BAHIRDARUNIVERSI

TY
DI
STANCEEDUCATI
ONPROGRAMME
DEPARTMENTOFECONOMICS

PREPAREDBY

GETACHEW YI
RGA
AND
ZELALEM YI
RGA

EDI
TEDBY
HI
WOTG/
MICHAEL

DECEMBER 2006
BAHIRDAR
COURSEI
NTRODUCTI
ON

I
nter
nat
ionalEconomi
csi
soneoft
hei
mpor
tantbr
anchesoft
hest
udyofEconomi
c
Sci
ence. Theeconomi
csoft
hemov
ementofourwor
ld’
sresour
cesandgoodsand
ser
vicesi
sabasi
cconceptt
hatmustbeunder
stoodbyst
udent
sofeconomi
cs.Thi
s
mayi
ncl
udeexpl
anat
ionsofwhyandhowt
heser
esour
cesandpr
oduct
sar
emov
edor
t
ransf
err
edf
rom onesegmentoft
hewor
ldt
otheot
her
.Iti
simpor
tantt
obeari
nmi
nd
t
hatt
hesemayormaynoti
nvol
vemov
ementofmoneyi
nther
ever
sedi
rect
ion.

Thecour
sei
sdi
vi
dedi
ntot
wopar
tsandhencei
sgi
veni
ntwosemest
ers.Thef
ir
stpar
t
i
sabouti
nter
nat
ionalt
rade.Thi
sfocusesondi
scussi
ngt
hev
ari
oust
radet
heor
ieswhi
ch
ev
eni
ncl
udest
hosedev
elopedbycl
assi
caleconomi
sts.Thedi
ff
erentt
radepol
i
cies
adopt
edbydi
ff
erentcount
ri
esoft
het
radegamear
eal
sot
hemaj
orcomponent
soft
his
f
ir tofI
stpar nter
nat
ionalEconomi
cs.Theset
opi
cs,wi
tht
hei
rrel
ati
ont
othegr
owt
hof
dev
elopi
ng count
ri
es,wer
e di
scussed as a one-
semest
er-
cour nI
se i nt
ernat
ional
Economi
csI
.

tofI
Thesecondpar nter
nat
ionalEconomi
csi
sgener
all
yabouti
nter
nat
ionalf
inanceand
f
inancepol
i
cies.Wewi
l
lint
roducemoneyasani
mpor
tantt
ool
ofanal
ysi
s.Oneofsucha
concepti
sint
ernat
ionalmacr
oeconomi
cwhi
chdeal
swi
tht
hebal
anceofpay
ment
s
(
BOPs)andexchanger
ateeconomi
cs.Themaj
orcomponent
sofBOPs,di
ff
erences
bet
ween BOPs bal
ance and equi
l
ibr
ium,det
ermi
nant
s ofexchange r
ate and ot
her
concept
srel
ated t
o t
hese t
he cor
efocus ar
eas.Adj
ust
ment mechani
sms t
o
di
sequi
l
ibr
ium i
nthebal
anceofpay
ment
sofcount
ri
esaswel
lasi
mpor
tantt
heor
iesof
capi
talmov
ement
swi
l
lal
sobeseenher
eint
hesecondpar
tofI
nter
nat
ionalEconomi
cs.
At
tempt
swi
l
lbemadet
oassoci
atet
heseandot
herr
elat
edconcept
stot
hecondi
ti
onof
Af
ri
caneconomi
csi
nagl
obal
economi
ccont
ext
.

HaveaGoodTi
met
oRead!
2
Thef
oll
owi
ngsy
mbol
sar
eusedi
nthecour
semat
eri
alasagui
de.

Thi
stel
l
syout
her
eisani
ntr
oduct
iont
othemodul
e,uni
torsect
ion.

Thi
stel
l
syout
her
eisaquest
iont
oanswerort
hinkabouti
nthet
ext
.

Thi
stel
l
syout
her
eisanact
ivi
t odo.
yt

Thi
stel
l
syout
onot
eandr
ememberi
mpor
tantpoi
nts(
ter
ms)
.

Thi
stel
l
syout
her
eisacheckl
istoft
hemai
npoi
nts.

Thi
stel
l
syout
her
eisasel
f-
testexer
cisef
ory
out
odo.

Thi
stel
l
syout
her
eisawr
it
tenassi
gnment
.

Thi
stel
l
syout
hatt
her
ear
etheanswer
stot
heact
ivi
ti
esandsel
f-
test
quest
ions.

3
 MODULE–1

BALANCEOFPAYMENTS,
EXCHANGERATEECONOMICS
AND
CAPI
TALMOVEMENTTHEORIES

PREPAREDBY
GETACHEW YI
RGA

EDI
TEDBY
HI
WOTG/
MICHAEL

TYPESETBY
GENETAYALEW

DECEMBER 2006
BAHIRDAR

4
 CONTENTSOFMODULE–1
I
NTRODUCTI
ONTOTHEMODULE……………………………………………………6
MODULEOBJECTI
VES………………………………………………………………….
..
6

CHAPTERONE:BALANCEOFPAYMENTS……………………………………………7
1.
0.Introduct
ionandObj ect
ives………………………………………………………………7
1.
1.Bal anceofPay mentsBookkeeping………………………………………………………8
1.1.1.Defi
niti
onsandConcept s…………………………………………………………. 8
1.1.2.TheDoubl e–EntryAccounti
nginBoPs………………………………………….10
1.1.3.BoPsSt r
ucture……………………………………………………………………. 11
1.
2.Bal anceofPay mentsDefici
tsandSurpl
uses…………………………………………….16
ChapterSummar y……………………………………………………………………………. 18
I
mpor tantTerms……………………………………………………………………………. .
18
Sel
f–TestEx erci
se- 1……………………………………………………………………. .
..
.19

CHAPTERTWO:EXCHANGERATEECONOMI
CS………………………………….
20
2.
0.Introduct i
onandObj ectiv
es……………………………………………………………. .20
2.
1.TheFor eignExchangeMar ket…………………………………………………………. .20
2.
2.Ex changeRat eDetermi nati
on…………………………………………………………. .
23
2.
3.Appr oachest oExchangeRat eDeterminati
on…………………………………………. .
.29
2.3.1.TheBal anceofPay ment s(BoPs)Approach……………………………………. 29
2.3.2.ThePur chasi
ng–PowerPar it
y( PPP)Approach………………………………. .29
2.3.3.TheMonet aryAppr oach…………………………………………………………31
2.
4.Ar bit
rage………………………………………………………………………………. .
..
.32
2.4.1.ExchangeAr bi
trage………………………………………………………………. .
.32
2.4.2.InterestArbit
rage………………………………………………………………. .
..
..
32
2.
5.For ei
gnExchangeRi sks,Hedgi ngandSpeculat
ion………………………………………36
ChapterSummar y……………………………………………………………………………. .
.39
I
mpor tantTer ms………………………………………………………………………………40
Sel
f–TestEx erci
se- 2 ………………………………………………………………………40

CHAPTERTHREE:BOPSANDEXCHANGERATEADJUSTMENTSAND
CAPI TALMOVEMENTTHEORI ES……………………………..…41
3.
0.IntroductionandObj ect
ives………………………………………………………………. 41
3.
1.Ex changeRat eSy stemsandBOPsAdj ust
ments…………………………………………41
3.1.1.ExchangeRat eSystems……………………………………………………………. .42
3.1.2.Balanceofpay ment sAdjust
ments…………………………………………………. 44
3.
2.Ex changeRat eAdj ustment s………………………………………………………………. 47
3.
3.Theor i
esofCapi tal Movement ……………………………………………………………. 50
ChapterSummar y………………………………………………………………………………. 52
I
mpor tantTerms………………………………………………………………………………. .
.53
Sel
f–TestEx er
cise-3…………………………………………………………………………53

ANSWERKEYSTOSELF–TESTEXERCI SES………………………………………….
.54
REFERENCES…………………………………………………………………………………55

5
I
NTRODUCTI
ONTOTHEMODULE

DearDi
stanceLear
ner
!InI
nter
nat
ionalEconomi
csI
,youhav
elear
ntabouti
nter
nat
ional
t
radet
heor
iesandpol
i
cies.Youhav
est
art
edf
rom t
heol
destcl
assi
calt
rademodeland
t
heny
ouhav
eseent
henew t
radet
heor
ies.Thev
ari
ouspol
i
ciest
hatt
radi
ngnat
ions
empl
oyt
ofaci
l
itat
e/r
educet
radewer
eal
soseen.Tar
if
fs,subsi
dies,i
mpor
tsubst
it
uti
on
andexpor
tpr
omot
ionwer
eamongt
hem.Youhav
eal
soanal
yzedt
hemer
it
s/demer
it
sof
di
ff
erentt
radepol
i
ciest
oAf
ri
caneconomi
es.

Thepr
esentmat
eri
al(
Modul
e–1)wi
l
lint
roducey
out
othebasi
cconcept
sofbal
anceof
pay
ment
s(BOPs)
,exchanger
atedet
ermi
nat
ionandi
tseconomi
cs,andt
het
heor
iesof
capi
talmov
ement
.Def
ini
ti
on,component
sofBOPsandot
herr
elat
edconcept
swi
l
lbe
di
scussedi
nthef
ir
stchapt
er.Thesecondchapt
eri
sdev
otedt
otheexchanger
ate
economi
cs.Det
ermi
ningt
heequi
l
ibr
ium exchanger
atef
rom demandf
orandsuppl
yof
f
orei
gnexchange,ar
bit
rage,specul
ati
onet
c.wi
l
lbeseenher
eint
heseconduni
t.We
hav
e basi
cal
l
ytwo t
ypes ofcapi
talmov
ementt
heor
ies -t
he f
low and t
he st
ock
(
por
tfol
i
o).Ther
elat
ivedet
ail
soft
heset
heor
iesandt
headj
ust
mentappr
oachest
oBOPs
andexchanger
atear
epoi
ntsofemphasi
soft
het
hir
dchapt
er.

MODULE OBJECTI
VES

Ef
fect
ivel
ygoi
ngt
hrought
hismodul
ewi
l
lmaket
hel
ear
nerbeabl
eto:

 Knowt
hebasi
cconcept
sofBOPsofacount
ry;
 Under
standexchanger
ateeconomi
cs;
 Ev
aluat
ethemet
hodsofadj
ust
ingBOPsdi
sequi
l
ibr
ia;
 Under
standt
her
elat
ionshi
pbet
weenBOPsandexchanger
ate;
 Knowhowaneconomymai
ntai
nsanexchanger
ateadj
ust
ment
;and
 I
dent
if
ythet
heor
iesofcapi
tal
mov
ement
s

6
CHAPTERONE
BALANCEOFPAYMENTS

1.
0.I
ntr
oduct
ionandObj
ect
ives

Iti
sof tenheardt hatlessdev el
opedcount ri
essuf f
erfrom adv ersebal
anceofpay ments
(BoPs)andconsequent lyexperiencechr oni
cf oreignexchangegap.Per si
stentBoPs
defi
citshavefor cedcount ri
estoresorttocorrectiv
emeasur eslikecur
rencydev al
uat
ion,
i
mposi tionoftar i
ff
s,exchangecont r
olscontracti
onarymonet ar
yandf i
scalpolici
esand
exchangecont rolsofv ar
ioussorts.Eventheso- cal
leddev elopedcountr
ieshav ebeenno
exceptiontot hist endency .Poli
ciesofi mpor tsubstit
utionandexpor tpromotionto
achieveexternalbal ance( orbalanceofpay ment sequi l
ibri
um)hav el edto seri
ous
problemsofgr owt handt radeforcountri
esoft hewor l
d.

TheBoPsaccount sareani ntegr alpartofthenationalincomeaccountsf oranopen

economy .Theyr ecordalltr
ansact ionsbetweenresi
dent softhecountr
yconcer nedand
thoseofot hercountri
es.Resident sar ebroadlyi
nter
pretedasalli
ndivi
duals,businesses,
andgov ernmentagenci es.Althoughacor por
ati
onisconsi der
edtobear esidentoft he
countryinwhi chi tisincorpor ated,itsov er
seasbranchorsubsi di
aryisnot .Mi l
it
ary
personnel,governmentdi pl
omat s,t our
ist
s,andwor kerswhoemi gratetempor ar i
l
yar e
consider
edr esi
dent softhecount r yinwhichtheyholdciti
zenshi
p.

Whatever t he obj ecti

ves of policy maker s and r egardless of the i
nsti
tuti
onal
arr
angement s,thest at
eoft heBOPs( orofsomesubsetofi t
scomponents)playsan
essenti
alroleinpr ovidi
nginformati
ont ogov er
nments,privateindi
vi
dualsandfi
rms.The
tr
adit
ionalandi mpor tantquesti
onaskedi swhet hert
heBOPsi sinequil
i
bri
um,sincethat
maypr ovokegov ernmentactionand/ orleadstochangesi nexchangerat
e.Asweshal l
see,howev er,therehav ebeen,andcont i
nuet obe,disagreement saboutwhatismeant
byequili
bri
um anddi sequil
i
brium i
ntheBOPs.

Dear Di
stance Lear
ner
!Unl
i
ke t
he f
ir t of I
st par nter
nat
ionalEconomi
cs,whi
ch
emphasizedoni nt
ernati
onalt
radefl
owsandcommer ci
alpoli
cies,ourattent
ionher ein
thesecondpar t wil
lbetoexaminethemonetaryaspectsofinternat
ionaltr
ade.Todo
so,wehav et ocar
efull
yconsi
derthedef
ini
ti
on,natureandroleofBoPsofnat ions.On
ourwayal so,wewillseeinwhatsenset
herewillbeabalancei ntheBoPsandi nwhat
waydefici
tsandsur pl
usescanexist
.Thechapterisdevot
edtot heseandot herrelated
probl
ems.

Obj
ect
ives

Uponasuccessf
ulcompl
eti
onoft
hischapt
er,
youwi
l
lbeabl
eto:

7
 Underst
andthebal
anceofpaymentsaccounti
ng;
I
denti
fythebasi
ccomponentsoftheBoPs;and
Defi
nedefi
cit
sandsurpl
usesinBoPs.

1.
1.Bal
anceofPay
ment
sBookkeepi
ng

TheBoPsi soneoft heoldestandthemosti mportantstati

sticalstatementsf orany
country,especiall
ythemor eopeneconomi es.Int hi
ssect i
on,t herefore,wewi lltryto
presentaf ormalandgener all
yaccepteddefinit
ionandst ructureoft heBoPs.Al though
dif
ferentcountriesmayhav etheirowndefini
tionsandsomewhatdi ff
erentcomponent s
forthe BoPs,t his mater
ialwilltake t
he wi delyused ones.The sy st
em ofBoPs
accounting,someoft heconceptsandt er
mi nologiesusedi ntheBoPsexpr essionand
theinter pr
etat
ion ofBoPscat egori
esareofut mosti mportancet o anyst udentof
i
nternationaleconomics.

Obj
ect
ives

Att
heendoft
hissect
ion,
youwi
l
lbeabl
eto:

 Defi
nebalanceofpayments;
 Appreci
atetheuseofdouble–entr
ybookkeepi
ngi
nBoPs;
and
 I
dentit
ytheimport
antpart
soft heBoPs.

1.
1.1.Def
ini
ti
onsandConcept
s

DearDistanceColleague!Youhavesomei deaaboutBoPsf rom yourstudyofthe

course‘Macroeconomics’.So,canyoudefinetheterm BoPsinyourownwor ds?Lety
ou
tr
y,please.
____
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_ __
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__ _
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_ _
______
_____
_____
_____
______
_ _
__.

Haveyoutri
ed?Thatisver
ygood.
Lear
ner!Overthecourseofayear
,ther
esi
dent
sofonecount
ryengagei
nav
ari
etyof
tr
ansact
ionswithresident
sabr oad.Thesei ncludepay ment
sf orgoodsandser v
ices,
l
oans,invest
ment s and gi f
ts.To anal yses the economici mportance of t
hese
i
nter
nati
onaltransacti
ons,iti s necessar
yt o classi
fyand aggregat
et hem i
nt oa
summarystat
ement .ThatstatementisthustermedBoPs.

TheBal
anceofPayment
sisar
ecor
d(summar
yst
atement
)of
t
he economi
ctr
ansact
ions 8
bet
ween t
he r
esi
dent
s ofone
count
ry and t
he r
esi
dent
s ofal
lot
hercount
ri
es dur
ing a
DearSt
udent
!Let
’scl
ari
fyt
hedef
ini
ti
ongi
venabov
efort
heBoPs.Fi
rstofal
l
,iti
s
obv i
ousthatt heli
ter
allymill
i
onsoft ransacti
onsoft her esidentsofanationwiththerest
oft hewor ldcannotappeari ndivi
duall
yint heBoPs.Asasummar ystat
ement ,the
balanceofpay mentsaggr egatesallmer chandi setradei nt oaf ew majorcategori
es.
This,forinstance,meanst hatthemonet aryv alueofEt hiopianexport
s/import
st o/f
rom
dif
ferenttradingnationswi l
lnotbet akenindi vi
duall
yf oreachexpor ter/
importerorfor
eachnat ion.Howev er,allexportsofdi ff
erentexpor terst odiffer
entcountr
ieswi l
lbe
summar i
zedi nasinglecategor
y .Thesamei st rueforallimpor t
smade.

Simil
arl
y,onl
yt henetbalanceofeachtypeofi nt
ernationalcapitalf
lowisincluded.We
shouldnotincludeev er
yamountofcapi talfl
ow int hebal anceofpay ments.Fur ther
more,theBoPsi ncl
udessomet r
ansact
ionsi nwhichther esi
dentsoff or
eignnationsar e
notdir
ectl
yinvolved.Forexampl
e,whent heNat i
onalBanksel l
sapor ti
onofitsf oreign
curr
encyholdingst o pri
vat
eand governmentcommer ci
albanks,t het r
ansactioni s
summar i
zedint hebal
anceofpaymentsoft hecountr
y.

DearDi
stanceLear
ner
!Al
so,not
ethatt
het
ransact
ionssummar
izedi
nBoPsar
e
i
nter
nati
onalt
ransact
ions.Whati
sanint
ernat
ionalt
ransacti
on?Canyoutr
y,pl
ease?
_
______
____
_____
_____
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___
___
___
____
_____
_____
_______
_____
____
___
___
____
_
______
____
_____
_____
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___
___
___
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_____
_____
_______
_____
____
___
___
____
_
______
____
_____
_____
______
___
___
___
____
_____
_____
_______
_____
____
___
___
___.

Al
ri
ght
!Ani
nter
nat
ionalt
ransact
ionr
efer
stot
heexchangeofgoods,ser
vicesorasset
s
(forwhichpay mentinusuall
yrequired)bet
weenr esi
dent
sofonecount ryandt hose
abroad.Howev er
,gif
tsandcert
ainothertr
ansfers(f
orwhichnopay mentisrequir
ed)are
alsoincl
udedi nanation’
sbal
anceofpay ments.Thequestionofwhoi sar esi
dentofa
nationalsorequi
ressomeclassi
ficat
ion.But
,explanati
onisprovi
dedintheintroduct
ion
tothechapter.Yougobackandchecki tsdef
init
ionandfurt
heranaly
zeitsimportanceto
theconceptofBoPs.

Lastly
,itisimport
antt okeepinmi ndthatthebalanceofpay ment
sr ecor
dsf l
ows
betweencountri
esov eraspeci
fi
edper i
odoft ime.Alt
houghsomeofi t
scomponent
accountsmayber ecordedforl
essthanay ear,thef
ullBoPsusual
lytakesacalendar
year.TheUnit
edStatesandsomeotherdevel
opedcount r
iesal
sokeepsucharecordon
aquar t
erl
ybasi
s.

9
 Coll
eague! Bytheway ,doyouknow whynati
onskeepabalanceofpayments
r
ecord? Let you t
ry, pl
ease.
_
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_ _
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_
_
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_ _
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_ _
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__
_
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_ __
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_ _
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_ _
___
___
___
___
____
____
___
_____
_.

Excel
l
ent
!Themai
npur
poseoft
hebal
anceofpay
ment
sist
oinf
ormt
hegov
ernmentof
theinter
nationalposi
ti
onoft henati
onandt ohelpitinit
sfor mulat
ionofmonetar
y,f
iscal
andcommer ci
alpoli
cies.Governmentsalsor egularl
yconsul ttheBoPsofi mportant
tradepartnersinmakingpolicydeci
sions.Theinformationcont ai
nedinanati
on’sBoPs
i
sal soindispensabletobanks,f i
rms,andi ndi
vidualsdirectl
yori ndi
rect
lyi
nvol
vedi n
i
nt er
nati
onal tr
adeandf i
nance.

1.
1.2.TheDoubl
e–Ent
ryAccount
ingi
nBoPs

Thebalanceofpaymentsinessential
lyanappli
cat
ionofdouble–entr
ybookkeepi ng,
si
nce itrecor
ds bot
ht ransact
ions and t
he money fl
ows associat
ed wi t
ht hose
tr
ansact
ions.Thi
s,in ot
herwor ds means t
hatthe arrangementofi nternati
onal
tr
ansact
ionsintoabalanceofpay mentsaccountrequi
resthateachtransactionbe
enter
edasacredi
toradebit.

