Lecture 11: The External Sector - Balance of Payments and Exchange Rates

Introduction to the External Sector and Open Economies

Economic Participation: Australians participate in the domestic economy as well as various economies globally. Activities include: * Buying Goods Made Overseas: Examples include high-tech products like an iPhone or vehicles such as a Hyundai car. * Services Provided Overseas: Examples include tourism and travel within Europe. * Asset Acquisition: Examples include purchasing shares in United States companies.
Interactions of an Open Economy: An open economy engages with the rest of the world through three primary channels: 1. World Product Markets: Buying and selling of goods and services. 2. World Asset Markets: Buying and selling of financial and physical assets. 3. Transfer Payments: Making or receiving unilateral transfers to or from other nations.

International Flows of Goods and Services

Balance of Trade (BT): This is the difference between the value of exports ( $X$ ) and the value of imports ( $M$ ). It is also referred to as Net Exports ( $NX$ ). * Formula: $BT = X - M = NX$
Trade Conditions: * Trade Surplus ( $BT+$ ): Occurs when there is an excess of exports over imports ( $X > M$ ). * Trade Deficit ( $BT-$ ): Occurs when there is an excess of imports over exports ( $M > X$ ). * Balanced Trade ( $BT = 0$ ): Occurs when the value of exports and imports are exactly equal.
Factors Influencing Trade Flow: * Consumer Tastes: Preferences of domestic and foreign consumers for locally made versus foreign-made goods. * Prices: The relative price levels of goods in the home country compared to prices abroad. * Exchange Rates: The rates at which individuals can swap domestic currency for foreign currencies. * Government Policies: National policies regarding international trade, such as tariffs, quotas, or trade agreements. * Transport Costs: The expense associated with moving goods from one country to another.

International Flows of Assets and Transfers

Asset Types: International asset flows involve: * Financial Assets: Shares, bonds, and other securities. * Physical Assets: Factories or houses, which remain physically located in the domestic country but are owned by foreign entities.
Net Foreign Investment (NFI): This represents the net flow of investment by domestic residents into overseas assets. It consists of two components: 1. Capital Outflow: The purchase of foreign assets by residents of the domestic country. 2. Capital Inflow: The purchase of domestic assets by foreign residents.
Australian Bureau of Statistics (ABS) Classification: The ABS categorizes foreign investment based on the level of control exercised by the owner: * Foreign Direct Investment (FDI): Occurs when a domestic entity establishes a high degree of control over a foreign asset (e.g., an Australian company opening a business branch in India). * Foreign Portfolio Investment (FPI): Occurs when an investor has less control over the entity (e.g., an Australian resident purchasing shares in an Indian corporation).
Factors Influencing NFI: * Interest rates paid on foreign financial assets. * Interest rates paid on domestic financial assets. * Interest Rate Differential: The difference between the domestic and foreign interest rates. * Relative rates of return or dividend yields on foreign versus domestic shares. * Prevailing exchange rates. * Perceived economic and political risks/rewards of holding assets in foreign jurisdictions. * Government regulations or policies regarding foreign ownership of domestic assets.
Transfer Payments: These are donations or gifts, such as foreign aid. They can be regular or irregular and may take the form of money or physical goods and services. Transfers typically represent a small percentage of total external transactions.

The Balance of Payments (BoP)

Definition: A summary of all transactions between the domestic economy and the rest of the world. * Formula: $BoP = ( ext{Total incoming payments from overseas}) - ( ext{Total outgoing payments to overseas}) = ext{Total net incoming payments}$
Sub-Accounts: 1. Current Account (CA): Records payments for goods and services as well as current transfers. 2. Capital Account (KA): Includes all payments related to assets (including central bank transactions) and capital transfers.
Accounting Conventions: * Credits (+): Incoming payments. * Debits (-): Outgoing payments.
Australia’s typical BoP position: Australia generally maintains a Current Account Deficit (CAD) and a Capital Account Surplus (KAS). * Equilibrium Condition: $BoP = CAD + KAS = 0$

Definition and Expression of Exchange Rates

Concept: The exchange rate is the price of one national currency expressed in terms of another.
Methods of Expression: * Approach 1: Value of 1 unit of domestic currency in foreign currency terms. * Example: $1 ext{ AUD} = 0.6937 ext{ USD}$ * Interpretation: If the number increases (e.g., to $0.7050 ext{ USD}$ ), the value of the Australian Dollar (AUD) rises. * Approach 2: Value of 1 unit of foreign currency in domestic currency terms. * Example: $1 ext{ USD} = 1.4415 ext{ AUD}$ * Interpretation: If the number increases (e.g., to $1.5050 ext{ AUD}$ ), the value of the AUD falls.

