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Services: The services category also includes the import and export of military
equipment, services, and aid.
Income: The income category tabulates interest and dividend payments to
foreign residents and governments who hold domestic financial assets. It also
includes payments received by domestic residents and governments who hold
financial assets abroad. The interest payment is an export, or credit, in the income
category of the current account. Economists do not record the purchase of a
financial asset in the income category. Only the income earned on the financial
asset is included in the current account, because income earned on assets can be
used for current consumption.
Unilateral transfers: This category records the offsetting entries of exports or
imports for which nothing except good-will is expected in return.
Since 1997, developed nations have experienced higher combined current
account deficits, which have been closely mirrored by combined current account
surpluses of emerging nations.
The capital account tabulates cross-border transactions of financial assets among
private residents, foreign residents, and domestic and foreign governments. The
private capital account tabulates two types of asset flows: investment flows and
changes in banks and brokers cash deposits that arise from foreign transactions.
To help distinguish between portfolio and direct foreign investment, economists
consider the foreign acquisition of less than 10 percent of the entitys outstanding
stock as portfolio investment, and the acquisition of 10 percent or more of the
entitys outstanding stock as foreign direct investment.
A debit entry in the capital account, for example, records the purchase of a
foreign financial asset by a domestic private resident.
The official settlements balance measures the transactions of financial assets and
deposits by official government agencies.
o Deficits and Surpluses in the Balance of Payments
The overall balance of payments is the sum of the credits and debits in the current
account, capital account, official settlements, and the statistical discrepancy. The
overall balance of payments necessarily is equal to zero.
A BoP deficit corresponds to a positive official settlements balance, and a BoP
surplus corresponds to a negative official settlements balance.
o The capital account and the international flow of assets
A net debtor nation is one whose stock of foreign financial assets held by
domestic residents is less than the stock of domestic financial assets held by
foreign residents. A net creditor nation is one whose stock of foreign financial
assets held by domestic residents is greater than the stock of domestic financial
assets held by foreign residents.
2. The Market for Foreign Exchange
Exchange rate and the market for foreign exchange
An exchange rate expresses the value of one currency relative to another.
o The Role of the Foreign Exchange Market
A spot market is a market for immediate purchase and delivery of an asset,
usually within two or three days.
o Exchange Rates as Relative Prices
An exchange rate is a relative price that indicates the price of one currency in
terms of another currency.
When a currency appreciates, it gains value relative to another currency. When a
currency depreciates, it loses value relative to another currency.
A cross rate is a third exchange rate that we calculate from two bilateral exchange
rates.
The bid-ask spread is the difference between the bid price, or price offered for
the purchase of a currency, and the ask price, or price at which the currency is
offered for sale. The bid-ask margin is the bid-ask spread expressed as a percent
of the ask price.
o Real Exchange Rates
A real exchange rate is a bilateral exchange rate that has been adjusted for price
changes that occurred in the two nations.
o The Effect of Price Changes
= ( )
The various factors that cause a change in the supply of a currency are the factors
that cause a change in a countrys demand for a foreign countrys goods, services,
and assets.
o The Equilibrium Exchange Rate
The equilibrium exchange rate is the rate at which the quantity of a currency
demanded is equal to the quantity supplied. At the equilibrium exchange rate, the
market clears, meaning that the quantity demanded is exactly equal to the
quantity supplied.
Purchasing Power Parity
Purchasing Power Parity (PPP) states that, ignoring transportation costs, tax
differentials, and trade restrictions, traded homogeneous goods and services
should have the same price in two countries after converting their prices into a
common currency.
Price differences could be considered a factor of currency demand because
relatively lower prices in a nation cause the demand for that nations currency to
increase.
Purchasing power parity is a theory of the relationship between the prices of
traded goods and services and the exchange rate.
Both absolute PPP and relative PPP do not consider financial flows and money
stocks.
o Absolute Purchasing Power Parity
Absolute PPP: = . The domestic price level expressed in the domestic
currency should equal the foreign price level expressed in the domestic currency.
When absolute PPP holds, then the bilateral spot exchange rate should equal the
ratio of the price levels of the two nations.
Some problems arise when applying absolute PPP to all goods and services of
two nations. One reason is that people in two nations may consume different sets
of goods and services. Thus, the price levels for the two nations would be based
on the prices of different goods, meaning that the arbitrage argument that lies
behind the absolute PPP condition could not apply.
If absolute PPP holds, then the real exchange rate is equal to 1.
o Relative Purchasing Power Parity
Relative PPP is a weaker version of PPP, as it addresses price changes as opposed
to absolute price levels. Relative PPP, as an exchange rate theory, relates
exchange rate changes to the differences in price changes across countries.
Relative PPP performs well during periods of very high inflation, because during
these periods price changes are the dominant influence on the value of a currency.