Acredi
ttransact
ionisonet hatr
esult
sinar ecei
ptofapay
mentf
rom
f
orei s.Adebi
gner tt
ransact
ionisatr
ansact
ionthatl
eadst
oapay
mentt
o
for
eigner
s.Notethatcredi
ttr
ansact
ionsar
eenter
edwit
haposit
ivesi
gn
anddebittr
ansact
ionsareenter
edwi t
hanegat
ivesi
gni
nthebal
anceof
paymentsofthecountr
y.

Tounderst
andthi
sdist
inct
ion,weneedt oassumethattr
ansact
ionstakepl
acebet
ween,
say
,Ethi
opianr
esi
dentsandf or
eigner
s,andthatal
lpayment
saref i
nancedi
nbir
rs.

Giv
ent heseassumpt ions, t
hef ollowingt ransacti
onsarecredi
tswhi
chl
eadt
other
ecei
pt
ofbir
rfrom foreignersf rom theEt hiopianper specti
ve.
 Mer chandi se( goodsandser vices)export
s;
 Tr anspor tationandt r avelreceipts;
 I ncomer eceiv edfrom i nvestment sabroad;
 Gi ftsr ecei
v edf r
om f oreignresi dent
s;
 Ai dr eceivedf rom foreigngov ernments;
 I nvestment sinEthiopi abyov er seasresi
dents.

Ontheotherside,whatt y
pesoft ransacti
onsaredebi t
sf r
om Et
hiopi
anv
iewpoi
nt,
whi
ch
i
nvol
vepay mentst of or
eigner s?Theyi ncl
udethef ol
lowing:
 Mer chandise( goodsandser vi
ces)imports;
 Transportationandt ravelexpenditur
es;
 Incomepai doni nvest mentsoff orei
gners;
 Gift
st oforeignr esidents!
 Aidgivenbyt heEt hiopiangov ernment!

10
  Ov
erseasi
nvest
mentbyEt
hiopi
anr
esi
dent
s.

Alt
hough we speak i nt erms ofcr edittr
ansacti
on and debitt ransact
ions,ev er
y
i
nternati
onaltransacti
oni nvolv
esanexchangeofasset sand, sohasbot hacr editanda
debi
tside.Eachcr editentryisbalancedbyadebitentr
y,andv i
ceversa.Ther ecordi
ngof
anyinternat
ionaltransaction,t
her ef
ore,l
eadstotwoof fset
ti
ngentries.Thismeans,as
we sai d earl
ier,thatt he bal ance ofpay ments accounts ut
il
ize a doubl e–entr
y
bookkeepingsy st
em.

Even though t
he enti
re Bops bydefini
ti
on mustnumerical
lybalance,itdoes not
necessaril
yhol
dthatanysi ngl
esub-accountorsub-
accountsofthest at
ementmust
balance.Forinst
ance,mer chandi
se export
s may ormay notbe i n balance wi
th
mer chandi
sei
mports.General
ly
,

Doubl
e-ent
ryaccount
ingassumesonl
ythatt
het
otalofal
lent
ri
esont
hel
eft
-
handsi
deoft
hest
atementmat
chest
het
otal
oft
heent
ri
esont
her
ight
-handsi
de.

DearDi
stanceLear
ner
!Inor
dert
ounder
standt
hedoubl
e-ent
rybookkeepi
ngsy
stem
usedi
nBOPs,
letust
aket
hef
oll
owi
ngexampl
es.

Exampl e-1.SupposeMESGETPl c.( anEt hi

opiancompanyi nvol
vedi ncoffeeexpor t
)
sellsBr .2mi ll
ionwor thofcof feet oaU. S.importer.Pay mentismadei nabi l
lof
exchange.Thi sincreasesthedollarholdingsofEt hi
opianbanks.Sinceexportinvol
v esa
transferofEthiopianassetsabroadf orwhi chpay menti stobereceiv
ed,iti
sent eredin
theEt hi
opianBOPsasacr editt
ransaction.MESGET’ sr ecei
ptofpaymentheldi ntheUS
banki sclassi
fiedashor t-
ter
m capitalmov ement .Thi
sisbecauset hefi
nanci
alclaimsof
EthiopiaagainsttheU. S.bankhav eincreased.Theent ri
esont heEthi
opianBOPswoul d
appearasf oll
ows:

Cr
edi
t(+) Debi
t(-)
Merchandi
zeExport
s..
..
..
..
..
..
..
..
..
..
..
..
..
.Br.2,
000,000
Short
-t
erm Capi
tal
Outfl
ow...
..
..
..
..
..
..
..
...
..
..
..
..
..
..
..
..
..
..
..
..
..
..
..
..
..
.Br
.2,
000,
000

Exampl e–2.Assumet haty ougot oFrancetov i

sitt
hePar i
sTowerandot herplaces
andspendBr .
10,
000onhot els,mealsetc.Thismeanst haty ouar epurchasingt ravel
servicesfrom for
eignersrequi ri
ngapay menti nter
msofFr enchf r
anc.Not ethatthisis
thesameasanEt hi
opiani mpor t
.Therefore,Ethi
opiawi l
ldebi tBr.10,000f ortravel
services.Yourpay menti tselfi nthenent ered asashor t–term credi
tsi nceFr ance
i
ncr easesitsclai
msonEt hiopia.Hence,itisacapitali
nflowt oEthiopiaandi srecorded
asashor t
–term capit
alcredi tofBr.10,
000.Theent i
retransactionisenteredasf ollows
i
nt heEt hi
opianbalanceofpay ments:

Cr
edi
t(+) Debi
t(-)
Trav
elServ
icespurchasedfr
om forei
gners……Br .10,000
Short
-t
erm capi
tal
infl
ow..
..
..
..
..
..
..
..
..
..
..
..
..
..
..
..
..
..
..
..
..
..
..
..
..
. Br
.10,
000

Exampl e–3.The US gov er

nmentdonat es a birramounti
ng 1.5 mil
li
on f orthe
rehabil
i
tati
on offlood – st
ri
cken peoplein Dir
e Dawa town.Thus,the Ethiopi
an
governmentwill
,attheendoftheyear
,recor
dthistransf
er(
cal
leduni
l
ater
altransfer
)as

11
acredi
t.Thi
sv al
ueisagai
naclai
m agai
nstt
heUSbankssot
hati
twil
lbedebi
tedasa
shor
t–term capi
tal
outfl
owint
heEthi
opi
anBoPs.Wesummar
izei
tasf
oll
ows:

Credit(
+) Debit(-)
Unil
ateralTransf
ers.
..
..
..
..
..
..
..
..
..
..
..
..
..
..
..
..
..
..
..
..
..Br.
1,500,000
Short
-term Capit
alOutfl
ow...
..
..
..
..
..
..
..
..
..
..
..
..
..
...
..
..
..
..
..
..
..
..
..
..
..
..
..
..
..
..
..
..
..
.Br
.1,500,
000

DearDi
stanceCol
l
eague!Youhavet
onot
e,howev
er,
thatal
thoughBoPshasi
tsr
oot
sin
double–ent r
ybookkeeping,i
tisrarelypresent
edint hatform.Tocl ar
ifythi
sstatement,
fi
rst,thev ari
oustransacti
ons(entriesoraccount s)wi llbegat heredt oget
heri none
columnwhi chgi
verisetothebalancingofmonet aryflowsunderwhatar econsider
edto
beappr opriat
eheadings.Thenetv aluesoft hemonet ar
yf l
owsar et henenteredinthe
correspondingheadingsinthesinglecolumn,wi t
ht heirsignreversed.Wet hushav ean
accounti n a singl
e column,whi ch mustsum t o zer o.You wi l
lunder st
and thi
s
explanati
onmor elateron,whenweseet heupcomi ngsub- sect
ion.

1.
1.3.BoPsSt
ruct
ure

Tradi
ti
onall
y,therearet wobasicelement sinaper f
ectl
ycompi ledsetofbal anceof
payments:the currentaccountand t he capi
talaccount.Each oft hese is usual
ly
subdi
vided,t
hef or
meri ntovi
sibl
eandinvisi
blet
radeandunr equi
tedtr
ansfers,thelatt
er
i
ntolong–term andshor t–t
erm pri
vat
et r
ansact
ionsandchangesi noff
ici
alreserves.

Lear
ner
!Theessent
ialdi
ff
erencebet
weent
het
woi
sthatcapi
talaccountt
ransact
ions
necessari
lyi
nvolvedomest i
cresi
dentseit
heracquiri
ngorsur
renderi
ngclaimsonforei
gn
resi
dents,whereascur rentaccounttransact
ionsdonot .I
npr acti
ce,ther
eisat hi
rd
element–thebalanci
ngi tem orerrorsandomi ssi
ons–whi
chr efl
ectsourinabi
li
tyto
recor
dal l
int
ernati
onalt
ransacti
onsaccuratel
y.

I
nt hissub- secti
on,weshallconsidereachoftheseaccountsonebyonebyr ef
erenceto
ahy potheticalcountr
y,andt henbuil
dupt hefullsetofbalanceofpay mentsaccounts.
Youshoul d,however,notethattherearesomei nternat
ionalt
ransacti
onswhichdonot
fal
lr eadi
lyint ooneorot herofthecategori
esdescribedinwhatf ol
lows.Ther
efore,we
wil
l presentthoseusedbyt hemaj ori
tyofworl
dcount ri
es.

A.TheCur
rentAccount

Thecurrentaccountr
ecor
dsexpor
tsandi
mpor
tsofgoodsandser
vicesanduni
l
ater
al
tr
ansf
ers.

Thecur
rentaccountoft
hebal
anceofpay
ment
sref
ers
t
otheov
eral
laccount
ingoft
hemonet
aryv
alueof
i
nter
nat
ionalf
lows associ
ated wi
tht
ransact
ions i
n
goods,
ser
vicesanduni
l
ater
alt
ransf
ers.

12
Thegoodsandser vi
cescomponentoft hecur rentaccountshowst hemonet ar
yv al
ueof
al
loft hegoodsandser v
icesanat i
onexpor tsori mports.Export
s,whetherofgoodsor
servi
ces,arebyconv ent
ionenteredasposi t
ivei t
ems( credi
t)intheaccount.Impor ts
accordingl
yareenteredasnegat ive(debit)i
tems.Expor tsarenormallycalcul
atedf .
o.b
(f
reeonboar d),i
.e.
,costsfortransportat
ion,insurance,etc.
,arenotincl
uded.Howev er
,
i
mpor tsarenormal l
ycalculat
edc. i
.f
.(costs,insurance,andfrei
ght),i
.e.
,tr
anspor t
ati
on,
i
nsurancecosts,etc,arei
ncluded.

DearDi
stanceSt
udent
!Canyoucat
egor
izecur
rentaccountel
ement
sasgoods
andothersasservi
ces?Whatit
emsoftr
ansact
ionsaregroupedasgoodsandser
vices?
Let you try, pl
ease.¬¬
___
___
_ _
_____
____
______
___
___
_____
___
___
___
____
_ _
___
_______
____
___
____
____
__
___
___
_ _
_____
____
______
___
___
_____
___
___
___
____
_ _
___
_______
____
___
____
____
__
___
___
_ _
_____
____
______
___
___
_____
___
___
___
____
_ _
___
_______
____
___
____
____
__.

Haveyout
ri
ed?Thati
sni
ce.Thegoodsaccountoft
hecur
rentaccounti
ncl
udest
he
monetaryvalueofmer chandi
seexpor tsandi mpor t
s.Theseitemsoff oreignexchange
earni
ngsandspendi ngarecall
ed‘visi
ble’
itemsandhencef ormthevisibl
et radebal
ance
i
nt heBoPs.I freceipt
sf r
om expor t
sequalt opayment sforimportsofgoods,t her
e
wouldexistazer obalance.Ifexportsexceedi mpor t
s,therewil
lbeaposi ti
vevi
sibl
e
tr
adebalancewhi chisfav
orableforacount ry
.Ont heotherhand,whenexpor t
sfal
lshort
ofimports,thecount r
yunderconsi derationwillexperi
enceanunf avorablenegativ
e
tr
adebalance.

Theser v
icespar
tofthecurrentaccountrecordsallt
heserv i
cesexpor t
edandimport
ed
byacount ryi
nay ear
.TheirnetvalueisenteredintheBoPsasi nvisibl
et r
adebal
ance.
Servi
cesar ecal
ledinvi
sibl
ei nthesenset hattheirr
eceiptsandpay mentsarenot
recordedattheportofentry.Exceptthi
s,t her
eisnomeani ngfuldiff
erencebet
ween
goodsandser vi
cesreceipt
sandpay ments.Bot hconsti
tuteear ningsorspendingof
forei
gnexchangeasopposedt oborrowi
ngsandl endi
ngoff oreignexchange.

DearCol
l
eague! Letusnowseet
hei
mpor
tantt
ransact
ionst
hatar
ebestr
egar
dedas
ser
vicetransactions.Theybasi call
yincl
udet hef ollowing:
 Tr anspor tati
on, banki ng and insurancer eceiptsand paymentsf rom and to
forei
gncount ri
es;
 Tour ism,t r
avelser vi
cesandt ouristpurchasesofgoodsandser v i
cesreceived
from foreignv i
si t
orstohomecount ryandpai douti nfor
eigncountr
iesbyhome
citi
zens;
 Expenses ofst udents studyi
ng abr oad and r ecei
ptsfrom forei
gn students
studyingint hehomecount ry;
 Expensesofdi plomaticandmi lit
aryper sonnelst ati
onedover
seasandr ecei
pts
from similarper sonnelfr
om overseasst ationedi nthehomecountry;and
 I nter
est,pr ofi
tsdi vi
dendsandr oyalt
iesr eceivedf r
om for
eigncountr
iesandpai d
outtof oreigncount ri
es.

13
DearDi
stanceLear
ner
!Asweseef
rom t
hedef
ini
ti
onofcur
rentaccount
,theot
her
componentisuni
lat
eraltransfer
s.Theyar
ealsocall
edunr
equi
tedr
eceipt
s,whichthe
resi
dent
sofacount r
yr eceiv
e‘ f
orfr
ee’
,wit
houthav
ingtomakeanypresentorfut
ure
paymentsi
nret
urn.

Uni
l
ater
alt
ransf
ersr
efert
otr
ansact
ionst
hatar
eone–si
ded,r
efl
ect
ingt
hemov
ement
ofgoodsandser vicesinonedirect
ionwit
houtcor r
espondingpay
ment sintheother
di
rect
ion.Receipt
sf rom abr
oadar eenter
edasposi ti
veitemspay mentsabroadas
negat
iveit
ems.Thiski ndofr
ecei
ptusual
lytakesoneoftwoforms–priv
atetransf
ersor
off
ici
altr
ansf
ers.

Thef ist– pr
r i
vatetransfers-referst ogift
smadebyi ndivi
dual sandnongov ernment
organizati
ons(NGOs)t oforei
gner s.Thesemi ght
,forinstance, i
ncludearemitt
ancef r
om
animmi gr
antli
v i
nginEt hiopi
atohi sr el
ati
vesinIndi
aoracont ri
butionbyaU. Sresi
dent
toar el
ieffundforEthiopia.
Thesecondcal ledoffi
cialorgover nmentt ransf
ers–r efer
st ogi ft
sorgrantsmadeby
onegov er
nmentt oforei
gnr esidentsorf orei
gngov ernment s.Inot herwords,theyare
payment sofpur eai
d( asopposedt otiedaid)bygov ernment sindev el
opedcount r
ies
(perhapsv i
ainternat
ionalagencies)t ogovernmentinlessdev el
opedcountri
es( LDCs).

e1-Cur
Tabl rentAccountSummar
iesf
orTwoCount
ri
es–AandB,
2005,
Val
uesi
n($USbi
ll
ion)

Count r
yA Count r
yB
A:Mer chandiseExports 151.31 269.59
B:Mer chandiseImports -
189. 26 -
192. 74
C:Visi
bleTr adeBalance(A+B) 37.96 76.85
D:Expor t
sofSer vi
ces 172.01 143.91
E:I
mpor t
sofSer vi
ces -
157. 79 159.53
F:I
nv i
sibleTradeBalance(D+E) 14.22 -
15. 62
G:PrivateTransfer
s(net) -
0.49 -
0.99
H:Offici
al Tr
ansfers(net
) -
6.93 -
3.30
I
:Cur r
entAccountBal ance(C+F+G+H) -
31. 16 56.94

14
i
nvestmentsabroad.Thesewi l
lberecor
dedintheBoPsasnegativeit
ems(debit
).A
capit
alinf
low canalsobel i
nkedtotheexpor
tofgoodsandserv i
ces.Conv
ersel
y,a
capit
aloutfl
owi ssimi
lari
neffectt
otheimpor
tofgoodsandser
vices.Ref
erthi
sback
totheexamplesthatwesawinsecti
on1.1.
2.

Letusnowconstructahypothet
icalcapi
tal
accountf
orthet
wocountr
iesAandBwhose
curr
entaccountwast akenearli
er.Thenetvalueoflong-
ter
m andshor
tter
m capi
tal
defnest
i hebal
anceoncapitalaccount.

e2 Capi
Tabl talAccountf
orCount
ri
esAandB,
2005(
$USbi
ll
ion)

Count
ryA Count
ryB
J:Di
recti
nvestment(net) 0.
23 -
45.22
K:Port
fol
ioinvestment(net) -
44.93 -
48.39
L:
LongTer m capit
alBalance(J+K) -
44.70 -
93.61
M:Short–Ter m capi
tal(net
) 27.
53 45.
86
N:Capit
alAccountBalance(L+M) -
17.17 -
47.75

C.TheRemai
ningI
temsi
ntheBoPs

DearDi
stanceSt
udent
!Usual
l
ythemonet
aryv
aluesofdebi
tedi
temsandcr
edi
teddonot
match.Thi
smaybebecauseofanumberofr easons.Themosti mport
antcausei sthe
i
nabil
it
yofgovernmentstati
sti
cianst
oacquireallt
henecessaryinf
ormati
onincompi l
ing
theBoPs.Thecostofcol l
ecti
ngbalanceofpay mentsstati
sti
csishi
gh,andaper fectl
y
accur
atecol
lect
ionsystem woul dbeprohi
bit
ivel
ycostl
y.Gov er
nmentstati
sti
ciansthus
basether
efi
gurespart
lyoni nf
ormati
oncoll
ectedandpar tl
yonesti
mates.

Whenst ati
sti
cianssum thecredi
tsanddebi
ts,
itisnotsur
pri
singwhenthetwotot
alsar
e
notequal.Becausetotaldebi
tsmustequalt
otalcredi
tsi
npri
ncipl
e,t
heyinser
taresi
dual
tomaket hetotalsequal.Thiscorr
ect
ingentr
yi sknownaser ror
sandomi ssi
onsor
stat
ist
icaldi
screpancy.

I
nt heBoPsst atement,er ror
sandomi ssi
onsistr
eatedaspartofthecapitalaccount
becauseshortterm capitaltr
ansact
ionsaregener
all
ythemostfrequentsour
ceofer r
or.
Besidesstat
ist
icalandr ecordingerr
ors,thesub-
accountofer
rorsandomi ssionsalso
i
ncludessmuggl ing,il
legalandsecr etcapit
almov ementsandi mperf
ectest i
mation
procedur
es.

Finall
y,wehav e,aspar toftheBoPs,changesi nther eservesoft hecount rywhose
balanceofpay ment swear econsideri
ngandchangesi nt hatpartoft her eser
vesof
othercount r
iest hatisheldinthecountryconcerned.Theser eservescouldbef orei
gn
currency reserves (usual
lythe US dol l
ar)
,gold orspeci aldr awing Rights(SDRs)
borrowedf rom theI MF.Notet hatr
eservesdonothav etobehel dwi thinthecount r
y.
Indeedmostcount ri
eshol dapr oport
ionoft heirreservesinaccount swi thforei
gn
central(national
)banks.Any ways,thenetv al
ue( change)i ntheser eserveswi l
lbe
enteredintheBoPsas‘ changesinreser
ves’oras‘int
ernati
onalli
quidit
y’
.

DearCol
l
eague!Wear
enowi
naposi
ti
ont
oputt
hef
ullbal
anceofpay
ment
saccounti
n

16
thefol
l
owingtabl
ewhosecurrentandcapit
alaccountbal
ancesareext
ract
edfrom t
abl
e
1.1andtabl
e1.2r
espect
ivel
y.Notethatt
heaccountsforeachcount
rysum upzer
o.