Market for AUD in the Foreign Exchange Market (FEM)

Supply of AUD ( $S_{AUD}$ ): Generated by Australians needing foreign currency to purchase items from abroad. Sources include: * Imports of goods and services. * Income payments sent to overseas entities. * Financial capital outflows (purchasing foreign assets). * Central bank sales of AUD.
Demand for AUD ( $D_{AUD}$ ): Generated by foreigners needing AUD to purchase Australian items. Sources include: * Exports of goods and services. * Income payments received from overseas. * Financial capital inflows (foreigners purchasing Australian assets). * Central bank purchases of AUD (buying AUD using foreign reserves).
Curve Characteristics: * Supply Curve: Assumed to be upward sloping; the exchange rate (ER) and the quantity of AUD supplied are positively related. * Demand Curve: Assumed to be downward sloping; the exchange rate (ER) and the quantity of AUD demanded are inversely related.

Exchange Rate Systems

Purely Flexible (Floating) Exchange Rates: * The ER is determined exclusively by market forces of Supply ( $S$ ) and Demand ( $D$ ) from the private sector and government. * Central Bank Role: There are no central bank transactions in the FEM in a pure float. * Equilibrium: The ER adjusts until the market reaches equilibrium at point $E$ , establishing the market-determined rate $ER^$ and the quantity of AUD exchanged $Q^$ .
System Classifications: 1. Floating/Flexible: The rate is free to vary according to market dynamics. 2. Fixed/Managed: The rate is controlled by authorities.
Hybrid Systems: Real-world systems often combine properties, such as: * Dirty Float: A floating system where the central bank occasionally intervenes to smooth out extreme volatility. * Crawling Peg: A system where the exchange rate is fixed but adjusted periodically.
Characteristics of a Pure Float: * Appreciation: A rise in the exchange rate. * Depreciation: A fall in the exchange rate. * Volatility: Because it is subject to market forces, it can experience large fluctuations. This is considered a disadvantage.

Exogenous Factors Affecting Exchange Rates

Exogenous changes shift the $S$ and $D$ curves, causing the ER to rise or fall as the market adjusts.

1. State of the World Economy

The economic health of the world affects demand for Australian exports ( $X$ ), which impacts the demand for local currency ( $D_{AUD}$ ).
Rising World Income: Leads to increased demand for Australian goods and services. The demand curve shifts right ( $D_{AUD1}$ to $D_{AUD2}$ ), leading to appreciation ( $ER^_1$ to $ER^_2$ ).
World Recession: Demand for exports and the local currency declines. The demand curve shifts left ( $D_{AUD1}$ to $D_{AUD3}$ ), leading to depreciation ( $ER^_1$ to $ER^_3$ ).

2. State of the Australian Economy

The health of the domestic economy affects the demand for imports ( $M$ ), which impacts the supply of local currency ( $S_{AUD}$ ).
Rising Australian Income: Leads to increased demand for foreign goods and services. The supply curve shifts right ( $S_{AUD1}$ to $S_{AUD2}$ ), leading to depreciation ( $ER^_1$ to $ER^_2$ ).
Australian Recession: Demand for imports and the supply of AUD declines. The supply curve shifts left ( $S_{AUD1}$ to $S_{AUD3}$ ), leading to appreciation ( $ER^_1$ to $ER^_3$ ).

3. Relative Inflation Rates

Relative inflation affects both exports ( $X$ ) and imports ( $M$ ), shifting both curves.
If Australian Inflation Falls relative to others: * Domestic goods become relatively cheaper for foreigners ( $X ↑$ ), shifting $D_{AUD}$ to the right. * Foreign goods become relatively more expensive for Australians ( $M ↓$ ), shifting $S_{AUD}$ to the left. * Final Result: The local currency appreciates ( $ER^_1$ to $ER^_2$ ).

4. Interest Rate Differentials

Interest rate differences affect financial asset attractiveness and the flow of financial capital.
If Australian Interest Rates Fall relative to US Interest Rates: * Capital Inflow ( $Ki$ ) decreases, causing the $D_{AUD}$ curve to shift left. * Capital Outflow ( $Ko$ ) increases, causing the $S_{AUD}$ curve to shift right. * Final Result: The Australian dollar depreciates ( $ER^_1$ to $ER^_2$ ).

Questions & Discussion

Question 1: Increased demand for a country’s exports causes its currency to _____, while increased demand for imports causes its currency to _____. * A. appreciate; appreciate * B. appreciate; depreciate * C. depreciate; appreciate * D. depreciate; depreciate * Correct Answer: B. Increased export demand shifts demand for currency right (appreciation), and increased import demand shifts supply of currency right (depreciation).
Question 2: If a country experiences a ______ in productivity relative to other countries, its currency will _____ because the cost of producing goods _______. * A. rise; appreciate; increases * B. rise; depreciate; decreases * C. decline; depreciate; increases * D. decline; depreciate; decreases * E. decline; appreciate; increases * Correct Answer: C. Lower productivity increases production costs, making exports less competitive and reducing currency demand, leading to depreciation.