Transcript Nominal Exchange Rates

Chapter 28
Exchange rates and the balance
of payments
David Begg, Stanley Fischer and Rudiger Dornbusch, Economics,
9th Edition, McGraw-Hill, 2008
PowerPoint presentation by Alex Tackie and Damian Ward
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Nominal Exchange Rates
• The nominal exchange rate is the
rate at which a person can trade the
currency of one country for the
currency of another.
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Nominal Exchange Rates
• The nominal exchange rate is
expressed in two ways:
– In units of foreign currency per one U.S.
dollar.
– And in units of U.S. dollars per one unit
of the foreign currency.
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Nominal Exchange Rates
• Assume the exchange rate between
the Japanese yen and U.S. dollar is
80 yen to one dollar.
– One U.S. dollar trades for 80 yen.
– One yen trades for 1/80 (= 0.0125) of a
dollar.
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Nominal Exchange Rates
• Appreciation refers to an increase in
the value of a currency as measured
by the amount of foreign currency it
can buy.
• Depreciation refers to a decrease in
the value of a currency as measured
by the amount of foreign currency it
can buy.
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The foreign exchange market
- the international market in which one national currency can be
exchanged for another.
The exchange rate is the price at which two currencies exchange.
Exchange rate ($/£)
Suppose 2 countries: UK & USA
SS
SS1
e0
DD shows the demand for
pounds by Americans wanting
to buy British goods/assets.
SS shows the supply of pounds
by UK residents wishing to buy
American goods/assets.
Equilibrium exchange rate is e0
e1
DD
Quantity
of pounds
If UK residents want more $
at each exchange rate, the
supply of £ moves to SS1
New equilibrium at e1.
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Exchange rate regimes
• In a fixed exchange rate regime
– the national governments agree to
maintain the convertibility of their
currency at a fixed exchange rate.
• In a flexible exchange rate regime
– the exchange rate is allowed to attain
its free market equilibrium level
without any government intervention
using exchange reserves.
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Intervention in the forex
market
SS
e1
E
A
Suppose the government is
committed to maintaining the
exchange rate at e1 ...
If the demand for pounds is DD1
there is excess demand AC.
C
DD1
DD
DD2
Quantity of £s
The Bank of England must
supply AC £s in return for $,
which are added to reserves.
The reverse occurs if
demand is at DD2.
When demand is DD, no
intervention is needed ...
there is a balance in transactions between the countries.
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The balance of payments
• … a systematic record of all transactions
between residents of one country and
the rest of the world
• Current account
– records international flows of goods,
services, income and transfer payments
• Capital account
– records transactions involving fixed assets
• Financial account
– records transactions in financial assets
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£ billion at current prices
The UK balance of payments,
1980-2006
50
40
30
20
10
0
-10
-20
-30
-40
-50
1980 1983 1986 1989 1992 1995 1998 2003
Current
Capital
Financial
Err & om
Source: Economic Trends Annual Supplement
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Balance of Payment
• The interaction between the domestic
agents with the foreign agents.
• 1. Current Account: Exports (+), Imports(), Take aid (+), Give aid (-), income
coming from abroad (+), income going to
abroad (-).
• 2. Capital Account: Foreigners buying
stocks (+), domestic buying foreign stocks
(-), capital investment to abroad (-),
foreign investment to Turkey (+).
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Balance of Payment
• Current Account + Capital Account
=0.
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Components of the balance of
payments
• The current account is influenced by:
– competitiveness
– domestic and foreign income
• The capital & financial accounts are
influenced by:
– relative interest rates
• which affect international capital flows.
• Perfect capital mobility
– occurs when there are no barriers to capital
flows, and investors equate expected total
returns on assets in different countries
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Balance of Payments (Turkey_2007-2011)
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Floating exchange rates
and the balance of payments
• If the exchange rate is free to move
to its equilibrium, there is no need
for intervention.
• Any current account imbalance is
exactly matched by an offsetting
balance in capital/financial accounts.
• If there is intervention, it is recorded
as part of the financial account.
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Fixed Exhange Rate and
Balance of Payments
• The central bank promises to keep
the nominal exchange rate at a
specified level.
• E.g. if exports<imports : need
foreign currency. Foreign currency
become more valuable, central bank
should increase the dollar supply by
using its reserves.
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Some Important Identities
• Assume a closed economy – one that
does not engage in international
trade:
Y=C+I+G
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Some Important Identities
• Now, subtract C and G from both
sides of the equation:
Y – C – G =I
• The left side of the equation is the
total income in the economy after
paying for consumption and
government purchases and is called
national saving, or just saving (S).
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Some Important Identities
• Substituting S for Y - C - G, the
equation can be written as:
S=I
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Some Important Identities
• National saving, or saving, is equal
to:
S=I
S=Y–C–G
S = (Y – T – C) + (T – G)
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The Meaning of Saving and
Investment
• National Saving
– National saving is the total income in the
economy that remains after paying for
consumption and government
purchases.
• Private Saving
– Private saving is the amount of income
that households have left after paying
their taxes and paying for their
consumption.
Private saving = (Y – T©The–McGraw-Hill
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The Meaning of Saving and
Investment
• Public Saving
– Public saving is the amount of tax
revenue that the government has left
after paying for its spending.
Public saving = (T – G)
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Saving, Investment, and Their
Relationship to the International
Flows
• Net exports is a component of GDP:
Y = C + I + G + NX
• National saving is the income of the
nation that is left after paying for
current consumption and government
purchases:
Y - C - G = I + NX
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Saving, Investment, and Their
Relationship to the International
Flows
• National saving (S) equals Y - C - G
so:
S = I + NX
or
Domestic
Net Capital
Saving =
+
Investment
Outflow
S
=
I
+
NCO
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International competitiveness
• The competitiveness of UK goods in
international markets depends upon:
– the nominal exchange rate
– relative inflation rates.
• Overall competitiveness is measured by
the real exchange rate
– which measures the relative price of goods
from different countries when measured in
a common currency.
– $/YTL Reel döviz kuru= e$/YTL *Ptr /Pabd
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1.1
2.5
Relative price 1
(UK/USA)
0.9
2
0.8
$/£
3
1.5
Exchange rate ($/£)
0.7
0.6
1
0.5
0.5
Relative price (UK/USA)
Relative prices and the nominal
exchange rate, UK & USA
0.4
1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002
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The real £/$ exchange rate
The real exchange rate is the nominal rate multiplied
by the ratio of domestic to foreign prices
2.5
2
£/$
1.5
1
0.5
19
72
19
74
19
76
19
78
19
80
19
82
19
84
19
86
19
88
19
90
19
92
19
94
19
96
19
98
20
00
20
02
0
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Real $/TL Exchange Rate
Reel $/TL döviz kuru (1995=100)
300
250
200
150
100
50
0
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
reel döviz kuru
30
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