Tabl
e2.
3.Bal
anceofPay
ment
sforCount
ryAandCount
ryB,
2005(
$USbi
ll
ion)

Countr
yA Countr
yB
CurrentAccountBalance -
31.16 56.94
CapitalAccountBalance -
17.17 -
47.75
Err
or sandOmi ssi
ons 38.98 -
21.96
TotalchangeinReser ves 9.35 12.77

1.
2.Bal
anceofPay
ment
sDef
ici
tsandSur
pluses

Thet er
ms‘ balanceofpayment sdefici
t’and‘balanceofpayment ssurplus’are
famil
iart othemostcausalst udentofeconomi caf f
airs.Theycar r
ywi ththem t he
suggestionthatsomet hingiswrongwit
ht henat i
onaleconomy ,sothatsomechange
maybeexpect edinthenearf ut
ure.Thet
ermsal sooftenconveysomei mplicitj
udgment ,
usual
lytot heeff
ectt hatacountr
ywithaBoPsdef ici
tisinsomesensei ntroubl
e, whil
e
onewi thasur plusi s‘str
ong’
.Thissecti
oni sdev otedt oar elat
ivedetailoft hese
i
mpor tantconcepts.

Obj
ect
ives

Uponasuccessf
ulcompl
eti
onoft
hissect
ion,
thedi
stancel
ear
neri
sexpect
edt
o:

 Di
scri
minat
ebetweenautonomousandaccommodatingt
ransacti
on;
 Def
ineBoPsdefi
citandsur
plus;
and
 I
denti
fyt
hedif
fer
encebetweenBoPsbalanceandBoPsequil
i
brium.

DearDi
stanceLear
ner
!Bef
orewedi
rect
lydi
scussaboutdef
ici
tsandsur
plusesi
nBoPs,
l
etus make t he f
oll
owing di
sti
nct
ion bet
ween aut
onomous and accommodating
t
ransact
ions.Thedist
inct
ioni
susefultodefi
net
heconcept
sofdefi
citandsur
plusesin
t
heBoPs.

Aut
onomousandAccommodat
ingTr
ansact
ions

Aut
onomousorabovet
hel
i
net
ransact
ionsar
ethoset
hatt
akepl
acer
egar
dlessoft
he
sizeofotherit
emsi nt
hebal anceofpay ments.Forinstance,theexportofgoodsi sa
tradetr
ansacti
onwhichtakesplacebecauseaf i
rm sell
sgoodst oaforeignbuyer.I
ti s
an ini
ti
ati
ng oran autonomous t ransact
ion and it
sv alue resul
tsin pay ments by
forei
gnerstothehomecount ry,whichisenteredasacr edi
titem.IfEthiopiarecei
ves
$10mi l
li
onfrom t
heEuropeanUni onasai dfortheflood-str
ickenpeopleof2006,t hen
thisamountisent
eredascreditint
oEt hi
opi
anBoPs’ accountcalledUni
lateralTr
ansfers.

17
Whenthecount
rybor
rows$17mill
i
onfrom t
heWor
ldBanktoconst
ructahighway,
the
sum of$17mil
li
oniscredi
tedi
ntotheLong–ter
m Capit
alAccountofthecount
ry’
s
BoPs.

Theaccommodat
ingorbel
owt
hel
i
net
ransact
ions g

18
Chapt
erSummar
y
DearDi
stanceLear
ner!Whenannualeconomict
ransact
ionsmadeamongcountri
esof
t
heworldarecompiledt
oget
her,wewillhav
ewhati sknownasbalanceofpayment
s.
BOPsaccount sareputinsinglecolumn–wher ecreditt
ransact
ionsar
egivenpositi
ve
val
uesanddebi tedonesareenter
edwi t
hanegati
vesign.Notethatwhenwesayacr edi
t
tr
ansacti
on,itmeansthatthecountryi
npar
ti
culari
sobt ai
ningmoneyabroad,wher
easa
debi
ttransacti
onmakest hecountr
ypaymoneyt ofor
eigners.

TheBOPsi sbasicall
ydi vi
dedintotwo:t hecur r
entaccountandt hecapitalaccount .The
formeri sagai nsub-dividedintothr ee– v isi
blet rade,inv i
sibletradeanduni l
ateral
transfers.Visibl
et r
adei mpli
esexpor tandi mpor tofgoodswhi l
einvisi
blet r
adeshows
thatofser v
ices.Unil
ateraltr
ansfersindicat egiftsmadebyf oreignindiv
iduals,NGOsor
gov ernment s.Thecapi talaccounti sal sosub- di
videdi ntoshor t
-t
erm andl ong-ter
m
capi t
al.Whent hedebitedandcr editedi t
emsdonotmat ch,weaddacor rectingent ry
calleder ror
sandomi ssions(stat
ist
icaldi screpancy)sot hatt hecol umnbecomeszer o.
Ther emayal soaf inalentryknownasi nternati
onall i
qui di
tywhi chi st her esultof
changesi ntheinter
nationalr
eserves( ofgol d,othercurrenciesorSDRs)oft hecount r
yin
consi derati
on.

Coll
eague!Wehavesaidearl
i
erthatBOPsdefi
cit
sandsur pl
usesar
edef i
nedafterwe
underst
and aut
onomous and accommodat
ing transact
ions.Whereas autonomous
tr
ansacti
onsarethecausesoftheBOPssituaton,accommodat
i i
ngt r
ansacti
onsare
causedbyt hesi t
uationthuscreated.Creditanddebitentriesofcur r
entandcapi tal
accounts ar e aut onomous whi l
et hose oft he int
ernat
ionall iqui
dit
y accountar e
accommodat i
ng ones.Accor dingly,BOPs defici
toccur sifaut onomous pay ments
exceedr eceipts,orifthei
nter
nationalli
qui
dit
yaccountiscredited(isposit
iv .Asur
e) plus
i
nBOPswi llexistwhent hereverseoft heaboveist r
ue.Wehav ealsosaidthatBOPs
equil
ibri
um i sdifferentfr
om balancei nBOPs.BOPsequi li
bri
um occur sifautonomous
receipt
sandpay mentsareequal ,orwhenaccommodat i
ngt r
ansacti
onsar eofzer o
balance.Not ethatBOPsbal ancecoul dexi
stevenwhent her
ear edef i
cit
sandsur pl
uses.

I
mpor
tantTer
ms
Pl
ease,
checkwhet
herornoty
ouknowt
hef
oll
owi
ngkeyt
ermsoft
hef
ir
stchapt
er.

Accommodat i
ngt ransact
ion BoPsequi l
ibr
ium
Asset BoPssur pl
us
Autonomoustransact i
on Capitalaccount
Bal
anceofPayment s Credittransaction
Bal
anceoncapi talaccount Currentaccount
Bal
anceonCur rentaccount Debittransaction
BoPsbalance Doubl eentryaccount
ing
BoPsdefici
t Err
or sandomi ssi
ons

19
Internati
onalli
qui
dit
y Resident
Internati
onaltr
ansacti
on Short–t erm capi
tal
Invisibl
etradebal
ance Unil
ateraltr
ansfer
Long–t erm capi
tal Visi
bletradebalance

Sel
f–TestExer
cise-
1
A.Wr
it
etr
ueorf
alse.

1.Whenwesayadebi ttransaction,wemeant hetr

ansacti
onbr ingsmoneyr ecei
pts.
2.Inthecal culat
ionofmonet ar yvaluesofexpor ts,t
hecost softransportat
ion,
i
nsur anceandot hersar eincorporated.
3.Ifyourof fi
cesponsor sy out ostudyM. A.coursesi neconomi csabr oad,the
expensespentony ouwi l
lber ecordedi ntheservi
cepartoft hecurr
entaccount .
4.Moneysentf r
om y ourbr otherinU. S.ist er
medauni l
ateralt
ransferandi s
recordedinthecur rentaccountoft heEt hi
opianBoPs.
5.Wesayequi li
bri
um i smai ntainedint heBoPswhent heaccountcalled‘changes
i
nr eserves’(or‘i
nternationalli
quidity
’)showsazer obalance.

B.Shor
tanswer
,di
scussi
onandwor
kout
.

1.Whati sacredittr
ansact i
on, andi tssignwhenent eredintot heBoPs?Wr itethree
int
ernati
onaltr
ansact ionsthatcanbestber egardedascr edi
tt ransactions.
2.AGer mancompanyi nvolvedinf l
owerpr oductionandexpor thasst ar
tedwor kin
Ethi
opianin2005.I thasexpor tedf l
owerv al
uedat0. 8mi ll
i
onbi rrin2006.How
doy ouputtheent ri
esi ntheEt hiopianBoPs?
3. Whati sal ong– t erm capi tal?Listt het ypesoft ransact i
onst hatar ebest
regardedaslongt erm capitaltransact i
ons.
4.Whydoweneedanent r
ycal l
ed‘ statist
icaldiscrepancy’inr ecordingbal anceof
payment saccounts?Di scuss.
5.Whatdowemeanbybal anceofpay mentsequi l
ibri
um?Di scussBoPsequi l
ibri
um
byconsideri
ngi t
sdi f
ferencewi hBoPsbal
t ance.

20
CHAPTERTWO
EXCHANGERATEECONOMI
CS

2.
0.I
ntr
oduct
ionandObj
ect
ives

Amongt hefactorsthatmakeInt
ernat
ionalEconomicsadist
inctsubjecti
stheexist
ence
ofdif
ferentnat i
onalmonetaryunitsofaccount .InEthi
opia,pri
cesandmoneyar e
measuredinteri
msoft hebirr
.Thedol l
arr epr
esentsUnit
edSt ates’uni
tofaccount ,
wher
east hefrancandy ensi
gnif
ytheunitsofaccountofFr
anceandJapan, respect
ivel
y.

Asy oumayknow,at ypi

cali
nternati
onaltransacti
onr equi
rest wodi st
inctpur chases.
Fir
st,t
hef oreigncurrencyisbought;second,theforei
gncur r
encyi susedt ofacil
itatethe
i
nternati
onalt ransacti
on.Thef i
rstpur chaseismadei nani nstit
uti
onalar r
angement
call
edt hef oreignexchangemar ket.Thepur chasei sdoneatapr icecal l
edf or
eign
exchanger ate.Thi sr atewil
lthusbeusedbygov ernments,firmsori ndi
vidualst o
opti
mi zetheirobject
ives.

Inthischapt er,ther
efor
e,wewi l
ldevelopway sofdeter
mini
ngtheexchanger
ate.We
shallthendiscussaboutarbit
rage,hedgingandspecul
ati
onwhichar
e,i
noneoranother
way, manif
est ati
onsofexchangeratedif
ferent
ial
s.

Obj
ect
ives

Att
heendoft
hischapt
er,
youar
eexpect
edt
o:

Defi
netheforei
gnexchangemar ketanditswor
ks;
I
denti
fythevari
ouswaysofdet er
mi ni
ngthefor
eignexchanger
ate;
Examinewhenandhowar bi
tr
ageoccur s;
St
atetheway sofavoi
dingaforeignexchanger
isk;and
Defi
nespeculat
ioni
nthef or
eignexchangemarket.

2.
1TheFor
eignExchangeMar
ket

A gi
venmoney( curr
ency)
,inaddit
iontobuy i
nggoodsandser v
ices,canbuy
anothermoney( curr
ency)
.Itmayalsobesol dbyit
selfforyetanot
hercurrency.Thi
s
i
mp
r li
esthatther
ei smarket(apl
aceorana r
rangement
) i
nw hi
chcurr
enci
eso f di
ff
erent
countri
esarepur a s h
r 21
Assumet hatdealeri
sbil
ledf oreachcaritimpor t
sattherateof$20,000percar.This
i
mpor terthuscannotwr i
teacheckf orthisamountbecausehedoesnothav ea
checkingaccountdenominatedinU. Sdoll
ars.Inst
ead,thedeal
ergoest ohi
sbank,say
BankofAby ssini
a,t
oarrangepay ment.Iftheexchanger at
eis$1Br .
9,theimporter
wri
tesacheckt otheBankofAby ssi
niaforBr.180,000(=20,
000x9)percar.Thebank
wil
lthenpayt heU.Smanufacture$20,000percarinU.S.

Theot herar rangementforforeignexchangei samongbanks.Howev er,t

hemaj orbanks
thatt r
adef oreignexchangegener all
ydonotdealdi rect
lywi t
honeanot herbuti nstead
uset heser vicesofforei
gnexchangebr okers.Thepurposeofabr okeri
st opermitthe
tradingbankst omaintai
nt hedesi redf or
eignexchangebal ances.Ifatapar ticul
ar
momentabankdoesnothav et hepr operforei
gnexchangebal ances,itcant ur
nt oa
brokert obuyaddi ti
onalforei
gncur rencyorsel lt
hesur plus.Brokerst husprovidea
whol esale,inter-
bankmar ketinwhicht radi
ngbankscanbuyandsel lforeignexchange.
Br oker
sar epai dacommi ssionfortheirserv
icesbythesell
ingbank.

Thethir
dt i
eroftheforeignexchangemar ketconsi
stsofthetr
ansacti
onsbetweent he
tr
adi
ng banks and t heir overseas branches or forei
gn corr
espondents. These
tr
ansacti
onsper mitthemat chingofsuppl yanddemandoff or
eignexchange.Such
i
nter
nationalt
ransact
ionsarecar r
iedoutprimari
lybytel
ephoneandcomputers.

B.Ty
pesofFor
eignExchangeTr
ansact
ions

DearDi
stancest
udent
!Whenconduct
ingpur
chasesandsal
esoff
orei
gnexchange,
bankspr omisetopayast i
pul
atedamountofcur
rencyt
oanotherbankorcustomeron
an agreed-up on dat
e.Bankst ypi
cal
l
yengage inthr
ee t
ypesoff or
eign exchange
tr
ansactionsspot,
forwar
dandswap.

Forcurrencyt radi
ngamongbanks,spott r
ansact
ionsarethemostwi delyused.Spot
tr
ansactionsr efertoani mmedi atepur chaseandsaleoff oreigncur r
encyf orcash
sett
lementnotmor ethantwobusi nessday saft
ert
hedatethetr
ansactionsarer ecorded
asspotdeal s.Thet wo-dayper
iod,knownasi mmediat
edeli
very
, all
owst i
mef ort hetwo
part
iestof or
war dinst
ructi
onstodebi tandcredi
tbankaccount
sathomeandabr oad.

Inmanycases,howev er,abusinessorf i
nancialinstit
uti
onknowsi twillber eceiv
ingor
payi
nganamountoff or
eigncurrencyonaspeci fi
cdat ei nthef ut
ure.Forexampl e,in
JuneanEt hi
opianimportermayar rangeforaspeci alEthiopi
anNew Yearshi pmentof
JapaneseToy ot
atoar ri
veinAugust .Theagr eementwi ththeJapanesemanuf acturer
maycal lforpay mentiny en(
Japanesecur rency
)onAugust15.Toguar dagai nstthe
possi
bil
ityoft hey en’
sbecomi ngmor eexpensi vei ntermst hebir
r,theimpor t
ermay
contr
actwi thhisbanktobuyy enatast i
pulatedpr i
ce,butnotact ual
lyreceivethem unt i
l
August15whent heyareneeded.Whent hecont ractmat ures,theEthiopiani mporter
paysforthey enwithaknownamountofbi rrs.Thi
si sknownasaf orwardtransaction.

Lear
ner
!For
war
dtr
ansact
ionsdi
ff
erf
rom spott
ransact
ionsi
nthatt
hei
rmat
uri
tydat
eis
morethant wobusi
nessdaysi
nthefut
ure.Af
orwardexchangecontact’
smatur
it
ydate
canbeaf ewmont hs,orev
enyear
s,i
nthefut
ure.Theexchangerat
ei sfi
xedwhenthe
cont
actisinit
ial
l
ymade.

23
Tr ading foreign cur r
enci
es among banks al so invol
ves curency swaps. Swap
r
transact i
onsent ai
ltheconversi
onofonecurrencytoanothercur
rencyatonepoint
, with
anagr eementt or econver
titbacktotheori
ginalcurr
encyatsomepoi ntinthefutur e.
Ther atesofbot hexchangesar eal
soagreedtoi nadvance.Swapsprovi
deanef f
icient
mechani sm throughwhi chbankscanmeett hei
rforei
gnexchangeneedsov eraper iod
oft ime.Banksar eabletouseacur r
encyforaper i
odinexchangeforanothercur
rency
thatisnotneededdur i
ngthatti
me.

Asanexampl eforaswapt ransact

ion,consi
derDashenBankwi thexcessbalancesof
birr
sbutashor tageofdoll
arstomeett herequir
ementsofi t
sclient.Atthesamet i
me,
BankofAby ssi
niamayhav eexcessbalancesofdoll
arsandinsuffi
cientamountsofbir
rs.
Thet wobankscoul dnegoti
ateaswapagr eementi nwhichDashenBankagr eesto
exchangebirr
sf ordol
lar
stodayanddol l
arsforbi
rrsi
nt hefut
ure.Thekeyaspecti st
hat
thetwobanksar r
angetheswapasasi ngl
et r
ansact
ioninwhicht heyagreetopayand
receiv
esti
pulatedamountsofcurrenci
esatspecifi
edrates.

2.
2.ExchangeRat
eDet
ermi
nat
ion

Exchangerat
ereferstot
heamountoft hehomecountr
y ’
scurr
encyhasbeaff
orded
i
nordertopurchaseanother(
for
eign)cur
rency.Thei
mport
antquesti
onisthus“
howcan
t
hisrat
e( pri
ce)bedet er
mined?
”I fweassumeaf r
eemar keteconomy

24
 Thesupplyofpoundsisdenot edbyl ineSfe infi
gure2.1.Thegraphr epresent
sthe
numberofpoundsoffer
edbyt heBr i
ti
shtoobt ainbir
rswhicht obuyEthiopiangoods,
servi
cesandasset
s.Iti
sdepictedinthefigureasaposi t
ivef unct
ionoftheEt hi
opi
an
exchangerat
e.Asthebi
rrdepr
eciatesagainstthepound(ast hebir
rpri
ceoft hepound
ri
ses),t
heBri
ti
shwil
lbei
ncli
nedt obuymoreEt hiopi
ancommodi ti
es.

Ther easonf orthathugepur chasei sofcour se,athigherandhi gherbirrpri

cesof
poundst heUKcangetmor eEthiopianbi
rrsandhencemor egoodsperpound.Ethi opian
goodst husbecomecheapert ot heBrit
ish,whoar einducedt opurchaseaddi ti
onal
quantit
ies.These purchases resultsin mor e pounds being off
ered i
nt he foreign
exchangemar kett
obuybi r
rswi thwhicht opayEt hi
opi
anexpor ter
s.But,notethatt he
supplyofforeignexchangecannotnecessar i
lybeupwardsl opi
ng.

C.Equi
li
bri
um ExchangeRat
e

DearDi
stanceLear
ner
!Aswehi
ghl
i
ght
ed ear
li
er,t
heequi
l
ibr
ium exchanger
atei
s
determinedbyt hemar ketforcesofdemandandsuppl ybutt hisreal
lyhappensifthe
monet aryauthori
ti
esdo notat t
emptt o st
abil
izeexchanger at
esormoder at
et hei
r
mov ements.Inotherwor ds,t
heremustexistafreemarketeconomyf ortheequi
li
bri
um
pri
ceoff or
eigncurrenci
est obefixedbyt
heirsuppl
yanddemand.

Sfe

15 F
. E
Bi
rr
sper13
pound
(R) 10 H

Dfe

10 20 30 40 50 Mi
l
li
onsofPounds/
day

Fi
gur
e2.
1ExchangeRat
eDet
ermi
nat
ionunderaFl
exi
bleExchangeRat
eSyst
em

DearDi
stance Leaner
!As we hi
ghl
i
ght
ed ear
li
er,t
he equi
l
ibr
ium exchange r
atei
s
determinedbyt hemar ketforcesofdemandandsuppl ybutt hisreal
lyhappensifthe
monet aryauthori
ti
esdo notat t
emptt o st
abil
izeexchanger at
esormoder at
et hei
r
mov ements.Inotherwor ds,t
heremustexistafreemarketeconomyf ortheequi
li
bri
um
pri
ceoff or
eigncurrenci
est obefixedbyt
heirsuppl
yanddemand.

26
Infi
gure2.1,exchangemar ketequi
li
bri
um occursatpoi ntE,whereSfeandDfeint
ersect
.
There,30mi l
l
ionpoundswi llbetr
adedatapr iceofbr.
13perpound.Att hisequi
li
bri
um
exchanger at
e,thef or
eignexchangemar ketiscleared.Itleavesneitheranex cess
supplynoranexcessdemandf orpounds.Giventhesuppl yanddemandschedul esof
fi
gure2.1,thereisnot endencyfortheexchanger atet odeviat
efrom theequili
bri
um
l
evel.

However,
inpract
ice,iti
sunli
kelythatt
heequili
brium exchangerat
ewi l
lremai
nveryl
ong
attheexi
sti
nglevel.Thisisbecausetheforcest hatunderl
iethelocat
ionofthesuppl
y
anddemandschedul estendtochangeovert
ime, causingshif
tsintheschedul
es.

