Balance of Payments and

Foreign Exchange
International Business
Lecture 2b

Factors of International
Business
Production of Goods and Services
Routes, Roads and Transportation
System
Technological Development
Development of Monetary and
Exchange System
Advertising world wide

 Today we want to talk about national

monetary system before we discuss
international monetary system
And influence and determination of
Exchange Rate

Exchange System

Foreign Exchange Rate

Foreign exchange rates (the price of
one countrys currency in terms of
anothers) are important because
they affect the price of domestically
produced goods sold abroad and the
cost of foreign goods bought
domestically.

Factors Affecting Exchange Rate

Long Run
The theory of purchasing power parity
suggests that long-run changes in the
exchange rate between two countries
currencies are determined by changes in
the relative price levels in the two
countries.
Other factors that affect exchange rates in
the long run are tariffs and quotas, import
demand, export demand, and productivity.

Determinants of Exchange Rate

Short Run
3. In the short run, exchange rates are determined
by
changes in the relative expected return on domestic
assets, which cause the demand curve to shift.
Any factor that changes the relative expected return on
domestic assets will lead to changes in the exchange
rate.
Such factors include changes in the interest rates
on domestic and foreign assets as well as changes in
any of the factors that affect the long-run exchange
rate and hence the expected future exchange rate.

Determinants of Exchange
Rate
4. The asset market approach to exchange rate
determination can explain both the volatility of
exchange rates and the rise of the dollar in the 1980
1984 period and its subsequent fall.
5. Forecasts of foreign exchange rates are very
valuable
to managers of financial institutions because
these rates influence decisions about which assets
denominated in foreign currencies the institutions
should hold and what kinds of trades should be made
by their traders in the foreign exchange market.

Absolute Purchasing Power

Parity

In short, exchange rate between two

countries is equal to the ratio of price
levels of them. This is absolute Purchasing
Power Parity (PPP) theory, which may be
denoted by,

Relative Purchasing Power

Parity
The absolute PPP was ultimately
revised to relative PPP theory, which
asserts that percentage change in
exchange rate between two countries
is equal to the difference of percentage
changes in their price level,

%e = %Pd -%Pf
Or,
When is inflation rate
%e = d - f
Note that inflation is the percentage changes in prices

Fisher Effect
Fisher Effect, named after Irving Fisher,
states that nominal interest rates in each
country are equal to the required real rate of
return plus compensation for expected
inflation.
i=r+
i$ = r $ + $ , i = r +

i= nominal interest rate, r = real interest
rate and is the expected inflation

 International Fisher Effect or

Fisher-Open states that the spot
exchange rate should change in an
amount equal to but in opposite
direction of the difference in interest
rates between two countries.
i$-i = r$ + $ - r - = $ - =
100x (S t-1 - S t)/ S t .... (approx.)

Bangladesh History of FE
Rate
Immediately before Independence Pakistani Rupee was pegged with
Pound Sterling. Up to December 31, 1971 1=Rs. 13.33
From January 1, 1972 1 = Tk. 18.98. Pegged to a single currency,
namely Pound Sterling.
May, 19751 = Tk.30
Since 1976 Re-fixed 18 occasions during 26 April 1976- 13 August
1979
August 1979 Pegged to multiple currencies, i.e., Trade Weighted
Basket Method, 4 Currencies: , $, DM, . being intervention
currency
11 January 1983 Trade Weighted Basket Method with 6 currencies,
Intervention currency US $.
July 1989Trade Weighted Basket Method with 10 currencies
1990 Single Rate, Trade Weighted Basket, daily monitoring through
calculation of REER to maintain purchasing power parity.

 From 1971 to 1990 multiple exchange rates were allowed (Export benefits
like, Export Bonus Scheme, XPL, XPB, Home Remittance Scheme etc.)
1983 a pegged to a basket policy: through monitoring REER, calculated on
the basis of a basket containing currencies of 10/15 countries.
Up to 31 December 1991, a Secondary Exchange Market existed
The SEM rate and the Official rates have been unified from 1 January,
1992.
Since 17 July, 1993, first step towards currency convertibility was taken.
Convertibility on current transactions was adopted in July 1993.
Forex rates were used to be calculated everyday on the basis of previous
days REER of the 15 currencies, dollar being the intervention currency.
Convertibility on capital accounts is not under consideration.

Bangladesh Taka was floated since May 2003 without any trouble.

Whats in the Balance-of-Payments

Accounts?
Three sub-accounts: Current Account, Capital
and Financial Account, Net errors and
omissions
Transactions Within the Current Account

Merchandise
Trade
Services
Transfers
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Income receipts:
Income derived from
ownership of assets, such as
dividends on holdings of
stock and interest on
securities
Page 16

Transactions Within the

Capital and Financial Account
Classification of transactions according to the
5th Edition of the Balance of Payments Manual
(characteristics of transactions)
Capital Account:
Capital transfers
Transfer of title to fixed assets, debt forgiveness, etc.