% = % %
3. Exchange-Rate Systems, Past to Present
Exchange-Rate Systems
A monetary order is a set of laws and regulations that establishes the framework
within which individuals conduct and settle transactions. It also sets forth the
rules that form the nations exchange rate system, and, either formally or
informally, the nations participation in an exchange rate system.
Firms with short positions in foreign currencies can assume long positions in the
forward market by purchasing forward contracts guaranteeing payments
denominated in foreign currencies.
Firms with long positions in foreign currencies can assume short positions in the
forward market by selling currencies in the forward exchange market.
o Determination of Forward Exchange Rates
If there are no currency restrictions or government interventions, the market
forces of supply and demand determine forward exchange rates.
o The Forward Exchange Rate as a Predictor of the Future Spot Rate
() =
( ) 12
100
This condition states that the forward premium must equal the expected
appreciation of the currency, and the forward discount must equal the expected
depreciation of the currency.
International Financial Arbitrage
o The International Flows of Fund and Interest Rate Determination
In a competitive market, the supply and demand for funds available for lending,
or loanable funds, determine interest rates. The market supply schedule for
loanable funds is an upward-sloping curve. The market demand schedule slopes
downward.
o Interest Parity
If expected returns on two similar instruments are different, savers will move
funds from one instrument to another. In equilibrium, these rates would be
equal. That is, we would have interest parity, in which interest rate equalization
across nations would ensure that no such flow of funds would occur.
+1
= ( ) (1 + )
(1 + ) = ( ) (1 + )
If the covered-interest parity condition is not satisfied, then a covered-interestarbitrage opportunity exists.
Uncovered interest Parity
o Uncovered Interest Arbitrage
+1
Buying currencies that are at a forward discount and selling currencies that are
at a forward premium is actually equivalent to borrowing currencies of nations
with low interest rates and lending currencies of countries with high interest
rates.
Foreign Exchange Market Efficiency exists when the forward exchange rate is
a good predictor often called an unbiased predictor of the future spot
exchange rate, meaning that, on average, the forward exchange rate turns out to
equal the future spot exchange rate.
International Financial Markets
International Capital Markets are the markets for cross-border exchange of
financial instruments that have a maturity of a year or more. International
capital market traders also exchange instruments with no distinct maturity. In
contrast, international money markets are the markets for cross-border
exchange of financial instruments with maturities of less than one year.
7. The International Financial Architecture and Emerging Economies
International Capital Flows
o Explaining the Direction of Capital Flows
Hence, an FDI inflow is an acquisition of domestic financial assets that results
in foreign residents owning 10 percent or more of a domestic entity. An FDI
outflow is an acquisition of foreign financial assets that result in domestic
residents owning 10 percent or more of a foreign entity.
Cross-border mergers and acquisitions are the combining of firms in different
nations. A merger occurs when a firm absorbs the assets and liabilities of
another firm. An acquisition occurs when a firm purchases the assets and
liabilities of another firm.
o Capital Allocations and Economic Growth
Foreign capital inflows can help to offset domestic business cycles, providing
greater stability to the domestic economy.
Financial development affects economic growth by promoting savings and
directing funds to the most productive investment projects.
o Capital Misallocations and their Consequences
Asymmetric information can bring about an inefficient distribution of capital
through resulting problems of adverse selection, herding behavior (savers who
lack full information base their decisions on the behavior of others who they
feel are better informed) , and moral hazard.
A policy-created distortion occurs when a government policy results in a
market producing a level of output that is different from the economically
efficient level of output.
explanation of the trilemma is that a nation may simultaneously chose any two,
but not three of them.
o Evaluating the Status Quo
Discretionary approach to establishing conditions under which the IMF lends
(ex post conditionality) undermines the IMFs credibility both with actual
borrowers and prospective borrowers.
Although the World Banks official mission is to lend to people in developing
nations with projects that cannot attract private capital, the development agency
increasingly competes with private investors. The World Bank also faces
pressure from the nations that are net donors to its lending pool to maintain a
significant revenue stream of its own, thereby reducing the donors risk of loss.
9. Monetary and Portfolio Approaches to Balance-of-Payments and Exchange-Rate
Determination
Central Bank Balance Sheets
o A Nations Monetary Base
Economists call total domestic securities and loans domestic credit, so the
monetary base by definition is the domestic credit plus the central banks
foreign exchange reserves.
Viewed from the asset side of a central banks balance sheet, the monetary base
is equal to domestic credit plus foreign exchange reserves. Viewed from the
liability side of the central banks balance sheet, the monetary base is equal to
currency plus bank reserves.