Accordingl
y,assumet hatEt hi
opiandemandcur vef orpounds(Dfe)hasshi ftedup( f
or
example as a r esultofi ncreased Et hi
opian tastes forBr i
ti
sh commodi ti
es)and
i
ntersectedwiththeEt hiopiansuppl ycurveforpoundsatpoi ntF,(seefi
gure2.1)
.Sucha
ri
ghtwardshiftissai dtobeani ncreaseindemand.Thi sr esul
tsinani ncr
easei nthe
equi
libr
ium exchanger atef r
om br 13/poundt obr.15/pound,andtheequil
ibri
um quantit
y
ofpoundswoul dbe40mi ll
i
onpoundsperday .Thebi r
risthensaidtohav edepreci
ated
agai
nstt hepoundsi ncei tnowr equires15(r
atherthant heprevi
ous13)birrstopurchase
onepound.Depr eciationt husreferst oanincreasei nthedomest i
cpriceofthef or
eign
curr
ency .

Ont heot herhand,iftheEt hi

opiandemandcur veforpoundsshift
sleftwardsoast o
i
nt ersecti t
ssupplycur veforpoundsatpoi ntH(againseefigur
e2.1),theequi l
ibr
ium
exchanger at
ewoul df al
ltoR=10.Suchadecr easeindemandmakest heequi l
ibr
ium
quant it
yofpoundst obeonl y₤20mi lli
onperday .Wet hussayt hatourbi rrhas
appr eciatedagainsttheUKpoundsi ncefewerbirr
sarenowneededt opurchaseapound
sterlng.Appr
i eciati
ont her
eforeref
erstoadecl i
neinthedomest i
cpriceoft heforeign
cur r
ency .Notet hatanappr eci
ati
onofthedomest i
ccurr
encymeansadepr eciati
onof
thef oreigncurrency.Forourcase,whent hebir
rappreci
atesthepounddepreciatesand
vicev ersa.

DearCol
league!WhatwillhappentotheEthi
opi
anbir
rifthereoccur
sachange(an
i
ncr
ease or a decr ease) i n t he supply of pounds by t he Bri
ti
sh?
_
___
______
___
_______
____
___
_
___
______
___
_______
____
______
_ _
_____
_____
____
____
___
___
______
_ _
______
___
____
_
___
______
___
_______
____
______
_ _
_____
_____
____
____
___
___
______
_ _
______
___
____.

Haveyout
ri
ed?Thati
sver
ygood.Ani
ncr
easei
nsuppl
yofpoundsbyUKci
ti
zensmeans
thecur
veSfeshowsar i
ghtwardshift
.Thisresult
sintheappreci
ati
onofourbi
rragai
nst
theUKpoundst erl
ing.Aleftwardshif
tinthesupplyofpounds(knownasadecreasein
suppl
y),
ontheot herhand,causesthedepreciat
ionofthebi
rr
.

Lear
ner
!Theexchanger
atecoul
dal
sobedef
inedast
hef
orei
gncur
rencypr
iceofauni
t
ofthedomest i
ccur rency.Thisistheinver
se,orrecipr
ocal,ofourpr evi
ousdef init
ion.
Thatis,
ifthebir
rpriceoft hepoundisR=13, thent
hepoundpr i
ceoft hebir
rwillbe1/ R
=0.077.Ifyouneed2bi rrt
opur chaseaJapaneseyen,youcansel l
y ourbi
rrathalfay en.
Thoughthisdefi
nit
ioni ssomet i
mesused,itisthefi
rstdef
init
ion-thedomest i
cpr iceof

27
theforei
gncur
rencyorthebi
rrval
ueofthepound-whi
chi
spopul
ar.Wewi
l
lthus
cont
inueusi
ngt
hisdef
ini
ti
oni
nthi
smater
ial
.

DearDi
stanceSt
udent
!Remembert
hatwehav
e,att
hebegi
nni
ng oft
hissect
ion,
assumedonlyt wonationsandt hust
wocurrenciesforsimpli
cit
y.Wef i
nall
yarri
veata
singl
eexchanger at
e(t
hebi r
rpri
ceofthedol
l
ar )
.InReali
ty,however,t
her
earenumer ous
exchangerates,onebetweenanypairofcurrencies.Thus,besi
dest heexchangerate
betweentheEthiopi
anbirrandtheUKpound,thereisanexchanger at
ebetweenbirrand
theJapanesey en,bet
weenbi r
randtheGermanmar k,betweent heUKpoundandt he
Japaneseyenandsoon.

Oncet heexchangerat
ebet weeneachofapairofcurrenci
eswi t
hr especttothebir
ris
establi
shed,t
hecrossratescanal
soeasil
ybedetermined.Forexampl e,i
ftheexchange
ratebetweentheEthi
opianbir
randtheUKpoundis10andt hatbet
weent hebi
rrandthe
Japanesey enis2,t
hentheexchangerat
ebet
weent hepoundandt heJapanesey enis5
(i
.e.,
ittakes5yentopurchase1₤)
.Thi
siscal
culat
edasf oll
ows:

R=y
en/₤=Bir
rvalueof₤ = 10= 5
Bir
rvalueofyen 2

D.Ef
fect
iveExchangeRat
e

Overt i
me,a given cur
rencymayappreci
ate wi
threspectt o some curr
enci
esand
depreci
ateagai
nstother
s.Suchevent
smayleavethegeneralpubli
cconfusedastot
he
actualval
ueoft
hatgivencurr
ency
.

Throughouttheday ,t
hev al
ueoft hebir rmaychanger el
ativ
et ot hev al
uesofany
numberofcur r
enci
esundermar ketdetermi nedexchanger ates.Directcompar i
sonof
thebirr
’sexchangerat
eov ert i
met husr equi r
esawei ghtedav erageofallthebilat
eral
changes.SupposetheEthiopianbirrappreci at
es3per centrelat
ivetot heJapaneseyen
and depreci
ates 5 percentagai nstt he Ger man mark.The change i nthe bir
r’
s
i
nternat
ionalvalueissomewei ghtedav erageoft hechangesoft heset wobilat
eral
exchangerates.Thi
saverageisreferredtoast hebi
rr
’seffect
iveexchanger ate.

Ef
fect
iveexchanger
atei
sawei
ght
edav
erageoft
heexchanger
ates
bet
weent
hedomest
iccur
rencyandt
henat
ion’
smosti
mpor
tantt
rade
par
tner
s,wi
thwei
ght
sgi
venbyt
her
elat
ivei
mpor
tanceoft
henat
ion’
s
t
radewi
theachoft
heset
radepar
tner
s.

Theef
fect
iveexchanger
atemaybenomi
nalorr .Thenomi
eal nalef
fect
iveexchange

28
r
atei
sonet
hatdoesnott
akei
ntoaccountdi
ff
erencesbet
weendomest
icandf
orei
gn
i
nfl
ationrates.Anincreaseint hebirr’
snomi naleffecti
v eexchanger at
e,fori nst
ance,
i
ndicatesanappreci
ationofthebirrrelat
ivetoot hercurrenciesoftr
adingpartners.This
i
sal ossofpr i
cecompet it
ivenessf orEthiopia.Conv ersely,adecreaseint hebirr
’s
nominaleffecti
ve exchange rateimpl ies a birrdepr eci
at i
on r
elat
ivet ot he other
cur
renciesandanimpr ovementinEthiopia’
sinternati
onal pr
icecompetiti
veness.

Itiswi del
ymai ntai
ned,howev er,t
hati nter
nati
onalt r
adepatternsdependoni nflati
on–
adjustedexchanger ates,r
atherthanont hepurel
ynomi nalexchangev al
ueofcur rencies.
Ther ealeffecti
veexchanger ateoft heEt hi
opianbirristhusder iv
edbyadj ustingthe
nomi nalexchanger atefort hedifferenti
albet weenEt hi
opiani nf
lati
onr ateandt he
weightedav erageoft hei
nflat
ionratesi ntheimpor t
anttradepartnersofEthiopia.Ifthi
s
realvalueri
ses, t
hebi r
rappreciat
esrelativetoothercurr
encies,andv i
cev er
sa.

E.SpotandFor
war
dRat
esofExchange

Whatarespotandf or
wardt r
ansacti
ons?Wehav eseent hem i
nsection2.1ofthi
s
chapter
.____
_____
_____
_____
_____
______
______
_____
_____
_____
______
_____
______
______
___
____
______
_____
_____
_____
_____
______
_____
______
_____
_____
_____
______
_____
____
____
______
_____
_____
_____
_____
______
_____
______
_____
_____
_____
______
_____
____.

Aswesai dearli
er,themostcommont ypeofforei
gnexchangetransact
ioninvol
vesthe
paymentandr ecei
ptofthefor
eignexchangewi thi
ntwobusinessdaysaf t
erthedaythe
tr
ansacti
onisagr eedupon.Thist ypeoftransact
ioniscall
edaspott ransacti
on.The
exchangerat
eatwhi chaspottransacti
ontakesplaceiscal
ledthespotr at
e(SR).The
exchangerat
eR=Br /
₤=13infi
gur e2.1ist
husaspotr at
e.

Ont heot herhand,wehav eforwar dt r

ansactions.Thesei nvolv
eanagr eementtodayt o
buyorsel laspeci f
iedamountofaf oreigncurrencyataspeci fiedf uturedateatar ate
agreedupont oday(theforwar drate,FR) .Theequi l
i
bri
um f orwardr atei sdet
ermi nedat
theintersecti
onoft hemar ketdemandandsuppl ycurvesoff oreignexchangef orf ut
ure
deli
very.Forexampl e,youmayagr eet obuy$2000amont hl at
eratar ateof8.60bi r
rper
doll
ar=FR=8. 6.Notethatnocur renciesar epaidoutont hedayy ousignt heagreement.
Itisr atherafteramont ht haty ouwi l
lgett he$2000 wheny oupayBr .
17,200 (=
2000x8.60) .Atthet i
mepay mentsar epai dout ,thespotr atemaybeexact yequalt
l o,
greaterthan,orlessthanthef orwar drate.

I
ftheforwardrateisbelowt hepresentspotrate,t
hef orei
gncurrencyissaidtobeata
for
warddiscount(FD)wi t
hrespectt othedomest i
ccur r
ency.Forourearli
erexample,i
f
thespotratewheny out akethe$2000af t
eramont hataf orwardr at
eofBr .
8.60per
doll
arwas,8.70thedollarisataf orwarddiscountof10cent sor1. 15percent(orata
13.8per
centannualdiscount)wi
thr espectt
ot hebi
rr.

Whent heforwardr ateisabovethepresentspotr at

et heforeigncur
rencyisataforward
premium ( FP)withr especttothedomesticcurrency.Forexampl e,supposethemonthly
forwardr ateisst
il
l Br8.60=$1butt hespotr at
ei si
nst ead8.55bir
rperdollar
.Thedoll
ar
i
st hereforesaidtobeatapr emium of5cent s( =8.60-8. 55)or0.6percent(orata7
percentfor wardpremi um peryear
)withrespecttotheEt hiopi
ancurrency.

29
DearLear
ner
!For
war
ddi
scount
sandpr
emi
umsar
eusual
l
yexpr
essedasper
cent
ages
peryearf
rom t
hecor
respondi
ngspotr
ate.Theycanbecal
cul
atedf
ormal
l
ywi
tht
he
fol
l
owingf
ormul
a:

Forward = For
war
drat
e–Spotr
ateχ ___12_
___
_ _
__ χ
100
Premium (
Discount
) Spotrat
e No.ofMonthsfor
war
d

I
ftheresul
tisnegati
ve,i
tmeansaf
orwar
ddi
scount
.Aposi
ti
ver
esul
timpl
i
esaf
orwar
d
pr
emium ofthefor
eigncurr
ency
.

Act
ivi
ty2.
1

Uset
heabovefor
mulat
ofor
mal
l
ycal
cul
atet
hef
orwar
dpr
emi
um anddi
scount
soft
he
pr
evi
ousexampl
es.

2.
3.Appr
oachest
oExchangeRat
eDet
ermi
nat
ion

The equil
ibri
um exchange r
ate between curr
enci
es oftwo nati
ons coul
d be
det
ermined i
nanumberofway s.But,her e,i
nt hi
smodul e,wewillseethet hr
ee
i
mportantonest hebal
anceofpay ments,thepurchasi
ngpowerparit
y(PPP)andt he
monetaryappr
oaches.

Obj
ect
ives

Theobj
ect
ivesoft
hissect
ionar
e:

 Usi
ngBoPstodetermi
neexchangerat
e;
 Def
ini
ngPPPandusei tt
oarr
iveatequi
li
brium pr
iceofaf
orei
gncurrency
;and
 Obt
aini
nganexchangerat
evaluebyappl
yingthemonetar
yapproach.

2.
3.1. TheBal
anceofPay
ment
s(BoPs)Appr
oach

Coul
dyoupl
easer
ecal
lwhatt
hedebi
tandcr
edi
tsi
desoft
heBoPsar
e,thatyou
saw i
n t
he f
ir
st chapt
er?

30
________
_______
_______
______
___
______
____
______
_____
____
___
___
_ _
__
________
_______
_______
______
___
______
____
______
_____
____
___
___
_ _
_____
_______
_
________
_______
_______
______
___
______
____
______
_____
____
___
___
_ _
_____
_______
_.
.
Alri
ght!Inshort,thedebitsi
deoftheBoPsofagi vencount
ryi
mpl i
esthosetransacti
ons
thatmaket hecountrytopaymoneyt ofor
eigner
s.Thecredi
tside,ont heotherhand,
referstothosetransacti
onswhichinvol
verecei
ptsofmoneyfrom for
eignresidentsand
gov er
nment s.

DearDi
stanceLear
ner
!Thedebi
tsi
deoft
heBoPsconst
it
utest
hedemandf
orf
orei
gn
exchangewhilethecredi
tsideformsthesuppl
yoffor
eignexchange.Thei
nter
secti
onof
thedemandf orandsupplyoff orei
gnexchangerat
e,ther
efore,gi
vestheequil
ibr
ium
exchangerate.Notethatthiswaswhatwesaw i nsecti
on2.2.So,youcanr ef
erback
thatsect
ionandal sothef i
rstchapt
ertounderst
andtheBoPsappr oachofexchange
ratedet
erminati
on.

The balance ofpayments approach isr ecogni

zed by economists as the gener
al
approachofexchanger at
edet erminati
on.Itpredi
ctsexchanger edepr
at eci
ationfor
nati
onswi hdef
t i
cit
sinthei
rinternat
ionaltr
ansactonsandappr
i eci
ati
onf ornat
ionswith
sur
pluses.

2.
3.2ThePur
chasi
ng–PowerPar
it
y(PPP)Appr
oach

Det ermi ni ngt hel ong– r unequi l

ibrium val ueofanexchanger at
e( t
hev aluet owar d
whi cht heact ualratetendst omov e,giv encurr enteconomiccondi t
ionsandpol icies)i s
i
mpor tantf orsuccessf ulexchange r ate management .Forexampl e,ifa nat ion’s
exchanger ater i
sesabov et hel ev elwar rantedbyeconomi ccondi tions,sot hati ts
currencybecomesov er
valued,t henat ion’scost swil
lnol ongerbecompet iti
veanda
tradedef ici
twi lll
ikelyoccur .Anunder valuedcur r
encytendstol eadtoat radesur plus.
Nat ionalaut hori
ti
est rytof orecastt hel ong–runequi li
bri
um exchanger ateandi nitiat
e
exchanger ateadjust mentst okeept heact ualr
at einli
newiththef or
ecastr ate.ThePPP,
theref or e,canbeusedt omakepr edicti
onsaboutexchanger ates.Itiswor thnot ingt o
seet het woi mpor tantconcept soft hePPPappr oach.

(
i)Absol
utePPP(
LawofOnePr
ice)

Thi
sist hesi
mplestconceptofthemodel ofPPP.Foranal
ysi
s,i
tassumesthefol
lowi
ng:
I
tiscostl
esstotransportcommodit
iesbetweennati
ons;and
Therearenobarrier
st otr
ade(
suchast ari
ff
s).
Giv
ent heassumptions,thelawofonepriceassert
sthati
denti
calgoodsshoul
dbesold
atasi
mil
arpr
iceorcosti
nal
lnat
ions.

DearSt
udent
! However
,bef
oret
he cost
sofgoodsi
n di
ff
erentcount
ri
escan be
compar ed,pricesmustf i
rstbeconver
tedintoacommoncur rency
.Onceconv er
tedat
thecurrentmar ketexchangerat
e,thepri
cesofident
icalgoodsf rom anytwocountri
es
shouldbei dent i
cal
.Af t
erconverti
ngbirr
si ntodollars,f
orexampl e,machi
net ool
s
purchasedinEt hi
opiashouldcosttheequaldol
l
arsasi dent
icalmachinetool
sboughtin
theUnitedSt ates.

31
This‘Law ofoneprice‘i
ssi mpl ycall
edt heabsol uteversi
onoft hePPP approach.
Accordi
ngtothisver
sion,theexchanger atebet weenanyt wocurr
enciesissi
mplythe
rat
ioofthetwocountri
es’generalpr
icelevels.Forinstance,i
fthepr
iceofakil
oofsugar
i
s$1i ntheUnitedSt
atesandBr .9inEthiopia,thent heexchanger
atebetweenthebirr
andthedoll
arshoul
dbeR=Br .9/$1=9( accor di
ngt ot hel
awofonepr i
ce)
.

I
npr acti
ce,howev er,thelawofonepr icedoesnotalwaysprevai
l.I
nter
nat
ionaltr
adeis
mor ecomplicatedt hansuggest edbysimpletheori
es(laws)
.Forexample,tari
ffsand
othert radeobst r
uct i
onst endt odr
iveawedgebet weenpricesofident
icalgoodsin
differentnat
ions.Mor eov er,t
hecostsoftr
ansport
inggoodsfrom onenati
ont oanot
her
restrictthepotent i
alpr ofi
tf r
om buyi
ngandsel li
ngidenti
calproduct
swi thdif
fer
ent
prices.

(
ii
)Rel
ati
vePPP

According t o the relati

ve purchasing power –parity t heor y of exchange r at
e
determinat
ion,changesi nrel
ati
venational(general)pri
cel evelsdeterminechangesin
exchangerat esovert
hel ong-
run.Thetheorypredictsthatt hef orei
gnexchangev al
ueof
acur r
encyt endstoappr eci
ateordepreciateatar ateequalt othediff
erencebetween
for
eignanddomest i
ci nfl
ati
on.A currencywoul dbeexpect edt o depreci
atebyan
amountequalt ot he excess ofdomest i
cinflati
on ov erf orei
gn inf
lati
on.Itwould
appreci
atebyanamountequal t
otheexcessoff oreigninflationov erdomestici
nfl
ati
on.

DearCol
l
eague!Aswesai
dbef
ore,t
hePPPt
heor
ycanbeusedt
opr
edi
ctl
ong–r
un
exchangerat
es.Wewillconsi
deranexampl
eusingt
hepr
icei
ndexes(P)ofEt
hiopi
aand
Germany.Let0bethebaseperiodand1beperi
od1.
Thepurchasi
ng–power–par i
tytheor
ycant
husbegi
veni
nsymbolsas:

R1 =Ro PE1/PEo = Ro.PGo .PE1

PG1/PGO PEo PG1

WhereRo i
stheequil
i
brium exchangerat
eexist
ingi
nthebaseper
iodandR1 equal
sthe
est
imat
edt ar
getatwhichtheactualr
ateshoul
dbeinthef
utur
e.

Example.Thegeneral
priceleveli
nEthiopi
aandi nGermanyi
n1995was100andt hebi
rr
pri
ceoft hemar kwasbi rr3dur i
ngt hi
speriod.For
ecasttheexchanger
atethatwi
ll
prevai
lin2010iftheEthiopianinf
lat
ionraterisesby100percentandGermany’
srat
e
remainsunchangedbytakingyear1995ast hebaseyear
.

Solut
ion.If1995isthebaseyear
,PEo =PGo =100.Andi
f2010i sthefi
rstperi
od,PG1 =
100butPE1 =200since100%risemeansdoubl i
ngoftheori
ginal
.Ro=Br .3.Theref
ore,
theexchangerat
ebet weent
hebir
randt heGermanmarkin2010wi l
lbe:
R1=Br.
3.100 .200 =6=Br .
6/mark
100 100

32
2.
3.3.TheMonet
aryAppr
oach

Unli
ket hebalanceofpaymentsapproach,whi
chdiscussesexchangeratedet
erminat
ion
i
nt er
msoft hef l
owoff undsinthefor
eignexchangemar ketoveraperi
odoftime,the
monet aryapproachv i
ewsexchangerat
esasdeterminedbyt her
esponsestochangesin
thestock(ortotal)demandsandsuppli
esofnati
onalcurr
encies.

Themonet
aryappr
oachemphasi
zest
hef
actt
hatt
hef
orei
gnexchangemar
keti
sa
monetar
yphenomenon,wheremoni esaretradedformoni es.Themoneysuppl yand
moneydemandathomeandabr oadarethususedt oexplai
nanat i
on’sexchanger
ate
tr
end.Because moneysuppli
es can be contr
oll
ed bycent r
albanks the monetar
y
appr
oachemphasesonanation’
sdemandf ormoneyandi t
sdet er
minant
s.

