciation.

The Real Exchange Rate

The real exchange rate (RER) measures the relative price of U.S. goods and services to foreign goods and services.
Formula: $RER = (E \times P) / P^*$ , where:
- $E$ = nominal exchange rate
- $P$ = U.S. price level
- $P^*$ = Japanese price level

Short Run

In the short run, changes in nominal exchange rates directly affect the real exchange rate because $P$ and $P^*$ are relatively fixed.

Long Run

In the long run, RER is determined by real demand and supply forces, influencing the nominal exchange rate: $E = RER \times (P^*/P)$ .
A rise in $P^*$ leads to U.S. dollar appreciation.
A rise in $P$ leads to U.S. dollar depreciation.

Exchange Rate Policies

Types of Policies

Flexible Exchange Rate: Determined by demand and supply without central bank intervention.
Fixed Exchange Rate: Pegged at a government-set value, requiring central bank intervention.
Crawling Peg: Exchange rate follows a predetermined path via active market intervention.

Fixed Exchange Rate Intervention

Central banks intervene to maintain a target exchange rate (e.g., the Fed selling dollars to increase supply when demand increases).
Persistent intervention is unsustainable.

Crawling Peg

Operates like a fixed exchange rate but with a changing target value.
Aims to avoid volatility and reserve depletion (China).

Financing International Trade

Balance of Payments Accounts

Record international trading, borrowing, and lending.

Components

Current Account: Records exports, imports, net interest, and net transfers.
- Current account balance = exports - imports + net interest income + net transfers.
Capital and Financial Account: Records foreign investment in the U.S. minus U.S. investment abroad.
Official Settlements Account: Records changes in U.S. official reserves (government holdings of foreign currency).

The sum of all three accounts always equals zero.

Borrowers and Lenders

Net Borrower: Borrows more than it lends (The U.S. has generally been a net borrower since the early 1980s).
Net Lender: Lends more than it borrows.

Debtors and Creditors

Debtor Nation: Has historically borrowed more than it has lent (The U.S. has been a debtor nation since 1986).
Creditor Nation: Has invested more than other countries have invested in it.

Implications of Borrowing

Net borrowing is acceptable if funds finance capital accumulation, but problematic if used for consumption.

Current Account Balance: Symbols and Equations

Variables

Exports (X) = 1,818
Imports (M) = 2,354
Government Expenditure (G) = 2,993
Net Taxes (T) = 1,698
Investment (I) = 1,839
Saving (S) = 2,598

Balances

Net Exports (X-M) = 1,818 - 2,354 = -536
Government Sector (T-G) = 1,698 - 2,993 = -1,295
Private Sector (S-I) = 2,598 - 1,839 = 759

National Accounts Relationship

$Y = C + I + G + X - M = C + S + T$
Rearranging: $I + G + X - M = S + T$
Therefore: $X - M = S - I + T - G$

Equation

Net Exports = Government Sector Balance + Private Sector Balance
$-536 = -1,295 + 759$

Current Account Balance (CAB) Equation

$CAB = NX + \text{Net interest income} + \text{Net transfers}$
The primary component of the CAB is net exports (NX).

Sector Surpluses/Deficits

Government sector surplus/deficit = Net taxes (T) - Government expenditure (G).
Private sector surplus/deficit = Saving (S) - Investment (I).

Equation

$NX = (T - G) + (S - I)$

U.S. Example (2010)

Net exports = -$536 billion
Government sector balance = -$1,295 billion
Private sector balance = $759 billion

Where is the Exchange Rate?

Short Run: A fall in the nominal exchange rate lowers the real exchange rate, making imports more expensive and exports more competitive, reducing the current account deficit.
Long Run: Changes in the nominal exchange rate do not affect the real exchange rate, so the nominal exchange rate does not influence the current account balance.