= +
= = ( + )
The Monetary Approach to Balance-of-Payments and Exchange-Rate Determination
The monetary approach to balance-of-payments and exchange-rate
determination postulates that changes in a nations balance of payments and the
exchange value of its currency are a monetary phenomenon.
o The Cambridge Approach to Money Demand
The Cambridge equation postulates that the quantity of money demanded is a
fraction of nominal income. People hold a fraction of their nominal income as
money.
=
o Money, the Balance of Payments, and the Exchange Rate
The current account balance plus the capital account balance is equal to the
official settlements balance. The official settlements balance consists mainly of
changes in the central banks foreign exchange reserves. We will assume that
the nations foreign exchange reserves are equivalent to its official settlements
balance. In this case, an increase in the official settlements balance (the foreign
exchange reserve component of the monetary base) is equivalent to a balanceof-payments surplus.
Economists who use the monetary approach assume that purchasing power
parity holds in the long run.
=
In equilibrium the actual money stock equals the quantity of money demanded.
Proponents
( + ) =
o The Monetary Approach and a Fixed-Exchange-Rate Arrangement
An event that causes a difference between the quantity of money demanded and
the quantity of money supplied generates a change in the nations balance of
payments or in the spot exchange value of its currency.
Under a fixed-exchange-rate arrangement, the monetary approach indicates that
an increase in domestic credit generates a balance-of-payments deficit, whereas
a decrease in domestic credit results in a balance-of-payments surplus.
A rise in either the foreign price level or domestic real income results in a
balance-of-payments surplus. Likewise, a decline in either the foreign price
level or domestic real income results in a balance-of-payments deficit.
o The Monetary Approach and a Flexible-Exchange-Rate Arrangement
Under a flexible-exchange-rate arrangement such as this, the domestic central
bank does not intervene in the foreign exchange market. The foreign exchange
reserves component of the monetary base, therefore, remains unchanged, and
the nation has neither a balance-of-payments surplus nor a balance-of-payments
deficit.
Under a flexible-exchange-rate arrangement, the monetary approach indicates
that an increase in domestic credit results in a depreciation of domestic
currency, whereas a decline in domestic credit results in an appreciation of the
domestic currency.
Under a flexible-exchange-rate arrangement, the monetary approach theorizes
that an increase in the foreign price level or domestic real income results in an
appreciation of the domestic currency.
o A Two-Country Monetary Model
The spot exchange rate is determined by the relative quantities of money
supplied and the relative quantities of money demanded.
= ; = ,
= ; = ,
=
=1
+
+
+ +
= 0 + ( )
= 0 + ( )
= 0 + ( ) + 0 + ( )
= (0 0 ) + [(1 ) ]
Whether induced by a fall in the real interest rate or expectations of higher real
returns on investment, an increase in desired investment causes investment to rise
at any given level of aggregate income: investment is autonomous.
We shall assume that the real government spending is equal to an autonomous
amount.
An increase in foreign real income levels or a depreciation of the domestic
currency causes exports to increase.
o Equilibrium Income and Expenditures
In equilibrium, the aggregate desired expenditures on domestically produced
goods and services by households, firms, the government, and foreign residents
are equal to total real income.
+ + +
= (0 0 ) + () ; = 0
= (0 0 ) ( 0 ) + ( )
(0 0 ) ( 0 ) + 0 + 0 + 0
o The IS Schedule
The IS schedule is a set of combinations of real income levels and nominal
interest rates that maintains equilibrium real income.
The Market for Real Money Balances: The LM Schedule
o The Transactions and Precautionary Motives for Holding Money
Transaction Motive. The motive to hold money for use in planned exchanges.
Precautionary Motive. The motive to hold money for use in unplanned
exchanges.
Portfolio Motive. The motive for people to adjust their desired mix of money
and bond holdings based on their speculations about interest rate movements and
anticipated changes in bond prices.
o The LM Schedule
An LM schedule is a set of all combinations of real income levels and nominal
interest rates that maintain equilibrium in the money market.
The Balance of Payments: The BP Schedule and the IS-LM-BP Model
Real income and the nominal interest rate together must determine a nations
balance of payments.
o Maintaining a Balance-of-Payments Equilibrium: The BP Schedule
A balance-of-payments equilibrium, however, is defined as a situation in which
the current account balance and capital account balance sum to zero, so that the
official settlements balance also equals zero.
o Economic Policies with Perfect Capital Mobility and Fixed Exchange Rate: The
Small Open Economy
An expansionary monetary policy declines the interest rate below its equilibrium
level. This induces significant flows of capital out of the country, which results
in a BoP deficit. To prevent a decline in the value of the nations currency, the
central bank sells foreign exchange reserves. An expansionary monetary policy
action ultimately has no effect on real income when the central bank maintains a
fixed exchange rate.