DearDistance Learner!From your‘Macr

oeconomics’lesson,whatar
et he
deter
mi nant
s of t he demand f or money ? Let y ou t r
y, please.
___
_ _
_______
___
______
______
_ _
____
_____
____
___
_ _
_______
___
______
______
_ _
____
_____
____
___
___
____
____
____
_ _
___
_ ___
___
___
__
___
_ _
_______
___
______
______
_ _
____
_____
____
___
___
____
____
____
_ _
___
_ ___
___
___
_.

Theaggr egatedemandf ormoneyi nanat i

ondependsont helevelofrealincome, prices
andi nter
estrates.Ast heeconomygr owsandr ealincome( t
hepur chasingpowerof
money )r i
ses,the publ i
c’
sdemand f ormoneyi ncr
easesin or dertof i
nance rising
transacti
ons.Thati s,ifpri
cesrise,thepublicwil
ldemandmor emoneyt ocov ertheir
economi ct r
ansactions.Loweri nterestrat
esinducet hepublict oholdmor emoney
becauset heopportunitycostofhol dingcashbal
ancesi sdecreased.Not ethatinterest
rater epresent
st he oppor t
unity cost of holding money .Conv ersely,as t hese
determinantsofmoneydemandchangei ntheoppositedir
ect
ion,thedemandf ormoney
decreases.

DearCol
l
eague!Thef
oll
owi
ng t
abl
esummar
izest
hei
mpactofchangesi
n money
demandandmoneysuppl
yont heequi
li
bri
um for
eignexchanger
ate.Not
ethatachange
i
nmoneysupplyimpli
esani ncr
easeordecreaseofmoneybyt hecentr
albankofa
count
ry,
saybyt
heNati
onalBankofEthi
opia.

Tabl 2.I
e2. mpactofChangesi
nMoneySuppl
yandDemandonMar
ketDet
ermi
ned
ExchangeRat
e(R)

Change I
mpactonR
I
ncreaseinmoneysuppl
y Depr
eci
ate
Decreasei
nmoneysupply Appr
eci
ate
I
ncreaseinmoneydemand Appr
eci
ate
Decreasei
nmoneydemand Depr
eci
ate

33
2.
4.Ar
bit
rage

Whenr estr
icti
onsdonotmodi fytheabi l
i
tyoft hef orei
gnexchangemar ketto
operateeffi
cientl
y ,normalmar ketforcesr esultinaconsi stentrel
ati
onshi
pamongt he
mar ketexchanger atesofal lcur r
encies.Thati stomean,t hepr i
cesforthesame
currencyindi f
ferentwor ldl ocati
onscoul dbei denti
cal.Thi sisdonebywhatwecal l
exchangear bitr
age.I nvestorsmaket heirfinancialdeci
si onbycompar i
ngtheratesof
ret
ur nofforeigni nvest
mentwi t
ht hoseofdomest i
cinv estment .Thi
smeanst heyare
doingwhati sknownasi nterestarbit
ragewhi chmaybeuncov eredorcover
edbyt he
for
war drat
eofexchange.Wewi llseetheseconcept sint hissection.

Obj
ect
ives

Att
heendofthi
ssect
ion,y
ouwi l
lbeexpect
edto:
 Defi
neexchangeaninter
estarbi
tr
age;and
 Dist
ingui
shbetweencoveredanduncover
edi
nter
estar
bit
rage.

2.
4.1.ExchangeAr
bit
rage

Theexchangerat
ebetweenanytwocurrenci
esiskeptt
hesamei
ndi
ff
erentmonet
ary
cent
ersbywhatinknownasexchangear
bit
rage.

Exchange ar
bit
rage i
sthe si
mul
taneous pur
chase and sal
e ofa
cur
rencyi
ndi
ff
erentf
orei
gnexchangemar
ket
sinor
dert
opr
ofi
tfr
om
exchanger
atedi
ff
erent
ial
sint
het
wol
ocat
ions.

Toill
ustrate,supposet hedoll
ar/poundexchanger atei
s$2=₤1i nNewYor kbut
₤1=$2. 01inLondonAf orei
gnexchanget rader(call
edanar bi
tr
ageur)wouldfindit
prof
itabletopur chasepoundsi nNewYor kat$2perpoundandi mmediat
elysel
lthem in
Londonf or$2. 01perpound.Apr ofi
tof1centwoul dbemadeoneachpoundsol d,less
thecostofbankt ransferandt heinterestchargeont hemoneyt i
edupdur ingt he
arbi
tragepr ocess,whi chareinsi
gnifi
cant.Notethatifthearbi
tr
ageurbuysandsells₤1
Mill
i
on, hisprofitwil
lbe$10, 000f oronlyafewmi nuteswork.

However,arbitragei ncr
easesthedemandf orpoundsinNew Yor k,therebyexerti
ngan
upwardpressur eont hedoll
arpriceofpoundsi nNew York( i
.e.
,mor ethan$2) .Atthe
sametime,t hesal eofpoundsi nLondoni ncr
easesthesupplyofpoundst here,which
makesthedol larpr i
ceofpoundst ofallbelow$2.01.Thi
scont inuesunt i
l t
hedollarpr
ice
ofpoundsqui ckl ybecomesequalbot hi nNewYor kandLondon( sayat$2. 005=₤1) ,
thusel
iminatingt heprofi
tabi
li
tyoff urtherexchangearbitr
age.Ar bi
tr
agebet weent he
twocurr
enciest herefor
eunifi
estheforeignexchangemar kets.

34
DearDist
anceLearner! Theprecedi
ngexampl ei
ll
ustr
at sknownast
eswhati wo–poi nt
ar
bitr
ageinwhi chtwocur renci
esar etradedbetweentwof i
nanci
alcenters.A more
i
ntri
catef
orm ofexchangearbit
rage, edt
cal
l hr
ee–poi
ntarbi
tr
age(ort
riangul
ararbi
tr
age)
i
nvol
vest hr
eecurrenci
esandt hreefinanci
almarket
s.Three-
poi
ntar
bit
ragerequi
res
swi
tchi
ng funds among three curr
encies i
n or
dert o prof
itf
rom exchange r
ate
i
nconsi
stenci
es,
asseeni nt
hefoll
owingexample.

Example.Considerthreecurrencies-t heU.S.dol l
ar($),theDeut schemar k(DM) ,and
theBrit
ishpound( ₤)-al lofwhi char etradedi nNew Yor k,FrankfurtandLondon.
Assumet hatt
heratesofexchanget hatprev ai
linallt
het hreefinancialcent
ersareas
fol
lows:(a)₤1=$1.50,(b)₤1=DM 4, and( c)DM 1=₤0. 50.
Becauset hesameexchanger ates( pri
ces)pr evai
lint hethreef i
nancialcent
ers,two-
pointarbitr
ageisnotpr of
it
able.Howev er
,t hesequot edexchanger atesaremut uall
y
i
nconsistent.

Thusanarbi
trageurwit
h$1.5mill
ioncouldmakeapr of
itasfol
lows:
1.Sellt
he$1. 5mill
i
onfor1mi l
li
onpounds(usingrateaabove);
2.Simult
aneously,sel
l1mi l
l
ionpoundsfor4mi ll
i
onmar ks(usi
ngexchanger
ateb
above);and
3.Atthesamet ime,sel
lthe4mi l
li
onmarksfor$2mi l
li
on(byusingr
atec).

Thear bi
trageurhast husjustmadear isk–fr
eepr of
itof$500,
000(=$2mill
ion-$1. 5
mill
ion)beforetransact
ioncost!Theset ransactionstendtocauseshif
tsi
nallthethree
exchange rates thatwoul d bri
ng them i nt o properali
gnmentand eli
minatet he
prof
itabi
li
tyofar bit
rage.From pract
icalst andpoi nt,oppor
tuni
tiesf
orsuchpr of
it
able
curr
encyar bit
ragehav edecreasedinr ecenty ears,givent
helargenumberofcurrency
tr
adersaidedbysophi sti
cat
edcomput erinfor
mat i
onsystems.

2.
4.2.I
nter
estAr
bit
rage

DearDi
stantSt
udent
!Whenwesayi
nter
estar
bit
rage,wer
efert
othepr
ocessofmov
ing
fundsintoforei
gncurrenciestotakeadv ant
ageofhigherinvestmenty
ieldsabr oad.But,
i
nv est
orsassumear i
skwhent heyhav efor
eigninvestments.Whent hei nvestment’
s
proceedsareconvert
edbacki ntot hehomecur r
ency,thei
rvaluemayf allbecauseofa
changei ntheexchanger ate.Investor
scanel i
minatet hi
sexchangeriskbyobt aini
ng
‘
cov er
’inthef
orwardmar ket

(
A) Uncov
eredI
nter
estAr
bit
rage

Alt
houghthi
spracti
ceisrar
elyused,l
etusseei
tthr
oughanexampl
esi
ncei
tisagood
pedagogi
cal
star
tingpoi
nt.

Uncover
edi
nter
estar
bit
rageoccur
swhenani
nvest
ordoesnotobt
ain
exchangemarketcovert
o pr
otecti
nvest
mentpr
oceedsf
rom f
orei
gn
curr
encyfl
uct
uati
ons.

35
Supposetheinterestrateona3- mont hTr easurybillis6%( perannum)i nNewYor kand
10% (perannum)i nLondon,andt hatt hecur rentspotr at ei s$2perpound.A U. S.
i
nvestorwouldseekt opr of
itf
rom thisoppor tunit
ybyexchangi ngdollarsf orpoundsata
rat
eof$2perpoundandusepoundst opur chasea3- mont hBr i
ti
shTr easurybi llsin
London.Theinvestorwoul dearn4%( =10%- 6%)mor eperyear ,or1%mor ef orthet hree
months,thanifthesamedol l
arshadbeenusedt obuyU. S.Tr easurybillsi nNewYor k
Howev er
,thi
samountwi l
lbereali
zedonl yiftheexchangev alueoft hepoundr emai ns
const
antov erthei nv
est mentperi
od.I ft hepounddepr eci atesagai nstt hedol lar,the
i
nvestormakesl ess;i fthepoundappr eciatesagai nstthedol l
ar,thei nv est
ormakes
more!

Assume, ov
erthei nvestmentperi
od( 3months)
,theexchanger atef
allsfr
om $2t o$1.99
(thepounddepr eciatesagai
nstt hedoll
ar)
.Whent hepr oceedsareconv ert
edbackt o
doll
ars,t
hei nv
estorl oses0.5% .Thei nvestort
husear nsonly0.5%
(=1%-0.5%)in3mont hsmorethanifthef
undshadbeenpl acedinU.S.Treasurybil
l
s.

Lear
ner
!Youcanver
if
ythat
,ift
hedol
l
arpr
iceoft
hepoundf
ellf
rom $2t
o$1.
98per
poundovertheinvestmentper
iod,
theU.
Sinv
est
orwoul
dear
nnot
hingext
rabyi
nvest
ing
i
nBr i
ti
shTreasurybil
l
s.

Act
ivi
ty2.
2

Supposethati
n3- mont
hst i
me,thepoundrisesfr
om $2to$2.02(a1% appreci
ati
on
agai
nstthedoll
ar)
.Wil
ltheprevi
ousU.S.i
nvestorl
oseorgai
nextr
as?Ifhe/
sheobtai
ns
ext
ras,cal
cul
atethi
saddit
ionalr
etur
nbesi
dest he1%ret
urnfr
om i
nter
estdif
fer
ent
iali
n
3mont hs.

Insummar y
,aU. S.invest
or’
sext
rar at
eofr etur
nonani nvest
mentintheU.K as
compar
edt otheU.S.
,equal
sthei
nter
estratedif
fer
ent
ialadj
ust
edforanychangei
nthe
val
ueofthepound.Thi
sissummari
zedasf ol
lows:

Ext
raRet
urn=U.
Kinter
estrat
e–U.
Sint
erestr
ate)-%depr
eci
ati
onoft
he
pound
OR
Ext
raRet
urn=U.
Kinter
estrat
e–U.
Sint
erestr
ate)+%appr
eci
ati
onoft
he
pound

(
B) Cov
eredI
nter
estAr
bit
rage

I
nvest
ingf
undsinafor
eignf
inanci
alcenterinvol
vesanexchangerat
eri
sk.Because
i
nvest
orst
ypi
cal
l
ydesi
retoav
oidthi
srisk,int
erestar
bit
ragei
susual
l
ycover
edthrough

36
t
hei
rent
rancei
ntot
hef
orwar
dmar
ket
.

Cov
eredi
nter
estar
bit
rager
efer
stot
hespotpur
chaseofaf
orei
gncur
rencyt
o
makei
nvest
mentandt
heof
fset
ti
ngsi
mul
taneousf
orwar
dsal
eoft
hef
orei
gn
cur
rencyt
ocov
ert
hef
orei
gnexchanger
isk.
Cov
eredi
nter
estar
bit
ragei
nvol
vest
wobasi
cst
eps:

1) Ani nvest
orexchangesdomest i
ccur rencyforf oreigncur rency,atthecur rent
spotrate,andusest heforei
gncurrencyt opurchaseaf oreignf i
nancialasset.
2) Atthesamet ime,theinvest
orcontractsinthefor wardmar kett osellt
heamount
off or
eigncur r
encyt hatwillbereceivedast hepr oceedsf rom theinv est
ment
wit
hadel iverydatetocoincidewit
ht hemat uri
tyoft heinvestment .I
tpaysf orthe
i
nvestortomaket hef or
eigninv
estmenti ftheposi t
iveint
er est-
ratedif
ferenti
alin
favoroft hef orei
gni nvest
mentmor et hanof fsetsthecostofobt ai
ningt he
for
war dcov er
.

Thefol
lowingtabl
econtai
nsanexampl ewhi
chshowsanetr at
eofr et
urnamounti
ngto
0.
5%mor emadebyaU. S.resi
dentbuyi
ngU.Ktr
easurybi
l
ls(TB).Thisret
urni
sar i
sk
fr
eereturnsincetheinvest
orhasent er
edintoaf or
wardmar ketagreementwit
ha
di
scountof0.5%.

Tabl 1.Uncov
e2. eredI
nter
estAr
bit
rage:AnExampl
e

Rat
ePerYear Rate per 3
Months
A.U.K.3-mont hTBi nter
estrate 12% 3%
B.U.S.3–mont hTBi nterestrate 8% 2%
C.Uncov er
ed inter
estr atedi f
ferent
ialf
avor
ing 4% 1%
t
heU. K( A-
B)
D.Forwar ddiscountont he3mont hpound -
2% -
0.5%
E.Cov eredinterestratediff
erenti
alfavor
ingthe 2% 0.
5%
U.K.

DearLear
ner
!Notethatifthereoccur
redaforwar
dpremium,t
heU. Sinv
estorwoul
d
makeextr
aret
urn(
i.
e.,D’i
‘ nt heabovetabl
ewoul
dtakeposi
ti
vev
alue)i
naddit
iontot
he
i
nterestrat
ediffer
enti
al.Not
eal sot hatt
hisinv
estmentopport
unit
ywillnotlastl
ong
(
therewi l
lneverbemor earbit
rage)sincetheinterestr
atedi
ffer
ent
ialbetweenthe
f
inancial
center
swi l
lbeequal
izedthroughcompetit
ion.

37
2.
5.For
eignExchangeRi
sks,
Hedgi
ngandSpecul
ati
on

Wehavealr
eadysai dear
li
ersai
dt hatthefor
eignexchangemar keti
samar ketwith
ri
sk.Inthissect
ion,wewi llt
rytoformallyexaminet hemeaningoff orei
gnexchange
ri
sks.Wet hendiscusshow theseriskscanbeav oidedorcov eredbyindi
v i
dualsand
fi
rmswhosemai nbusi nessisnotspecul ati
ng.Finall
y,ther
ei sasub-sect i
ont hat
emphasizesonhow specul at
orsatt
emptt oear napr ofi
tbytryingtoanti
cipatefuture
for
eignexchangerates.

Obj
ect
ives

DearDi
stance St
udent
!You car
eful
l
ygo t
hrough t
his sect
ion and f
inal
l
y,y
ou ar
e
expect
edt
o:

 Defi
neaf or
eignexchangeriskandit
scauses;
 Suggesthowaf orei
gnexchangeriskcoul
dbeav oi
ded;
and
 Defi
nespeculati
oninforei
gnexchangemar ket
.

A.For
eignExchangeRi
sk

Withthepassageoft i
me,anat i
on’ sdemandandsuppl ycurvesf orforei
gnexchange
shi
ft,causi
ngt hespot( andthef orwar d)r atesofexchanget ofrequentl
yvary.They
changeasar esultofchangesintast esf ordomesticandforei
gnpr oductsint
henat i
on
andabroad,dif
ferentgrowthandinf l
ationr atesindif
fer
entnations,changesi
nr el
ati
ve
rat
esofinter
est,changi
ngexpectationsandsoon.

I
ngener al
,wheneverafuturepaymentmustbemadeorr ecei
vedinaforei
gncurr
ency,a
for
eign exchange ri
sk i
si nv
olv
ed because spotexchange r
ates var
y overtime.
Businessmenareriskaverseandwi l
lwanttoavoidorinsur
ethemselv
esagainstthei
r
for
eignexchangeri
sk.

Notethataforeignexchangeriskcoul
dal soari
sefrom theneedtovalueinv
ent
ori
esand
asset
s held abr oad i
nter
ims oft he domestic cur
rencyf ori
nclusion i
nthe fi
rm’
s
consol
idat
ionbal ancesheet,
andinestimatingthedomest i
ccurr
encyv al
ueoft
hefutur
e
prof
it
abil
it
yoft hef i
rm.

Lear
ner
!Beari
nmi
ndt
hatexchangear
bit
ragedoesnoti
nvol
veanyexchanger
isk.Thi
s
i
sbecauseinexchangearbit
rage,t
hecurrencyisboughtatacheaperpri
cei none
monet
arycent
ert
ober esol
dimmediatel
yatahigherpr
icei
nanot
hermonet
arycenter
.

B.Hedgi
ng

38
Hedgingist heav oi
dance( covering)ofaf oreignexchanger isk.Itinvol
vesdif
ferent
mechanismsbybusi nessmeni nt hespotorf orwar dmarket
s.Inawor ldofforeign
exchangeuncertai
nty,theabili
tyoft r
adersandinv estorst
ohedgegr eatl
yfaci
li
tat
est he
i
nternat
ionalfl
ow oft radeandi nvestment
s.Wi thouthedging,therecouldbesmal l
er
i
nternat
ionalcapitalfl
ows,l esst radeand speci ali
zati
on i
n producti
on,and smal l
er
benefi
tsfrom t
rade.

C.Specul
ati
on

Specul
ati
oni
stheat
temptt
opr
ofi
tbyt
radi
ngonexpect
ati
onsaboutpr
icesofcur
renci
es
i
nt hefuture.Speculat
ors( financi
alinst
itut
ions,f
ir
msori ndivi
dual
s)buycurrenciesthat
theyexpectt ogoupi nv alueandsel lcurr
enciesthatt
heyexpectt ogodowni nv al
ue.
Speculat
ioni st heopposi teofhedgi ng.Wher easahedgerseekst ocov eraf or
eign
exchanger isk,aspeculatoracceptsandev enseeksoutaf or
eignexchangerisk.Ifthe
speculat
orcor r
ect
lyanticipatesfuturechangesi nspotrates,hemakesapr ofi
t,other
wiseincursal oss.

Notethediff
erencebet weenar bi
tr
ageandspecul at
ion.Wi t
harbi
trage,
acur rencyt r
ader
simul
taneousl
ybuysacur rencyatal owpr iceandsellsthatcurr
encyatahi gherprice,
thusmakingar isk-
lessprofit
.Aspecul at
or ’
sgoalhowev eristobuyacur rencyatone
moment( suchast oday)andsel lt
hatcurrencyatahigherpr i
ceinthefut
ure( suchas3
monthsfrom today).Specul
ationthusimpliesadeli
berateassumpt i
onofexchanger i
sk.

DearCol
l
eague!Tounder
standspecul
ati
on,i
tisbet
tert
otakeexampl
esont
hemost
specul
atedcur
renci
esi
nthet
womar
ket
s–t
hespotmar
ketandt
hef
orwar
dmar
ket
.

Specul
ati
ngi
ntheSpotMar
ket

I
maginethatyouar
eacurrencyspeculatori
nNew York,wi
l
li
ngtori
skmoneyony
our
ownopini
onaboutf
utur
epr
icesofaforeigncurr
ency
-sayaGermanmark.

Case–1:Speculati
ngonaGer manmarkappreci
ati
on
Given:Today’sspotpr
icei
s$0.
40permar k.
Assumption:In3months,t
hespotpr
iceofthemar
kwi
l
lri
set
o$0.
50.

