The balance of payments

• A record of all transactions made between one particular country and all other countries during a specified period of time.

• This is split in to three accounts:• Current account• Capital account and • Financial account

Current Account• This is the difference between a nation's total exports

of goods, services and transfers, and its total imports of them.

• This includes:• Balance of trade (visible trade)• Balance on services (invisible trade)• Income balance (Interest, Profits and Dividends)• Current transfers balance (taxes, subsidies, aids, gifts…)

Capital account

• A national account that shows the net change in asset ownership for a nation.

• (Houses, machinery, factory buildings, sale of fixed assets)

Financial account

• This is the flow of money into and out of a national economy for investment in capital, company shares and in loans. (IPD will be recorded in current account)

Direct and Portfolio investments

• Direct inward investment:• Foreign owned firm sets up a factory, office

or retail outlet in a country.• Portfolio investment:• The purchase of shares and loans of money

(debt)

• Inwards investments creates external liabilities. (have to repay later)

• Outward investments creates external assets. (some day they will be repaid)

Hot money

• This refers to short term investments of large sums of money that are moved by investors from country to country in search of the best short-term interest rates and returns.

Balancing

• If there is a deficit, the government tries to balance by:

• Drawing money from reserve assets (gold reserves and foreign currency reserves)

• Borrow from IMF or from central banks of other countries.

Net errors and omissions

• Inflows and outflows of money may not be able to record precisely over a long period. Things left out or recorded with errors are included as Net errors and omissions.

Foreign exchange market

• The market in which participants are able to buy, sell, exchange and speculate on currencies.

What forms a forex market?

• This consists of all those consumers, firms and governments willing and able to buy foreign currency and all those willing and able to supply foreign currency.

Exchange rate

• The price of a foreign currency expressed in terms of other currency is known as its exchange rate.

What determines exchange rate?

• Like any other commodity, price (exchange rate) of a currency also is determined by the demand and supply the same in the market.

Why Indian currency is demanded?

• Consumers, firms and governments in other countries would buy Indian currency (INR) to pay for their imports from India and also to save and invest in Indian companies.

Why INR is supplied?

• Indian consumers, firms and government buy foreign currencies to pay for the imports from other countries and also to make investments in other countries.

Equilibrium in foreign exchange market

• The value of pound expressed in terms of Euro.

• Here the price of pound (exchange rate) is: 1 Pound = 1.60 Euro

Exchange rate index

• The average value of a currency against a basket of currencies of those countries that are the international trading partners.

• (It is just like the calculation of CPI)

Floating exchange rates

• If an exchange rate is allowed to float (determined by the free forces of demand and supply, without an interference by the government), it is called floating exchange rate system.

Depreciation and Appreciation• Depreciation:• When the value of one

currency falls against other currencies it is known as a depreciation.

• Appreciation:• If the value of a currency

rises against one or more other currencies it is called an appreciation a currency.

Why currencies fluctuate?

Changes in balance of

tradeInflation

Changes in interest rate Speculation

Changes in balance of trade in goods and services

More imports

Less exports

Current account deficit

More supply of domestic currency

Less demand for the domestic

currency

Price of currency depreciates

Inflation

High inflation

Rise in price compared to foreign prices

Less demand for domestic goods

Less exports

Less demand for domestic currency

Depreciation of currency

Changes in interest rates

High interest rate

More demand for domestic

currency

Appreciation of currency

Speculation

Fear of fall in value

Sell currency

Increase in supply

Depreciation

Making money by

buying and selling foreign

currencies to try to

make speculative

gains.

Managed floating exchange rates

• A managed currency is an exchange rate that is basically floating in the foreign exchange markets but is subject to intervention from time to time by the monetary authorities, in order to resist fluctuations that they consider to be undesirable.

Currency appreciation• The appreciation of a country's currency refers to an

increase in the value of that country's currency. • When the Canadian dollar appreciates relative to the

euro, the exchange rate falls: it takes fewer Canadian dollars to purchase 1 euro (1 EUR=1.5 CAD → 1 EUR=1.4 CAD).

• When the Canadian dollar appreciates relative to the Euro, the Canadian dollar becomes less competitive. This will lead to larger imports of European goods and services, and lower exports of Canadian goods and services.

How currency appreciates?

• When a country's exports are high, the buyers of these exports need its currency to pay for those exports.

• When the country's central bank increases interest rates, people will want that currency to deposit in the banks to earn that higher interest rate.

• When employment and per capita income in a country increase, the demand for its goods and services increases, along with demand for that country's currency in the local market.

Currency depreciation

• The depreciation of a country's currency refers to a decrease in the value of that country's currency.

• For instance, if the Canadian dollar depreciates relative to the euro, the exchange rate (the Canadian dollar price of Euros) rises: it takes more Canadian dollars to purchase 1 euro (1 EUR=1.5 CAD → 1 EUR=1.7 CAD).

When currency appreciates:

Rise in the

value of currenc

y

Expensive

export

Low overseas demand

for currency

Govt supply currenc

y

Lower interest

rate

Fixed Exchange rates

• The value is fixed against the value of another single currency or to a basket of other currencies.

• This makes trade and investments between the two countries easier and more predictable.

Problems with trade surplus

• Political and economic pressure on the govt.• Demand pull inflation.• Eventually, high value of currency may reduce

demand for exports.

Problems with trade deficit

• Less money spent on domestic goods.• Imported inflation.• Declining industrial base.

How to correct trade balance?

• Do nothing, floating exchange will correct it.• Ex:• 1 Pound= 2 Euros• I bottle of French wine=4 Euros• When the same is imported to UK, its price

would be 2 Pounds.• If pound value falls, price of imported wine in

UK will rise, then there will be less demand.

How to correct trade balance?

• Fiscal policy.• Contractionary fiscal policy• Expansionary fiscal policy.

How to correct trade balance?

• Adjust interest rate.• Trade deficit…increase interest rates.• Trade surplus…decrease interest rates.

How to correct trade balance?

• Protectionism.• Tariffs, quota, exchange control, embargo…