An increase in government spending rises the interest rate above the foreign
interest rate, so the nation experiences a balance of payments surplus as the
higher domestic interest rate induces significant inflows of capital from abroad.
The central bank begins to accumulate foreign exchange reserves in its efforts to
keep the exchange rate from changing. Consequently, fiscal policy has its
greatest possible effect on equilibrium real income when capital is perfectly
mobile.
12. Economic Policy with Floating Exchange Rates
Floating Exchange Rates and Imperfect Capital Mobility
o The Effects of Exchange-Rate Variations in the IS-LM-BP Model
A fall in the value of a nations currency makes imports more expensive.
Consequently, expenditures on the nations exports increase. Hence, the IS
schedule shifts to the right.
A currency depreciation causes the BP schedule to shift to the right.
o Monetary Policy under Floating Exchange Rates
An increase in the money stock causes the LM schedule to shift rightward. Hence,
there is a balance-of-payments deficit. This places downward pressure on the
value of the nations currency. Thus, the domestic currency depreciates. This
causes export spending to rise and import spending to fall. Under a floating
exchange rate, therefore, an increase in the quantity of money unambiguously
constitutes an expansionary policy action that induces at least a near-term
increase in a nations real income level.
o Fiscal Policy under Floating Exchange Rates
The effects of fiscal policy actions on a nations BoP and the value of its currency
hinge on the degree of capital mobility.
With low capital mobility an increase in government spending causes the IS
schedule to shift to the right. Therefore, the immediate effect of the rise in
government spending is a balance of payments deficit caused by an increase in
import spending resulting from a rise in real income. The nations currency
depreciates in the face of the BoP deficit. The resulting rise in the exchange rate
induces net export expenditures to increase. Furthermore, the currency
depreciation causes the BP schedule to shift to the right.
With high capital mobility the resulting rise in the interest rate causes significant
capital inflows into this nation. This induces a BoP surplus and the nations
currency appreciates, which spurs import expenditures and reduces export
spending. Hence, the IS schedule shifts leftward. The currency appreciation also
causes the BP schedule to shift leftward.
Floating Exchange Rates and Perfect Capital Mobility
o Economic Policies with Perfect Capital Mobility and a Floating Exchange Rate: The
Small Open Economy
An increase in the money stock causes the LM schedule to shift rightward. The
induced decline in the equilibrium interest rate generates considerable capital
outflows. This causes the country to start to experience a BoP deficit, which
places downward pressure on the value of the nations currency. Thus, import
spending declines and export spending rises. Monetary policy has the largest
possible immediate effect on real income with a floating exchange rate and
perfect capital mobility.
With perfect capital mobility, fiscal policy actions have complete crowding-out
effects. Any increase in government spending crowds out an equal amount of net
export spending by foreign residents because of the currency appreciation that
the fiscal policy action causes. On net, therefore, equilibrium real income is
unaffected by the fiscal policy action.
Fiscal Policy
Maximum Effect
Minimum Effect
o Economic Policies with Perfect Capital Mobility and a Floating Exchange Rate: A
Two-Country Example
Under a floating exchange rate and perfect capital mobility, a domestic monetary
expansion can have a beggar-thy-neighbor effect on the foreign country. If the
exchange rate floats, domestic monetary policy can affect levels of real income
and interest rates in both nations within the same two-country world. Hence, the
foreign economy is no longer insulated from domestic monetary policy actions
under a floating exchange rate.
Under a floating exchange rate and perfect capital mobility, a domestic fiscal
expansion has a locomotive effect on the foreign country. An increase in domestic
government spending results in expansions of real income levels in both nations.
In a two-country world with a floating exchange rate a foreign fiscal expansion
generates a locomotive effect.
Fiscal Policy
Beggar-thy-neighbor
Locomotive Effect
There is a trade-off between the social costs incurred in hedging against foreign
exchange risks in a system of floating exchange rates and the risk of experiencing
unhedged losses as a result of unexpected devaluations in a system of fixed
exchange rates.
o Stability Arguments for Fixed versus Floating Exchange Rates
Variations in aggregate desired expenditures lead to real income instability under
a fixed-exchange-rate system. Permitting the exchange rate to float automatically
reduces the real income effects of volatility in desired expenditures.
Variations in the demand for real money balances contribute to real income
instability under a floating-exchange-rate system. Fixing the exchange rate
automatically reduces the real income effects of volatility in money demand.
Maintaining a fixed exchange rate could, under some circumstances, be the better
policy choice from the standpoint of achieving greater real income stability, but
adopting a system of floating exchange rates might lead to a higher level of
overall economic efficiency.
o Monetary Policy Autonomy and Fixed versus Floating Exchange Rates
Adopting a system of floating exchange rates gives a nations central bank policy
autonomy that it does not possess under a system of fixed exchange rates.