Pr
ocedur
e:
1.Purchasemar ksatt
oday’srateof$0.
40anddepositthem i
nabanktoear
n
i
nterest
.
2.I
n3mont hs,
sellt
hemarksatthepr
evai
l
ingspotpr
iceof$0.
50permar
k.

Outcome:
 I
fassumpti
oni
sri
ght
,pr
ofi
t=$0.10permar k.
 I
fassumpti
oni
swrongandthespotpriceofthemarkfal
lsinst
ead,
youi
ncura
l
oss,r
esel
l
ingmar
ksatapri
celowerthanthepurchasepr
ice.

Case-2:Specul
ati
ngonaGer
manmar
kdepr
eci
ati
on

39
 Given:Today’
sspotpr
icei
s$0.40permark.
Assumpt i
on:I
n3mont hs,
thespotpr
icewi
ll
fal
lto$0.
25permar
k.

Pr
ocedur
e:
1.Borr
owmar kstoday,exchangethem f
ordol
lar
satthepr
evai
li
ngspotpr
iceof
$0.
40permar k,anddepositthedol
l
arsinabankt
oearnint
erest
.
2.I
n3mont hs,buymar ksattheprevai
li
ngspotpr
iceof$0.25permarkand
usethem t
opaybackt hel
oan.

Out
come:
 I
ftheassumpt i
onisri
ght,pr
ofi
t=$0.15permar k.(Thi
sret
urnisr educedbythe
i
nter
estpaidonbor r
owedmoney ,
butincreasedbyt heint
erestreceivedonthe
banksavi
ngsaccount.)
 I
ftheassumpt i
oniswrongandthespotpr iceoft hemarkri
sesinst ead,
youwil
l
i
ncuraloss,buyi
ngmar ksatahigherpri
cet hantheini
ti
alsell
i
ngpr ice.

Specul
ati
ngi
ntheFor
war
dMar
ket

Althoughspeculationinthespotmar ketcanleadtopr ofi

ts,ithasaseriousdrawback:
thespeculatormusthav eal argeamountofi dl
ecashorhast obor r
ow,whichr equi
res
i
nterestpay ments.Speculat
ionintheforwardmarket,howev er,doesnotrequi
recashor
creditfaci
l
iti
es.Allthespeculat
orneedst odoissi
gni ng aforwar dcont
ractwithabank
toeitherpurchaseorsel laspeci f
iedamountoff oreigncurrencyataspeci f
iedf ut
ure
date.Inpracti
ce,mostspecul at
ionisdoneinthef
or wardmar ket.

DearLear
ner
! Letusagai
nseeexampl
est
ounder
standspecul
ati
oni
nthef
orwar
d
mar
ket
.

Case1:[Spotrateishigherthana3- monthsfor
wardrate]
Given:Thecurrentpri
ceoft he3-monthfor
wardmar kis$0.
40.
Assumpt i
on:In3mont hs,
theprevai
li
ngspotpr
iceofthemarkwil
lbe$0.
50.

Pr
ocedur
e:
1.Contr
acttopurchaseaspecif
iedamountofmar
ksintheforwar
dmarket
,at
$0.
40permar k,f
or3–mont hdeli
very
.
2.Aft
errecei
vingdeli
veryofthemar ksin3mont
hs,resel
lthem i
nthespot
marketatt
heprevail
i
ngpri
ceof$0.50permar
k.

Out
come:
 I
fassumpti
oniscor
rect
,pr
ofit
=$0.
10permark.
 I
fassumpti
oniswrongandtheprevai
li
ngspotpr
icei
nthe3mont
hst
imei
s
l
owerthan$0.
40permark,y
ouwilli
ncural
oss.

Case–2 [ Spotr
atei
slessthan3mont hsforwardrat
e]
Given:Thecur
rentspotr
ateis$0.40permar k.
Assumpt i
on:I
n3mont hs,t
heprevail
ingspotpri
ceoft
hemar
kwi
l
lbe$0.
30.

Pr
ocedur
e:

40
 1. Contracttosellaspecif
iedamountofmar ks(whi
chy oudonotcur
rent
lyhav
e)
fordeli
ver
yin3mont hsatt
hef orwardpri
ceof$0.
40permar k.
2. I
n3mont hs,purchaseanidenticalamountofmarksinthespotmar
ketat$0.
30
permar kanddelivert
hem tofulfi
ll
thefor
wardcontr
act.

Out
come:
 I
fassumpti
onisr
ight,pr
ofi
t=$0.10permark.
 I
fassumpti
oniswr ongandt heprevai
li
ngspotpr
icei
n3mont
hsi
shi
gher
t
han$0.40permark,youwil
li
ncuraloss.

DearColleague! Specul
ati
oncoul dbeeit
herst
abil
izi
ngordest
abi
l
i ng.St
zi abi
l
izi
ng
specul
ati
onr ef
erstothepurchaseofaf
orei
gncur
rencywhent
hedomesti
cpri
ceofthe
f
oreigncurr
ency(i.
e.,exchangerate)f
all
s,i
nanexpect ati
ont hatitwi
llsoonri
se,thus
l
eadingtoaprofi
t.Or,i
treferst
othesaleoft
hef or
eigncurrencywhentheexchangerate
r
ises,in an expectati
on thatitwi l
lsoon fall
.St abi
l
izing specul
ati
on moderates
f
luctuat
ioni
nexchanger atesover
ti
meandper f
ormsausef ul f
uncti
on.

Ont heot dest

herhand, abi
li
zingspeculat i
onr eferstothesal
eofaf orei
gncurr
encywhen
theexchangeratef al
ls,i
nt heexpect ationt hatitwillf
allevenloweri nthefut
ure.
Destabi
li
zi
ngspeculationmayal sot aket hepur chaseofaf orei
gncur r
encywhenthe
exchangerateisri
sing,int heexpect ationt hatitwi l
lri
seev enhigherinthefut
ure.
Destabi
li
zi
ngspeculati
ont husmagni fi
esexchanger atefl
uctuati
onsoverti
meandcan
provever
ydisr
upti
vet otheinter
nati
onal f
lowoft r
adeandinvestment.

Chapt
erSummar
y
A mar ketwher ef oreigncurrenciesar esol dandboughti scalled foreignexchange
mar ket.The par ticipants coul
d be i ndividuals,firms,banks orgov er nments.The
transacti
onst husmadecoul dbespot ,for wardorswap.Thepr i
ceatwhi chthef oreign
currencyisboughti ssaidtobef oreignexchanger ate.I
nafreemar ket(f
lexibl
esy stem),
thisrateisdet erminedbyt heintersectionoft hedemandf orandsuppl yoft hef oreign
exchange.Howev er,thepriceofonecur rencymayf l
uct
uate(appreciateordepr eciate)
wi t
hrespectt oothercur renci
es.Thewei ghtedav eragerat
eoft hesechangesi sreferred
toast heeffectiveexchanger at
eoft hatcur rency,whichcouldeitherbenomi nalorr eal
.
Themet hodofdet ermini
ngt heabov eexchanger ateiscall
edBOPsappr oach.Ot her
met hodsincludePPPandmonet aryappr oaches.

DearSt
udent
!Whenagi
vencur
rencyi
ssol
datdi
ff
erentr
atesi
ntwomar
ketcent
ers,
traders( knownasar bitrageur s)trytogetpr ofitbybuy i
ngthecur rencyatal owerpr i
ce
andi mmedi atel
ysel l
i
ngi tatahi gherpri
ce.Thisi ssai dt obeexchangear bitrage.Making
profitfrom interestdiff
er entiali
scal l
edalsocal ledinter estarbi
trage,whi chmayormay
notbecov eredbyt hef or wardexchanger ate.Par tici
pantsi nt hef oreignexchange
mar ketar eusual l
yatr isksi nceexchanger ateschangeduet odi fferentreasons.They ,
therefore, arr
angemechani smsofav oi
dingthesef or eignexchanger isks,oneofwhi chis
hedgi ng.Specul ati
on ( theopposi teofhedgi ng)i s,howev er,seeki ng outr iskinan
attemptt omakepr ofi
tonexpect at
ionsaboutf uturepr icesofcur rencies.Ifexpectat
ions

41
becomecorrect
,thespecul
atormakesapr
ofi
t;ot
her
wise,al
oss.Specul
ati
oncoul
dbe
ei
therst
abi
l
izingordest
abil
i
zing.

I
mpor
tantTer
ms
Thef
oll
owi
ngwer
ethekeyt
ermsoft
hesecondchapt
er.

Absol utepur chasingpowerpar i

ty Hedging
Appreci ation Monet aryappr oach
Balanceofpayment sapproach Moneydemand
Cover edi nterestarbitr
age Moneysuppl y
Demandf orf orei
gnexchange Nominalef fectiverate
Depreci ation Realeffectiveexchanger at
e
Destabi l
izingspecul ati
on Relat
ivepur chasingpowerpari
ty
Eff
ect iveexchanger at
e Spotrate
Equil
ibr i
um exchanger at
e Spottransact i
on
Exchangear bit
rage Stabi
li
zingspecul at
ion
Foreignexchangemar ket Supplyoff oreignexchange
Foreignexchanger isk Swapt ransaction
Forwar dr ate Uncover edinterestarbi
tr
age
Forwar dt ransaction

Sel
f-TestExer
cise–2
A.Tr
ueorFal
se

1.Thefundament alsupplier
sanddemander soff oreigncur r
encyarebanks.
2.Thoset ransacti
onst hatmakeacount rypaymoneyabr oadareusedt oderivethe
supplyoff orei
gnexchangei ntheBOPsappr oachofexchanger atedet er
minat i
on.
3.Whent hedomest i
cpr iceofaf orei
gncur r
encydecr eases,wesayt hefor ei
gn
curr
encyhasdepr eciated.
4.A givencur rencydepr eciatesrelati
vet oot hercur renciesifther ealeffecti
ve
exchanger atedecreases.
5.Whent henat i
onalBankofEt hi
opiai ncreasest hebi rrsupply
,thebi rrvalueis
expectedt odecrease( depreci
ate),accordingthemonet ar
yapproach.
6.Speculationisonewayofav oi
dingr i
skint heforeignexchangemar ket.

42
B.Shor
tAnswer/Di
scussi
on/wor
kout

1.Discusst heimpactofadecr easeint hedemandf orforei

gnexchangeont he
equili
brium exchanger ate.
2.Givent hef oll
owi ng:Theexchanger atebet weent hedol l
ar(US)andtheeur ois
0.82wher east heexchanger atebetweent hedollarandt hepound( Bri
ti
sh)is
0.55.Cal culat
et heexchanger atebetweent heeuroandt heBrit
ishpound.
3.Thepr icei ndexi nEthiopiain1991was100.Thi swi llr
iseto240i n2009.The
generalpr i
celev elofCanadasl i
ghtl
yi ncr
easesf rom 100t o110bet weent he
years1991and2009.I ftheexchanger atethatexistedintheyear1991bet ween
theCanadi andol l
arandthebi r
rwas2. 1,esti
matet heexchanger at
eof2009.
4.Definespecul ati
onanddi ff
erenti
atebetweent hetwot ypesofspeculat
ion.

CHAPTERTHREE
BOPS AND EXCHANGERATEADJUSTMENTSAND CAPI
TAL
MOVEMENTTHEORI ES

3.
0.I
ntr
oduct
ionandObj
ect
ives

Inthepasttwochapt ers,wehav ediscussedaboutBOPsandexchanger ateconcept sin

rel
ati
vedetail
.Since,usually
,countr
iesencount ereitherabal anceofpay mentsdef ici
tor
surpl
us,theremustbeamechani sm ofadj usti
ngt hesei mbalancest oequi l
ibrium.If
monet ar
yandf i
scalappr oaches(poli
cies)becomeunabl et odoso,t hefi
nalresor twil
l
bebringi
ngequi l
ibr
ium throughexchanger ateadj ustments.Toadj ust(fi
xedorf loati
ng)
exchanger at
es,weal sohav edifferentapproaches.Thechapt ert husdev elopst he
rel
ati
onshipbetweenBOPsandexchanger atesy stems, andt hei
radj ustments.Itisalso
devotedtoabriefdiscussionofthetheoriesofcapi talmov ements.

Obj
ect
ives

DearDi
stanceLear
ner
!Ify
ousuccessf
ull
ycompl
etet
hepr
esentchapt
er,y
ouwi
l
lbe
abl
eto:
Di
stinguishbetweenvariousexchangerat
esy st
ems;
Developast r
ongrelat
ionshipbetweenBOPsandexchangerat
e;
St
ateappr oachestoBOPsandexchanger at
eadjust
ment;
and
St
atet hetheori
esofcapitalmovements.

3.
1.ExchangeRat
eSy
stemsandBOPsAdj
ust
ment
s

Forcent
uri
es,
manycountri
esofthewor l
doperatedunderalar
gel
yunif
orm syst
em
offixedexchanger at
esforthei
rcurrenci
es.Butthe1960sand1970scr isisi
nt he
for
eignexchangemar ketledtoref
ormsi nt heinternat
ionalmonet
arysystem.This

43
permitt
ednationst ochoosetheexchanger atesystem mostcompatibl
ewi t
ht hei
rown
economi cobj
ective.I
ndoingso, anationmustdeci dewhethert
oallowitscur
rencytobe
determinedbyf reemarketforces(floati
ngr at
e)ort obef i
xed(pegged)againstsome
standardofv alue.Thissecti
on,t herefor
e,t r
eat
st hesetwotypesofexchanger at
e
systems.

TheBOPS di
sequi
l
ibr
iathatwesaw inthefi
rstchaptercoul
dbeadj ust
edindi
ffer
ent
mechani
smsandinthetwoexchangerat
esystems.Thepresentsect
ional
sodi
scusses
thev
ari
ouswaysofbri
ngingbal
anceofpaymentsequi
l
ibri
um.

Obj
ect
ives

Uponcompleti
onoft hissect
ion,t
hedist
ancelear
nerwi
l
lbeablet
o:
 Identi
fythet
y pesofexchangeratesy
stems;
 Understandther el
ati
onshi
pbetweenBOPsandexchanger
ate;
and
 Discussthemet hodsofadjust
ingBOPs.

3.
1.1.ExchangeRat
eSy
stems

Nat
ionsmayadoptaf ixed(pegged)exchanger
atesy
stem orafl
oati
ngonewhi
chi
s
det
erminedsol
elybyt
hef or
cesofsuppl
yanddemandinafreemar
ket.

A.Fi
xedExchangeRat
eSy
stem

Underaf ixedexchanger at
esy stem today ,gover
nment sassi gntheircurrenciesapar
val
uei ntermsofot herkeycur renci
es.Akeycur rencyi sonet hatiswi delyusedwi t
h
rel
ati
velystabl
ev al
ueov ert
ime.Themostcommonkeycur r
encyi stheU. S.dollar.We
canthusdet er
minet heof fi
cialexchanger ateoftwocur r
enciesbycompar i
ngt hei
rpar
val
ues.Iti
sdev el
opingcount rieswhousual lypeg(tie)theircurr
enciestoakeycur rency.
Assume, f
orexampl e,thatArgent i
necentralbankersf i
xtheircurrency(peso)at20peso
perU.S$1, whereasEcuador ’
ssucr eissetat10sucr es=$1U. S.Theof f
icialexchange
rat
e between Argentina’speso and Ecuador ’
ssucr e becomes1 peso = 0. 5 sucre

Notethatperval
ueswer
eexpressedi
ntermsofgol
dunt
ilgol
dwasphasedoutoft
he
i
nter
national
monetar
ysy
stem i
ntheear
ly1970s.
Maintaini
ngpegst oakeycur rencyprovidessev eralbenef i
tsfordevelopingnations.
Fir
st,t
hepr icesofmanydev elopingnati
on’stradedpr oduct saredet
erminedpr i
mar i
lyin
themar ketsofi ndustri
ali
zednat i
onssuchast heUni t
edSt at
es;bypegging,sayt ot he
doll
ar,thesenat ionscanst abili
zet hedomest i
ccur rencypr i
cesoftheirimpor t
sand
exports.Second,manynat i
onscoul dreducei nfl
ati
onbypeggi ngt oakeycur rency.
Lesseningofi nflat
ionaryexpectationsl
eadstol oweri nt
erestrat
es,l
essl ossofout put
duetodi si
nflat
ion,andamoder ationofpri
cepr essures.

DearLear
ner
!Inmai
ntai
ningf
ixedexchanger
ates,nat
ionsmustdeci
dewhet
hert
opeg
t
hei
rcur
renci
est
oanot
hercur
rencyort
oacurr
encybasket
.Peggi
ngtoasingl
ecurrency
i
sgener
all
ydonebydevel
opi
ngcountri
eswhosetr
adeandf i
nanci
alr
elati
onshi
psar e

44
mainl
ywithasi
ngleindust
ri
al-
count
rypar
tner
.Forexample,I
vor
yCoast
,whi
cht
rades
pr
imari
lywi
thFr
ance,
pegsitscurr
encyt
otheFrenchf
ranc.

Developingnati
onswi t
hmor ethanonemaj ortradingpartneroft
enpegt heircurr
enci
es
toagr ouporbasketofcur r
encies.Thebasketiscomposedofpr escr
ibedquant i
ti
esof
for
eigncur r
enciesi
npr opor
ti
ont otheamountoft radedonewi ththenati
onpeggi ngi
ts
curr
ency .Oncet hebaskethasbeen sel ected,thecur r
encyv al
ueoft henat i
on i
s
comput edusingtheexchangeratesoftheforei
gncur renciesi
nthebasket.Peggingthe
domest i
ccur r
encyv al
ueoft hebasketenablesanat iont oaverageoutf luct
uati
onin
exportorimpor tpr
icescausedbyexchanger atemov ement s.Theeff
ectsofexchange
rat
echangesont hedomesticeconomyarethusr educed.

Afirstrequir
ementf oranat i
onpar ti
cipati
ngi naf i
xedexchanger atesyst
em ist o
det
ermineanof f
ici
alexchanger at
eforit
scur rencyafterpegging.Thenextstepistoset
upanexchangest abi
li
zati
onf undtodef endt heof f
ici
alrate.Throughpurchasesand
sal
esoff orei
gncurrenci
es,theexchangest abil
izat
ionfundat temptstoensurethatthe
marketexchangeratedoesnotmov eaboveorbel owt heoffi
cialexchanger
ate.

Underaf i
xedexchangeratesystem, anati
on’smonet aryaut
horit
ymaydecidetopur sue
BOPsequi l
ibr
ium bydeval
uingorrevalui
ngitscur r
ency.Thepurposeofdeval
uati
onist o
cause the home cur r
ency’s exchange value to depreci
ate,thus count
eracti
ng a
paymentsdef i
cit
.Thepurposeofcur rencyrevaluati
onistocauset hehomecur r
ency ’
s
exchangevaluetoappreci
ate,t
huscount er
actingapay mentsurpl
us.

Notet hatt he terms deval

uation and reval
uati
on ref
ertoal egalredefi
nit
ion ofa
curr
ency ’
sparv alueunderasystem off i
xedexchangerat
es.Thetermsdepreciati
onand
appreci
ation,however,ref
ertotheact uali
mpactont hemarketexchangeratecausedby
aredefini
tionofaparv alue,ortochangesi nanexchangeratestemmingf r
om changes
i
nthesuppl yofordemandf orforei
gnexchange.

B.Fl
oat
ingExchangeRat
eSy
stem

Byfloat
ing( fl
exibl
e)exchanger ates,wemeancur r
encypri
cest hatareestabl
isheddai ly
i
nt hef oreignexchangemar ket.Theyar efixedi ndependentofr estr
ict
ionsmadeby
governmentpol icyontheext entt owhichthepr icescanmov e.Wi t
hf l
oati
ngr at
es,there
i
sanequi li
brium exchanger atet hatequatest hedemandf orandsuppl yoft hehome
curr
ency .Changesi nt heexchanger atewi l
lideallycorr
ectapay mentsi mbalanceby
bri
ngingaboutshi f
tsini mpor tsandexpor tsofgoodsser vicesandshor t
-t
em capi tal
mov ement s.Theexchanger at ei nfl
exi
blesy st
em dependsonr el
ati
vemoneysuppl i
es,
i
ncomel evels,int
erestratespr icesandot herf actor
sdiscussedi nsection2.3oft he
secondchapt er
.

Oneadv antagecl ai
medf orfloati
ngr at
esi st rsi
hei mpli
city.Floati
ngratesallegedly
respondqui ckl
ytochangi ngsupplyanddemandcondi t
ions,cleari
ngthemar ketof
shor t
ages and sur pluses of a gi ven curr
ency.Because f l
oat i
ng r
ates fluctuate
throughoutt heday ,
theyper mitconti
nuousadjustmenti
nt hebalanceofpay ments.The
adv er
seef fectsofpr olongeddisequil
ibri
athattendtooccurunderf i
xedexchanger ates
aremi ni
mi zedunderf l
oatingrates.