Financial Account:
Direct Investment:
At least a ten percentage share of the foreign investor
in the capital of the economic subject the foreign
investor invested in
International Finance
Mojmir Mrak

Page 17

Transactions Within the Capital and Financial

Account
Financial Account(continued):
Portfolio investment:
Less than ten percent share of the foreign investor

Other investment:
Trade credits and all other types of long-term and shortterm borrowing abroad (except securities), including
IMF credits and bank credits

International monetary reserves:

Foreign assets under the control of the central bank
Monetary gold
SDR assets
Reserve position of the country in the IMF

International Finance
Mojmir Mrak

Page 18

Errors and Omissions

Complete recording of transactions is impossible
Errors and omissions reflect the statistical discrepancy
of recording the BOP transactions:
Difference between recorded credit statements and
recorded debit statements

Reasons for errors and omissions:

Incomplete recording of transactions between residents
and non-residents
Tax evasion
Time discrepancy between the occurrence of the
transaction and its settlement
Unregistered international merchandise trade
Incomplete data about the escape of capital and about
the financial transactions in offshore centers

International Finance
Mojmir Mrak

Page 19

5. What Are Balance-of-Payments

Surpluses and Deficits?
Sum of the BOP statements is always zero :
Autonomous transactions:
Goals unrelated to the balance of payments

Accommodating (compensatory) transactions:

Finance the difference between autonomous credits and
autonomous debits in BOP

Autonomous credits > autonomous debits: surplus

Which
transaction
s are
autonomou
s?
International Finance
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Merchandise trade
balance
Current account
balance
Basic
balance
Overall balance
Page 20

BOP of Bangladesh
Trade Balance

FY 02

FY 03

Bangladesh
BOP
-1768
-2207

Exports, fob (including EPZ) 1/

5929

6492

Imports, cif (including EPZ) 2/

-7697

-8699

Services (net)

-499

-688

Income (net)

-319

-195

Current transfers

2826

3418

Current Account Balance

240

328

Capital account (net)

410

392

Capital transfers

410

392

Financial account

71

302

Direct investment

65

92

Portfolio investment

-6

Other investment

12

208

-356

-123

365

899

-365

-899

Errors and omissions

OVERALL BALANCE
Reserve Assets

FY 04
-2319

FY 05
-3297

7521

8573

-9840

-11870

874

-870

-374

-641

3743

4290

176

-518

196

163

196

163

78

744

385

540

-313

204

-279

-228

171

161

-171

-161

CONVENTIONS IN
FOREIGN
EXCHANGE
MARKET

(1) Quoting

Wall Street Journal

Argentina (Peso) 0.9900 1.0100
Country Buying Selling
Bid
Ask (Offer)

(2)
Digits Four after decimal

(3)Three letters
Exchange Name
US Dollar USD
Bangladeshi Tk. BDT
Indian Rs.
INR
Pakistani Rs.
PKR

(4) Quotation System Price /Direct Quotation

Indirect Quotation

In Dhaka
Price/Direct Quotation:
1 USD = BDT 60.0000
Indirect Quotation:
1 BDT = USD 0.0167 or 0.0166

5. Notation

/$
eY
/$
e

Taka per USD

Yen per USD

6. Spread
Ask - Bid
Sell - Buy
7. Points (PiP)
1 USD = IRS 57.3005 Ask
= IRS 57.3000 Bid
___________
0.0005 5 points

8. Cross Rate
Bid

Spot

Ask

NPR/USD 49.4000

49.5000

INR/USD 31.3500

31.4500

Cross INR/NPS 31.3500/49.5000 31.45/49.4000

= 0.6333

= 0.6366

Cross NPS/INR 49.4000/31.4500 49.5000/31.35

=1.5707

= 1.5789

(Others Bid divided by own Ask; Others Ask divided

by own Bid)

9. Value date/Delivery date

Bank Note Travelers Demand
Spread is high
Value date : Immediate
Spot Market Spot Rate
Value date 1 or 2 days
Spread very low
Largest Market
Open 24 hours
2/3 months transaction is equal to NYSEs
one day

Forward Market
(Contacted today for the exchange of currencies at a specified
date in the future)
1, 2, 3, 4, 6, 9, 12 months
Value date + 1/2 days
No forecasting
No Speculation
Ensure supply of currency later

Forward Premium Forward Rate Spot Rate

Forward Discount Forward Rate Spot Rate
Forward FlatForward Rate = Spot Rate