Lecture 7 - 1 Lecture 7 The Balance of Payments and...

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Unformatted text preview: 1 Lecture 7 The Balance of Payments and Exchange Rates Foreign exchanges refer to currencies of foreign countries Note: 1. Demand for foreign currency is equivalent to supply of domestic currency 2. Supply of foreign currency is equivalent to demand of domestic currency 2 Balance of Payments (BOP) Records a country’s transactions in goods, services and assets with the rest of the world BOP is also a record of a country’s sources (supply) and uses (demand) of foreign exchanges Rules: 1. Transactions that create earnings (supply) of foreign exchanges carry a positive sign 2. Transactions that use up (demand) foreign exchanges carry a negative sign 3 Current account Exports of goods and services + XXX Imports of goods and services- XXX Balance of trade XXX Income received on investments + XXX Income payments on investments- XXX Net transfers XXX Current account balance XXX Capital and financial account Changes in private domestic assets abroad (increase is -) XXX Changes in foreign private assets in domestic country (increase is +) XXX Statistical discrepancy XXX Capital account balance XXX Official settlement account Changes in official reserves XXX Format of BOP 4 Example 1 A Hong Kong textile company sells US$1m of products to the US, then deposits the US$1m revenue in a bank in New York Records in HK BOP: Exports of goods and services +HK$7.8m Changes in private domestic asset abroad-HK$7.8m 5 Notice that the sum of the balances on these three accounts must be summed to zero (Why?) Example If a country has a trade deficit (imports exceeds exports, e.g., $1m) ⇒ It has to be financed by the capital and financial account surplus (e.g. by attracting foreign investment of $1m) Or by changes in the official reserves (government uses its foreign exchange reserve of $1m) 6 Notice that both the current account and capital account concern with transactions of the private sector Official settlement account concerns with transactions of the government sector Normally the BOP Balance is defined as the balance of the private sector: BOP Balance = Balance in the Current Account + Balance in the Capital and Financial Account 7 Under flexible exchange rate, there is no government intervention in the foreign exchange market ⇒ Official settlement account balance equals zero ⇒ BOP balance also equals zero Under fixed exchange rate, there may be either excess demand or excess supply of foreign exchange ⇒ Official settlement account balance may not be zero ⇒ BOP balance may not be zero 8 Example of government intervention under fixed exchange rate: Imports (-) > Exports (+) and/or Investment to overseas (-) > Investment from overseas (+) ⇒ There will be a BOP deficit (-) This deficit has to be covered by government selling foreign currencies (+) 9 Equilibrium output in an open economy AE = C + I + G + EX - IM Assume 1. EX is exogenous 2. IM = m Y where m is marginal propensity to import (MPM) 10 Equilibrium condition: Y = AE = C + I + G + EX - IM = a + b Y + I + G + EX - m Y = a + I + G + EX + (b - m) Y Y = a + I + G + EX 1 - (b - m) 11...
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This note was uploaded on 11/02/2009 for the course FB AF2602 taught by Professor Aliceshiu during the Winter '08 term at Polytechnic University of Puerto Rico.

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Lecture 7 - 1 Lecture 7 The Balance of Payments and...

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