45
I
ti salsoar guedthatfl
oatingratesparti
all
yinsulat
ethehomeeconomyf r
om exter
nal
forces.Thismeanst hatgov er
nmentswi l
lnothav etor est
orepay ment sequil
ibri
um
throughpai nfuli
nfl
ati
onaryanddef l
ationaryadjust
mentpol i
cies.Switchingtoflexi
ble
rates frees a nation from hav i
ng t o adopt poli
cies that perpetuate domestic
disequil
i
br i
um asthepriceofmaintai
ningasat i
sfact
oryBOPsposi t
ion.

Alt
houghtherearest rongargumentsinfav oroff
loati
ngexchangerat es,t
hissystem i
s
consi
deredtobeofl imit
edusef ul
nessf orbankersandbusi nesspeopl e.Crit
icsof
fl
exi
bleratesmai ntainthatanunr egul
atedmar ketmayl eadtowi def l
uctuati
onsin
curr
encyv al
ues,discouragi
ngf or
eigntr
adeandi nvestment.Eventhought radersand
i
nvestor
smaybeabl etohedgeexchanger ateri
skbydealinginthefor war
dmar ket,t
he
costofhedgingmaybecomepr ohibi
ti
vel
yhi gh.

 Adj
ust
abl
ePeggedRat
es

Aconsensuswasr eachedbymostnat ionsofthewor l

dthatnei thercompl etelyfixed
exchangeratesnorf l
oati
ngrateswer eoptimal
;i
nst ead, t
heyadopt edaki ndofmanaged
exchangeratesy em knownasadj
st ust
ablepeggedexchanger ates.Thi ssystem lasted
from 1944to1973.Themai nfeatureoft hi
ssystem wast hatcurrenciesar eti
edt oeach
othertoprovi
dest abl
eexchanger atesforcommer cialandfinancialtransacti
ons.When
theBOPsmov esawayf rom itslong–runequi l
ibrium positi
on,anat ioncanr epegi ts
exchanger at
ev i
adev aluati
onorr eval
uationpolicies.Thisispr ov i
dedt hatf i
scaland
monet ar
ypolici
esfailt
omaket heequi l
i
br i
um.

 ManagedFl
oat
ingRat
es

Thesesubstitut
edtheinter
nationalmonetarysyst
em basedonadjustabl
epeggedrat
es
afer1973.Undermanagedf
t l
oati
ngrates,anat i
oncanal t
ert
hedegr eetowhichi t
i
nterveneson t hefor
eign exchangemar ket
.Heav i
erint
erv
ent
ion mov esthenati
on
nearerthefi
xedexchanger atecase,whereaslessint
erv
enti
onmov esthenati
onnearer
thefloat
ingexchanger
atesy stem.

Undera managed f loat

,marketinterventi
on (cent
ralbank ormonet
aryaut
hor
it
y’s
i
ntervent
ion)isusedtostabi
li
zeexchanger atesintheshort
-r
un.However
,int
hel
ong
run,
mar ketfor
cesarepermi
tt
edtodet er
mi neexchangerat
es.

3.
1.2 Bal
anceofPay
ment
sAdj
ust
ment
s

Theimport
antobj
ect
iveofthi
ssub-sect
ioni
stodiscusstheautomat
icadj
ust
ment
sof
thebal
anceofpay mentsthatoccurunderafixed exchangerat
esy st
em.Var
ious
appr
oachestoBOPsadjust
mentwil
lbeseen.

A.Pr
iceAdj
ust
ment
s

46
Theoriginalt
heor
yofBOPsadj
ust
mentiscr
editedtot
heEngl
i
shmanDav idHume(1711
-1776)
.Hi stheor
ystr
essest
herol
ethatadjustment
sinnat
ionalpr
iceslev
elspl
ayin
promotingBOPsequil
i
bri
um.

 Gol
dSt
andar
d

Thecl assi
calgol dstandardthatexi
stedf r
om thelate1800stotheear l
y1900swas
characteri
zed byt he foll
owi
ng condit
ions:(
1)Each membernat i
on’s moneysuppl
y
consistedofgol dorpapermoneybackedbygol d;(2)Eachmembernationdef
inedt
he
off
icialpri
ceofgol dintermsofi t
snationalcur
rencyandwaspreparedtobuyandsell
goldatt hatprice;and( 3)Fr
eei mportandexpor tofgoldwaspermitt
edbymember
nati
ons.

Thesecondi t
ionsresulti
nacount ry’smoneysuppl ybei
ngdi r
ectlyti
edtoitsbal
anceof
payments.A nat i
onwi thabal anceofpay ment ssurpl
uswoul dacquiregol
d,dir
ectl
y
expandi
ngi tsmoneysuppl y .Conv ersel
y,themoneysuppl yofadef i
citnat
ionwould
decl
ineasduet ogol doutf low.Thi scausedt heint
ernalpricestofalli
nt hedefi
cit
nati
onalandr i
seinthesurplusnation.Asar esul
t,t
heexportsoft hedef
ici
tnati
onwould
beencour agedandi mport
swoul dbedi scourageduntilthedef i
citi
ni t
sBOPswas
el
iminat
ed.

 Quant
it
yTheor
yofMoney

Ther educt
ionofi
nter
nalpr
icesi
nthedef
ici
tnat
ionasaresul
tofthegol
dlossand
reducti
onofi t
smoneysupplywasbasedonthequant
it
ytheoryofmoney.Thi
sis
expl nedbyMV=PQ.
ai

WhereM i
sthenation’
smoneysupply,
Visthevel
ocit
yoft heci
rculat
ingmoney ,Pisthe
gener
alpri
ceindexandQ isphy si
caloutput.Accordi
ngt oclassi
cals,Q andV ar e
const
ant
s.Hence,achangei
nM leadsadir
ectandproport
ional
changei ngeneralpr
ices,
P.

Thus,ast hedef i
citnati
onl ostgold,it
smoneysuppl ywouldfal
landcausei nternal
pri
cestof allproporti
onatel
y.Thi swouldencour ageexportsanddiscouragei
mpor tsof
thedeficitnation.Theopposi t
ewoul dtakepl aceint hesurpl
usnat i
on.Thepr ocess
wouldcont inueuntilt
hedeficitandsurpl
uswer eel i
minated.Not
ethattheadjust
menti s
automatic.Itstart
sassoonast heBOPsdi sequili
bri
um ari
sesandcontinuestooperate
unti
lthedisequi l
i
bri
um isentirel
yeli
minated.

Howev er,t
hisclassi
calpr i
ceadjustmentmechani sm isahot l
ydebat edissue.Itis
questi
onedonmanygr ounds.Itsv i
ew thatf ul
lemploymental waysexist
shasbeen
chal
lenged.Ithasalsobeenpoi ntedoutt hat,inamoder nindustr
ialworl
d,pri
cesand
wagesar einfl
exi
bleinadownwar ddirect
ion.Therefor
e,changesinM wi l
laff
ectnotP
butratherQ.(Adef i
citnati
on’
sfalli
ngmoneysuppl ywouldbringaboutaf al
linoutput
andempl oyment.
)Furthermore,
thestabili
tyandpredict
abil
it
yofVhav ebeencrit
ici
zed.

B.I
nter
estRat
eAdj
ust
ment
s

47
DearDi
stanceFr
iend!Forsi
mpl
i
cit
y,consi
derawor
ldoft
wocount
ri
es–AandB(
A
enj
oy ingasur plusandBf aci
ngadef i
cit
).Thei nf
low ofgol df rom thedef i
cittothe
surplusnat i
onaut omaticall
yresult
sinani ncreasei nnat i
onA’ smoneysuppl yanda
decli
nei nt hemoneysuppl yofnat i
onB.Gi venaconst antdemandf ormoney ,the
i
ncreasei nnat i
onA’ smoneysuppl ywoul dl owerdomest icinterestrates.Atthesame
ti
me, interestratesinnat i
onBwoul drise.Asar esult
,investorsofnat i
onAwoul dfi
ndit
att
ract i
vet osendaddi t
ionalfundsabr oad.Conv ersel
y ,nati
onB’ sinvestor
swoul dnot
onlybedi scouraged fr
om sendi ng moneyov erseas,butmi ghtf i
nd itbenefici
alto
l
iquidatefor ei
gni nvest
menthol di
ngsandputt hefundsi ntodomest icassets.

Thispr ocessf aci

li
tatestheaut omati
crestor
ation ofpay mentsequi l
i
br i
um in bot
h
nations.Becauseoft heinducedchangeinint
erestrates,stabi
li
zingcapitalmovements
automat i
call
yflow from thesur pl
ustothedef i
citnation.Thisr educest hepayment
i
mbal ancesofbot hnat i
ons.Alt
houghthi
sinducedshor t-t
erm capitalmov ementisofa
tempor ar
yratherthancont i
nuousnatur
e,i
tneverthel
essf acil
it
atest heautomati
cBOPs
adjustmentprocess.

C.I
ncomeAdj
ust
ment
s

DearDi
stanceLear
ner
!Wehaveseent
hatt
hecl
assi
calBOPsadj
ust
mentt
heor
yrel
i
ed
pri
mari
lyont hepri
ceadjustmentmechani
sm,whiledelegatingasecondar
yrol
et ot
he
eff
ect
sofi nt
erestr
atesonpr i
vat
eshortt
erm capi
talmov ements.Themaincr
it
icism of
thecl
assicaltheor
ywast hatital
mostcompl et
elynegl ected t
heeff
ectofi ncome
adj
ust
ment s.Thisl
atert
heorywasdevel
opedbyKey nesin1930s.

TheKey nesianadjustmentt heor

ysuggeststhat,underasystem off ixedexchanger at
es,
thei nf
luenceofi ncomechangesi nsurplusanddef i
citnati
onswi llaut omati
callyhelp
restorepay mentsequi l
i
br i
um.Givenaper si
stentpaymentsimbal ance,asur pl
usnat i
on
willexperiencerisingincome,andi tsimportswilli
ncrease.Conv ersely,adefi
citnati
on
willexperienceaf alli
ni ncomeresult
inginadeclineinimports.Theseef f
ect
sofi ncome
changesoni mpor tlevel
swi ll
rev
ersethedisequil
ibr
ium i
nthebal anceofpay ment s.

D.Monet
aryAdj
ust
ment
s

Themonet ar
yappr oach viewsdisequil
i
brium intheBOPspr i
mar i
l
yasamonet ary
phenomenon.I temphasi zesthatdisequil
ibri
um ref
lect
san imbalancebet
ween t he
demandandt hesupplyofmoney .Moneyact sasbothadist
urbanceandanadj
ustment
tobalanceofpay ments.Thisadjust
menti ntheBOPsi sagai
nv i
ewedasanautomat i
c
process.Let’
sfir
stunderstandthedet er
minantsofthedemandf orandt
hesupplyof
money .

DearSt
udent!Thewr
it
erissuret
hatyouknow whatdeter
minethequant
it
iesof
moneydemandedandmoneysuppl
i
ed.Cany
oupleasewri
tethem her
e?

48
_
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
_
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
_
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
.

Haveyouwr
it
ten?Thati
sver
yni
ce.Asyouknow,t
hequant
it
yofnomi
nalmoney
bal
ancesdemandedi sdi rectl
yrelatedtoincomeandpr i
ces.Incr
easesinincomeand/ or
pri
cest ri
ggeri ncreasesint hevalueoft r
ansacti
onsandani ncreasedneedf ormoneyt o
fi
nancet het ransactions,andv i
cev er
sa.Thequant i
tyofmoneydemandedi si nversely
rel
atedt ot hei nterestr ate.Whenev ermoneyi sheldr at
hert hanusedt omakean
i
nvest ment,themoneyhol dersacri
ficesinter
estthatcoul
dhav ebeenear ned.Ifinterest
rat
esar ehigh, peoplewi l
l trytokeepasl it
tlemoneyonhandaspossi bl
e,putti
ngt her est
i
ntoi nter
estear ni
ngi nvest ments.Conv ersel
y,adeclineininter
estrat
esi ncreasest he
quantityofmoneydemanded.

Asy oual
soknow,anat ion’smoneysupplyi
samul t
ipl
eofthemonet ar
ybaset hat
i
ncludestwocomponent s.Thedomest i
ccomponentr ef
erst
ocr editcr
eatedbyt he
nation’
s monetary aut
hor i
ti
es.The i
nter
nati
onalcomponentr ef
erst othe f
oreign
exchangereservesofanat i
on,whi
chcanbei ncr
easedordecreasedastheresul
tof
balanceofpaymentsdisequili
bri
um.

Oncey ouknowaboutt hedet ermi nantsofmoneysuppl yanddemand, l

etmet akey outo
themonet aryapproachofbal ancepay ment sadjustmentonceagai n.Accordingtoi t
,al
l
payment sdefici
tsinBOPsar ether esultofanexcessi nthesuppl yofmoneyov erthe
demandf ormoneyi nthehomecount ry.Underaf i
xedexchanger atesystem, t
heex cess
supplyofmoneyr esul
tsinf oreignexchanger eserves’flowi
ngov erseas,t
husr educing
thedomest i
cmoneysuppl y.Conv ersely,anexcessdemandf ormoneyi nt hehome
count r
yl eadst oapay ment ssur plus.Thisbr i
ngsi nt heinfl
ow off orei
gnexchange
reservesf rom abroad,therebyi ncreasingt hedomest i
cmoneysuppl y.Balanceint he
nation’
spay mentsposit
ioni srest oredwhent heexcesssuppl y,ort heexcessdemand,
hasf allenenought orestoret heequi li
bri
um condi t
ion:moneysuppl yequalsmoney
demand.

Tabl 1.I
e3. mpactofChangesi
nMoneySuppl
yandDemandonBOPsunderFi
xedExchange
Rat
es

Change I
mpactonBOPs
I
ncreaseinmoneysuppl
y Def
ici
t
Decreasei
nmoneysupply Sur
plus
I
ncreaseinmoneydemand Sur
plus
Decreasei
nmoneydemand Def
ici
t

Start
ingfr
om aposi
ti
onatwhi
cht
henat
ion’
smoneydemandequal
smoneysuppl
yandi
tsBOPsi
sin
equil
i
br i
um.

Whatdoyout hi
nkaboutthepolicyimpli
cati
onsofthemonet ar
yapproachofBOPs
adj
ust
ment?___
________
_____
_____
_______
______
_____
_____
_____
______
_____
_____
__
___
___
___
____
_____
__ _
_____
_____
_____
_______
______
_____
_____
_____
______
_____
__
___
___
___
____
_____
__ _
_____
_____
_____
_______
______
_____
_____
_____
______
_____
_.

Theappr
oachsuggest
sthateconomi
cpol
i
cyaf
fect
sthebal
anceofpay
ment
sthr
ough

49
i
tsimpactont hedomesticdemandf orandsuppl yofmoney.Poli
ciesthatincr
easet he
supplyofmoneyr elat
ivetothedemandwi l
lleadt opayment
sdef i
cit,anout f
low of
for
eignexchangereserv
es,andar educt
ionint hedomesticmoneysuppl y.Pol
icesthat
i
ncreasethedemandf ormoneyrel
at i
vetothesuppl ywi
llt
ri
ggerapay mentssurplus,an
i
nflowofforei
gnexchangereser
ves,andani ncreaseint
hedomesticmoneysuppl y.

Themonet aryBOPsadj ustmentmechani sm al

sosuggeststhatnonmonet ar
ypoli
cies
thatattempttoinfl
uenceanat i
on’
sBOPs( li
ketari
ff
s,quotas,orcurrencydeval
uat
ion)
areunnecessary.Thisi sbecauseoft hefactthatpayment sdi sequi
li
bri
aaresel f
-
correct
ingovert i
me.Howev er,intheshort– run,suchpol i
ciesmayspeedupt he
adjustmentprocessbyr educingexcessesinthesupplyofmoneyort hedemandf or
money .

Themonet aryappr oachalsohaspol icyimpli

cati
onsforthegr owthoft heeconomy .
Starti
ngfrom thepoi ntofequi
li
bri
um, asthenation’
soutputandrealincomeexpand,so
dot henumberoft ransact
ionsandthequantityofmoneydemanded.I fthegover
nment
doesnoti ncreasethedomest i
ccomponentoft hemoneysuppl ycommensur atewitht
he
i
ncreasei nthequant it
yofmoneydemanded, t
heexcessdemandwi l
li
nduceani nf
lowof
fundsf r
om abr oadapay mentssur
plus.

3.
2.ExchangeRat
eAdj
ust
ment
s

Theprevi
oussect i
ondemonst r
atedthatBOPsdisequi
li
bri
atendtober ev
ersedby
aut
omat i
cadj
ustment sinprices,int
erestrat
esandincomes.Iftheseadj
ustmentsare
notal
lowedtooperate,howev er
,reversi
ngBOPsdisequil
ibr
iamaycomeatt heexpense
ofdomesticr
ecessionorpricei nf
lati
on.Thecuremaybeper ceiv
edaswor sethanthe
di
sease.

I
nsteadofr elyi
ngonadj ustmentsinpr i
ces,inter
estrates,andincomest ocounteract
paymentsimbal ances,governmentsper mital
ternati
oninexchanger at
es.Byadoptinga
fl
oati
ngexchanger at
esy stem,anat i
onper mitsit
scurrencytoappreci
ateordepreciate
i
naf reemar ketinresponset oshift
sineitherthedemandf ororsuppl
yofthecurrency.
Underafixedexchanger atesy st
em,r at
esar esetbyt hegov er
nmentintheshort–r un
wit
htheadopt ionofdev al
uationreval
uati
onov eraper i
odoft i
me.

I
nthissect i
on,wewi
l
lseethev ar
iousway sofadj
usti
ngexchanger at
es.Onourway ,
we
wil
lexami nethei
mpactofexchangerateadjust
mentsont hebalanceofpayments.We
wil
llearnunderwhatcondit
ionscurrencydepreci
ati
on(dev al
uati
on)andappreciat
ion
(
revaluat
ion)wil
li
mprov
e/wor senanation’
spaymentsposi
tion.

Obj
ect
ives

DearDi
stanceLear
ner
!Asuccessf
ulcompl
eti
onoft
hissect
ionwi
l
lmakey
oubeabl
eto:

50
  Examinehowexchangerat
escanbeadjusted;and
 Eval
uatetheef
fectonBOPsofexchangerateadjust
ment
s.

Basical
ly,wehavethreeapproachestowardsexchangerateadj
ustment.Thef
ir
st-the
elast
ici
tyapproachemphasizestherelat
ivepr
iceef f
ect
sofdepreci
ati
onandsuggests
thatdepreci
ati
onworksbestwhendemandel asti
cit
iesarehi
gh.

Theabsor
pti
onapproachdeal
swiththeincomeef
fect
sofdepr
eciat
ion.Thei
mpl
i
cat
ion
i
st hata decr
ease in domest
ic expendit
urer
elat
ivet
oi ncome mustoccurfor
depr
eci
ati
ontopromotepayment
sequili
bri
um.

Themonetar
yapproachstressest
heeff
ect
sdepreciat
ionhasonthepur
chasi
ngpower
ofmoneyandtheresul
ti
ngimpactondomest
icexpendi
turel
evel
s.
Letusnowseeeachapproachonebyone.

A.TheEl
ast
ici
tyAppr
oach

Currency devaluati
on ( depreciat
ion)aff
ect s a country’
s balance oft r
ade through
changesint herelat
ivepr i
cesofgoodsandser vi
cesinternati
onall
y.At radedefi
citnati
on
maybeabl etor ever
sei t
si mbalancebyl oweri
ngi t
sr elat
iveprices,sot hatexpor t
s
i
ncreaseandi mportsdecr ease.Thenationcanl owerr elat
ivepricesbyper mitti
ngi t
s
exchanger atetodepr eciateinaf reemarketorformal l
ydev al
uingi t
scur r
encyundera
system off i
xed exchange r ates.The ult
imate outcome ofcur rencydepreciati
on
(devaluat
ion)dependsont hepr i
ceelast
ici
tyofdemandf oranat ion’simport
sandi t
s
exports.

Whati
s,bytheway,thepri
ceelast
ici
tyofdemand?Whatdot hevar
iousnumeri
cal
v
alues of t
he coeff
ici
ent i
ndi
cate?
_
_____
___
___
____
____
_____
_____
_____
_____
_____
____
___
___
_
_____
___
___
____
____
_____
_____
_____
_____
_____
____
___
______
______
___
___
___
_ _
__

Excel
l
ent
!Inshor
t,pr
iceel
ast
ici
tyofdemandr
efer
stot
her
esponsi
venessofbuy
erst
o
changesi
npr
ice.Mat
hemat
ical
l
y,

El
ast
ici
ty=%Changei
nQuant
it
yDemanded=ΔQ/Q
%Changei
nPri
ce ΔP/
P

Theelastici
tycoeff
icientisst
atednumer
ical
ly,wit
houtr egar
dt othealgebrai
csign.Ift he
coeffi
cientexceeds1,demandi ssaidto ber elat
ivelyelasti
c.Thismeansagi v en
percentagechangei npriceresul
tsi
nalargerpercentagechangei nquant i
tydemanded.
Iftheratioislessthan1,demandi srel
ati
velyinel
astic.Ifexactl
y1,i ti
scalleduni tary
elast
ic( thepercentagechangei nquantit
ydemandedj ustmat chest heper centage
changei npri
ce).

DearDistanceStudent
! Letusnow t
akeanexampl
etounder
standmor
eaboutt
he
el
asti
cit
yapproach.

51
SupposetheEt hi
opiangov er
nmentdecidestodevaluethebirrby5percenttocorr
ecta
tr
adedeficitwi t
hJapan.Whet hertheEthi
opi
ant r
adebal ancewil
lbeimproveddepends
onwhathappenst otheyenin-pay
mentsforEthi
opianexportsasopposedtotheyenout
-paymentsf orit
simpor t
s.This,i
ntur
n,dependsonwhet herthedemandf orEt
hiopian
expor
tsisel asti
cori nel
ast
icandwhethertheEthi
opiandemandf orJapaneseimportsis
el
asti
cori nelasti
c.

Dependi
ngont hesizeoft
he demandelasti
cit
ies forEthi
opi
anexpor
tsandimport
s,
Et
hiopi
a’str
adebalancemayi
mprove,worsenorremainunchangedinr
esponsetot
he
bi
rrdeval
uati
on.Thegener
alr
ulethatdet
erminestheactualoutcomei
stheso-cal
l
ed
Mar
shal
-Ler
nercondi
ti
on.

TheMar shalLernerconditi
onst ates:
1. Dev al
uation (
depr eciat
ion)wi l
limprovet he trade balance i
ft he dev al
uing
nation’
sdemandel asti
cit
yf orimportsplustheforeigndemandel astici
tyforthe
nation’
sexport sexceeds1.
2. Ifthesum oft hedemandel ast
ici
ti
esinlessthan1,dev aluat
ionwillwor senthe
tradebalance.
3. Thet radebal ancewi l
lbenei t
herhelpednorhur tifthesum oft hedemand
elasti
cit
iesequals1.

Theconditi
onmaybest at
edintermsofthecurr
encyofeit
hert
henat
ionundergoi
ng
deval
uati
onoritst
radi
ngpar
tner
,buti
tcannotbeexpr
essedi
nter
msofbothcur
renci
es
si
multaneousl
y.

B.TheAbsor
pti
onAppr
oacht
oExchangeRat
eAdj
ust
ment

Accordi
ngt otheelasti
cit
iesappr oach,cur
rencydev aluati
onof fer
sapr i
cei ncenti
vet o
reduceimpor t
sandi ncreaseexpor ts.Butev eni felasti
cityconditionsar ef avorable,
whetherthehomecount ry’str
adebal ancewillactual
lyimpr ovemaydependonhowt he
economyr eactst
ot hedev al
uaton.Theabsor
i pt
ionappr oachpr ov
idesi nsi
ght sintothis
questi
onbyconsi deri
ngt hei mpactofdev aluati
onont hespendi ngbehav i
oroft he
domesticeconomyandt hei nf
luenceofdomest i
cspendi ngont hetradebal ance.

DearLear
ner
!Theabsor
pti
onappr
oachst
art
swi
tht
hei
deat
hatt
hev
alueoft
otal
domesticout
put( Y)equal
sthel eveloftotalspendi
ng.Totalspendi
ngconsist
sof
consumpti
on(C)
,invest
ment(I
),governmentexpendi
tur
e(G)andnetexport
s(X-
M.
Thatis:
Y=C+I+G+(
X-M)

TheabsorptionapproachthenconsolidatesC+I
+Gi ntoasi
nglet m A,
er whichi
srefer
red
toasabsor pti
on.(
X-M)i sdesignatedasB.Tot aldomest
icoutputthusequal
sthesum
ofabsor
ptionandt helevelofnetexports,orY=A+B  B=Y-A

Thisexpressi
onsuggeststhatthebalanceoft rade( B)equal
st hedif
fer
encebet ween
tot
aldomest i
coutput( Y)andt helevelofabsor pti
on(A).Ifnati
onaloutputexceeds
domestic absor
pti
on,the economy ’
st rade balance wil
lbe positi
ve.Conv er
sely,a
negat
ivet r
adebalancesuggestst hananeconomyi nspendingbey onditsabili
tyto

52
pr
oduce.

The absorpt
ion approach predi
ctsthat
,ifcur
rency deval
uat
ion i
st oimprov
e an
economy’str
adebal ance,nati
onalout
putmustr
iserel
ati
vetoabsorpti
on.Thi
smeans
thatacountrymusti ncreaseitstot
aloutput
,reduceitsabsorpti
on,ordo some
combinat
ionofthetwo.
C.TheMonet
aryAppr
oacht
oExchangeRat
eAdj
ust
ment

DearDi
stance Col
l
eague!You coul
d easi
l
ynot
ethatt
he el
ast
ici
tyand absor
pti
on
approachesofexchangerateadj
ustmentappl
yonlytothet
radeaccountoftheBoPs.
Theynegl ectt
heimplicat
ionsofcapi
talmovements.I
tisthemonetaryapproacht
o
devaluat
ionwhichaddr
essesthi
sshort
coming.

According t he monet ar
y approach,cur r
ency devaluation may i nduce a t emporar
y
i
mpr ovementi nanat i
onsBOPsposi ti
on.Assume,fori nstance,thatequili
bri
um init
ial
l
y
exi
stsint hehomecount r
y’smoneymar ket.Adevaluationoft hehomecur rencywould
i
ncreaset hepr i
cel evel(
thatis,thedomest i
ccurr
encypr i
cesofpot ent
ialimportsand
export
s) .Thisi ncreasesthedemandf ormoneybecausel argeramount sofmoneyar e
neededf ort ransaction.I
fthatincreaseddemandi snotf ulfi
ll
edfrom domest icsources,
aninfl
owr esultsinaBOPssur plusandar i
seinint
ernational r
eserves.

Butt hesur plusdoesn’tl astforever.Byaddi ngtothei nt

ernationalcomponentoft he
home – count r
ymoneysuppl y ,the devaluat
ion l
eads to an i ncrease in spendi
ng
(absorpti
on) ,which reduces t he sur pl
us.The sur pl
us ev entuall
y disappears when
equili
bri
um i srestoredint hehomecount ry
’smoneymar ket.Theef fectsofdev al
uati
on
onr ealeconomi cv ari
ablesaret hust emporary.Overthelongr un,cur r
encydev al
uati
on
mer el
yraisest hedomest icpri
cel evel.

3.
3.TheTheor
iesofCapi
tal
Mov
ement

Sof ar
,wehav econcentr
atedeit
heront hecurrentaccountinthebalanceof
payments,orononeofi t
smaj orcomponents,thebalanceoftrade.Ifther
ewer eno
capit
alfl
ows,t henatheoryofthecurr
entaccountwoul dbeat heoryofthebal
anceof
payments.Althoughcapi
talmov ement
swerer estr
ict
edf ormanyyearsduetodiff
erent
reasons,
nowaday stheyhavere-
emerged.

Themostcasualexami nationofrecentBOPsaccount sshowst hatcapi

talmovements
throughpr i
vat
emar ketsar ethedomi nantitem.A theor
yoft hemoder nBOPsmust
therefor
eembodyat heoryofinter
nationalcapi
talmovements.I
nt hi
ssection,weshal
l
disti
nguishtwosuchtheories.

Obj
ect
ives

Att
heendoft
hissect
ion,
youar
eexpect
edt
o:

 Statethetheor
iesofcapit
almovement;
and
 Relatethecapi
talaccountt
oexchangerat
esy
stems.

53
DearDi
stanceLear
ner
!Wehavebasi
cal
l
ytwoi
mpor
tantt
heor
iesofcapi
talmov
ement
.
Theyhav eincommonanemphasi sont heroleofinter
estrat
edi f
ferent
ial
sbetween
count r
iesinexplai
ningcapitalmovements,butdif
feri
not herimportantaspect
s.The
oldesti sthe f
low theory,inwhichagi veninter
estratedif
ferent
ialwil
lresul
tina
continuousfl
owofcapi talfr
om onecount
rytotheother
.

Thesecondi sastocktheoryi
nwhichachangei ntheint
erestrat
ediff
erenti
alwil
l l
eadto
anadjustmenti npor
tfol
iosofassets.Thatdif
ferent
ial
,ifmaintai
nedandnot hingelse
changes,leadstoafl
owofcapi t
alunti
lanewst ockequi
li
brium i
sestabl
ished,butnotto
acontinuousflowofcapit
al.Letusnowdiscusseachoft heseintur
n.
A.TheFl
owTheor
yofCapi
tal
Mov
ement
s

Thisisthesimplestandt heoldesttheoryofcapit
almov ement s.Itsimpl
ystatesthat
capit
alwil
lfl
owfrom onenat i
ont oanotheraslongasthereisadi f
ferencei
ntheint
erest
paymentsbetweent hetwonat i
ons.Theor igi
nsofthi
sf l
owt heorymaybet r
acedback
totheexperi
enceoft hegoldstandard,dur
ingwhenani ncreaseinthedomest i
cint
erest
rat
ewasseent ostimulateaninfl
owofgol d.

Themoder nf low theoryarguesthatinat wocount

ryworld,ot
herthi
ngsremaini
ng
constant(
incl
udingt heexchangerate)
,wemaywrit
ethechangeincount
ryA‘
sstockof
for
eignli
abil
it
ies(i
.e.,l
i
abil
it
iestocountr
yB)as:

ΔFA =I
A +f
A(r
A,
rB)

WhereΔFA isthechangei nthest

ockofl iabi
l
iti
es(i
.
e.,acapit
alfl
ow);rAandrBar
ethe
i
nter
estratesincountri
esAandBr especti
vel
y;andIA i
sthatcomponentofthecapi
tal
f
lowthatisindependentofi
nter
estr
at es.

I
tisassumedt hat∂f
A /∂r
A >0a nd∂f A/∂rB<0.Thatis,anincreaseinthedomestic
i
nterestr
ater
elativ
etothefor
eigninterestrate,
oradecreaseintheforei
gnint
erestr
ate
rel
ati
vetothedomest i
cone,wi l
lincreaseani nfl
ow offorei
gncapi t
alordecr
easean
outf
low.

B.TheSt
ock(
Por
tfol
io)Theor
yofCapi
tal
Mov
ement
s

The portfol
iot heor
y shows how r ati
onalindivi
dual
s would dist
ri
butetheirwealt
h
betweendi f
ferentassetsinordertomaximizet hei
rut
il
it
y.Centralt
ot hi
stheoryi
sthe
recognit
ionthatthereturntoanassetsissubjecttori
sk,andthatassethol
derswil
lbe
i
nf l
uencedbybot htheexpectedretur
nt otheassetandt heuncertai
ntyoftheactual
retur
n.

I
ngener al,wemi ghtexpectt hattherewi l
lbeal owercor rel
ati
onbet weent heyi
elds
(r
eturnsfrom)countr
yAasset sandcount ryBassetsthanbet weent heyiel
dsofassets
wit
hinanyonecount r
y.Thissuggest st hatwemi ghtexpecti nvestorstoholdassets
fr
om bothcountri
es.Changesi ny i
eldsinonecount r
ywillthenleadt oanadjustmentof
port
foli
osi nbothcount r
ies.Hencef orei
gnassetsandl iabi
li
ti
eswi l
lchange.Inan
i
nternati
onalset
ti
ng,howev er,ther
emaybeanot hersourceofr isk–theexchangerate
maychange.

54
 St
ockModelwi
thFi
xedExchangeRat
es

Ift
heexchangerat
ei sfixed( orispeggedwithnopossibi
l
ityofachangei
nthepar
val
ue),
theonl
ysourcesofriskareintheyi
eldsofasset
s.I
nsuchacase,
whatwi
ll
bethe
eff
ectofagener
ali
ncreaseinterestr
atei
ncountryB?

Supposet hatinv
est orsinthet wocount ri
esar einit
iall
yinequil
ibrium,holdingpor t
foli
os
ofasset sfrom bot hA andB ( exampl ebondsi ssuedbyt hegov ernment sinbot h
countr
ies).Assumingt hatinvestorsdonott hi
nkt her i
sknessofcount r
yBbondshas
i
ncreased,theywi l
ladj usttheirpor tf
olios.Theyt husr educeholdingsofmoneyandof
countr
yAbonds, andi ncreasetheiry i
eldsandi ncreasingtheincent i
vetopur chasethem,
whil
et hepr iceofcount r
yB bondswi l
lri
sewi tht heopposi teeffect.I nthef inal
equi
li
brium,howev er ,i
nvestorswi llholdahi gherpr oporti
onoft heirwealthincount r
yB
bondsthanbef ore,andal owerpr opor t
ioni ncountryAbonds.

Thei ncr
easeinB’ sint
erestratehasl edtoachangei nthepatter
nofassethol di
ng.
Therefor
e,ther
ewi l
lbeaonce- and-f
or-al
lcapi
talf
lowf r
om At oB.Thecapitalf
lowmay
be spread outov ertime,since adjustment
si n portf
oli
os need notofcour se be
i
nstantaneous,butoncetheadjustmentiscompletedthecapit
alfl
owwi l
lcease.

 St
ockModelWi
thFl
oat
ingExchangeRat
es

Underafloat
ingsyst
em,anaddi ti
onalel
ementofuncertai
ntyisint
roduced.Togai
n
someinsi
ghti
ntotheconsequencesofthi
s,weshal
luseanothersi
mpleexample.

Supposethattherearetwoasset,oneissuedbyA’sgov ernmentanddenominatedinA’ s
currency(t
he₤),t heotherbyBi nB’scurrency(the$).Assumeal sothattheinterest
ratesonthesebondsar eknownandf ixedsothatinvestorsfacenouncert
aintyabout
yieldsi
nthecurrencyinwhichthebondi sdenominated.Theonlyri
skfaci
ngani nvestor
from A,whohol dsB’ sbonds,isthusanexchanger atechange.Heisuncer t
ainhow
many₤shewi llreceiv
ef ort
hegivenyi
eldonacount r
yBbond.

Providedt hatt
hey i
eldoncount r
yBbondsi shigherthanthatonA,thei nvest
ormaybe
preparedt oacceptthei
ncreasedv ariabil
i
tyinhisyieldi
nretur
nf orhi
gherexpectedy i
eld,
andhol dsomeofhi swealthint hef orei
gnasset .Eveniftheinvest
orexpectst he₤t o
appreciate,he mayhol d some f oreign assets provi
ded thattherei s a suff
ici
ent
dif
ferencei nyi
eld.I
fheexpect sthe₤t odepreciate,hemayacceptal owery i
eldont he
forei
gnasset .Ofcourse,i
fhei sabl etouseaf orwardexchangemar kethecanr emov e
theri
sk, butatthecostofthepremi um hemustpay .

Chapt
erSummar
y
Theoretical
ly,wehav et wopol arexchangeratesystems:f i
xedandf lexible(f
loati
ng)
dependingonwhet hertheexchanger atesar
edet er
minedbymar ketfor cesornot .The
for
merusesmonet aryaut hori
ti
estofixtherat
eusual l
ybyassigningparv al
uescal l
ed
pegging.Thel atterdetermi nestheexchangeinthemar ket.Wit
hintheset woext r
emes
are adjustable pegged r ates and managed fl
oati
ng rates.Disequi
libr i
a( def
ici
ts or

55
surpl
uses)inBoPscoul dbeadj ustedthr
oughpr i
ce,int
erestr
ate,incomeormonet ary
approaches ofadjustments.Alloft hem resul
ti n automat
ic adjust
ment st owards
equil
ibri
um.These di sequi
li
bri
a could also be attempted t
hrough exchange r ate
adj
ust ment
s.Flexi
bleexchangeratesmaybeadj ustedbyapplyi
ngel ast
ici
ty,absorpt
ion
ormonet ar
yapproaches.

Li
kegoodsandser v
ices,capi talalsocrossesboundariesofnat i
ons.Toexpl ainthe
movementofcapital
,wehav et wot heor
ies–t heflow t
heoryandt heportf
oli
ot heory
.
Theformersimplystatest hati fther
einterestdif
fer
ential
,capit
almov es.Thel at
ter,
however
,showshowr ationalindivi
dualsholdthei
rwealthinter
msofdi ff
erentassetsto
getpr
ofi
t,subj
ectt
orisk.Ther iskprimari
l
ycomesf rom fl
uctuat
ionsinexchangerates.

I
mpor
tantTer
ms
Thet
hir
dchapt
erhadt
hef
oll
owi
ngkeyt
erms.Besur
eyouknowt
hem.

Absor pt i
on
Adjust ablepeggedr ate
Deval uation
El
ast icity
Fi
xedExchanger at
esystem
Fl
exi bleexchanger atesystem
Fl
owt heor yofcapitalmovement
Gol dst andar d
I
ncomeadj ustment
I
nter estr ateadjustment
ManagedHeat i
ngrate
Mar shal–Ler nercondit
ion
Monet aryadj ustment
Priceadj ust ment
Quant ityt heoryofmoney
Reval uation
Stockt heor yofcapitalmovement

Sel
f–TestExer
cise–3
A.Wr
it
etr
ue/
fal
se

1.Fl
exi
ble exchange r at
e system i
s ofenor mous importance t
o banks and
busi
nesspeopletherebyencouragi
ngforei
gntr
adeandi nv
estment.
2.The monetaryappr oach ofBOPs adjustmentsuggestst hathigh t
ari
ff
s on
i
mportabl
eanddev al
uationofacur
rencyarei
mportant.

56
 3.Curr
encydevaluat
ion(
depreci
ati
on)wil
lbri
ngadesirableoutcomef oranat
ionif
andonlyi
fthedemandelasti
cit
yfori
mportsandexpor t
sisinelast
ic.
4.Theabsorpti
onapproachtoexchangerateadjust
menti sindi sagr
eementwit
h
thei
deathatdeval
uati
onalonecanbri
ngfavor
ableeffectst
ot heeconomy.

B.Di
scussi
on/
Shor
tAnswer/Wor
kout

1.Discusstheimportanceofcurr
encypegsfordev
elopi
ngcountr
ies.
2.Statetheint
erest–ratemechani
sm ofadj
usti
ngBOPsdisequil
i
brium.
3.Explai
naboutt hest ocktheor
yofcapitalmovementinflexi
bleexchanger
ate
regi
me.

ANSWERKEYSTOSELF–TESTEXERCI
SES(
ofModul
e–1)

Sel
fTestExer
cise–1

A. 1.Fal
se 2.Fal
se 3.Tr
ue 4.Tr
ue 5.Tr
ue
B. 1.Ref
ersub-
secti
on1.2.
2.
Cr
edi
t(+) Debi
t(
-)
2.Merchandizeexport
s--
---
--
--
--
--
--
--
--
--
--
--
---
---
-Br.800,000
Short
-ter
m capit
aloutf
low---
--
--
--
--
--
--
--
--
--
---
---
--
--
---
--
--
--
--
--
--
--
Br.
800,
000
3.Refersub–sect i
on1.1.3(B)–TheCapi talAccount
4.Refersub-sect
ion1.1.
3( C)-TheRemai ningItemsintheBOPs.
5.Refersecti
on1.2

Sel
f–TestExer
cise–2

A.1.Fal
se 2.Fal se 3.True 4.True 5.Tr
ue 6.Fal
se
B.1.Refersect
ion2.
2(Equi
l
ibr
ium ExchangeRate)
2.R=

3.

4.Ref
erSect
ion2.
5(C)

57
Sel
f–TestExer
cise–3

A.1.False 2.Fal se 3.Fal

se 4.Tr
ue
B.1.Refersubsecti
on3.1.1(A)
2.ReferSubsection3.1.2(B)
3.Refersect
ion3.3(B)

REFERENCES
Car
baugh,
Rober
t.J(
1995)
,Int
ernat
ionalEconomi 5thedi
cs, ti
onSout
hWest
ern
Publ
i
shi
ngCompany
,Ohi
o.
Soder
sten,
BoandReed,
Geof
frey(
1994)
,Int
ernat
ionalEconomi 3rdEdi
cs, ti
on,
Macmi
l
lan,
London.
Sal
vat
ore,
Domi
ni I
ck,nt
ernat
ionalEconomi 3rdEdi
cs, ti
on.
Mannur
,H.
G.(
1983)
,Int
ernat
ionaleconomi
cs-Theor
yandPol
i
cyI
ssues,
Del
hi.
Pi
l
beam,
Kei
th(
1992)
,Int
ernat
ionalEconomi
cs,
Macmi
l
lan,
London.
Ki
ndl
eBer
ger
, 1991)I
P.( nter
nat
ionaleconomi 8thEdi
cs, ti
on,
LaxmanChang,
Del
hi.
Hal
l
wood,
C.Paul
andMacdonal
d,R.(
1994)
,Int
ernat
ionalMoneyandFi 2nd
nance,
Edi
ti
on,
Blackwel
l
,Oxf
ord.

58