BLOCK 20 (OPEN

ECONOMY)
(BVFD CHAP 24)

EXCHANGE RATES AND

THE BALANCE OF
PAYMENTS
Exchange rates and international
trade
• In open economies imports (Z) and exports
(X) take place which are denominated in
different currencies.

• The domestic price of foreign exchange

(exchange rate) is the quantity of domestic
currency per unit of the foreign currency.

• The foreign exchange market (forex)

exchanges one national currency for
another at a price called the exchange
rate (e).
 Exchange rate regimes
• The exchange rate (e) can be
denominated as unit of domestic currency
per unit of foreign currency or vice versa
Activity 20.1
• In a fixed exchange rate regime
– the national governments agree to
maintain the convertibility of their
currency at a fixed exchange rate.
• In a flexible exchange rate regime
– the exchange rate is allowed to attain its
free market equilibrium level without any
government intervention using exchange
reserves.
•Flexible/Floating e is determined by the
forces of demand and supply of foreign
currency

• The demand curve for foreign

currency is negatively sloped. As e
increases imports become expensive,
demand for imports and hence the demand
for foreign currency decreases (at given
prices).

• The supply curve of foreign currency is

positively sloped. As e increases, exports
become cheaper and hence exports and
supply of foreign currency increases.
 The foreign exchange market
and floating Exchange Rate
The foreign exchange market is the international market in
which one national currency can be exchanged for another.
The exchange rate is the price at which two currencies exchange.
Under floating exchange rate
Suppose 2 countries: UK & USA System, the exchange rate is
(UK is home country) allowed to find its equilibrium leve
Without central bank intervention
Exchange rate ($/£)

SS(£) Exchange rate is determined by

imports The market forces of demand and
Supply.
e0
DD shows the demand for
pounds by Americans wanting to
buy British goods/ assets. (exports)

DD(£) SS shows the supply of pounds by

exports UK residents wishing to buy
Quantity American goods/assets. (imports)
of pounds Equilibrium exchange rate is e0
 The foreign exchange market
If exports exceed imports, demand for domestic currency exceeds
supply of domestic currency. This increases value of domestic currency
and e increases.

Suppose 2 countries: UK & USA If UK imports exceed

exports and UK
residents want more
Exchange rate ($/£)

SS $ at each exchange
SS1 rate, the supply of £
moves to SS1.
e0
New equilibrium
e1 exchange rate
decreases and
becomes e1.
DD
Quantity
of pounds
 e (₤/$)

D ($) imports S ($) exports

e D=S

0
$0 Quantity of dollars ($)

In this diagram exchange rate is measured as

the value of one unit of foreign currency in terms
of units of domestic currency. Be careful while
reading the exchange rate.
Appreciation and Depreciation

Increase in international value of domestic

currency due to changes in demand and
supply is defined as appreciation of
domestic currency.
• A fall in international value of domestic
currency due to changes in demand and
supply is defined as depreciation of
domestic currency.

•Fixed e is determined by the central bank

of the country and to maintain this e it is
always ready to sell and purchase any
amount of foreign currency at this rate
 Intervention in the forex
market under fixed
exchange rate
Suppose the government is
committed to maintaining the
SS exchange rate at e1 ...
$/£

If the demand for pounds is DD1

A C there is excess demand AC,
e1 E stating that £ is under valued .
The Bank of England must
supply AC £s in return for $,
DD1 which are added to reserves.
DD The reverse occurs if
DD2 demand is at DD2 where £ is
over valued
Quantity of £s
When demand is DD, no intervention is needed ...
there is a balance in transactions between the countries.
Activity SG20.2
Assume that the UK is the domestic country (and the
central bank is the Bank of England) and that the
exchange rate ($/£) is fixed. Supply the correct
combination to fill the gaps in the following
sentence.

If, at the fixed exchange rate the pound (£) is ……

the Bank of England must …….. pounds and its dollar
($) reserves will ……..
consideration that
a currency is overvalued if private
a. Overvalued buy rise demand for the currency at the
going exchange rate is less than total
b. Overvalued sell rise
private supply
c. Undervalued buy rise
d. Overvalued buy fall

An overvalued exchange rate means that the countries exports will be

relatively expensive and imports cheaper. An overvalue exchange rate
 The balance of payments
(BOP)
• … a systematic record of all transactions
between residents of one country and the rest
of the world. It is sum of following accounts.
• Current account
– records international flows of goods, services,
income and transfer payments
• Capital account
– records transactions involving capital
• Financial account
– records international purchases and sales of
financial assets
 Current account
Includes
Exports (X), Which depend upon world income
(Yf) and international competitiveness i.e. real
exchange rate. X=X(Yf, e*P/Pf)

Imports (Z), which depend upon domestic

income (Y) and international competitiveness.
X=X(Y,e*P/Pf)
Other items included are foreign aid, spending
on military abroad, net flows of interest, dividend
and profits.

X-Z is also defined as net exports (NX) or trade

surplus/deficit
 The capital account
• The capital account covers payments such as:
• receipts from other countries for investment in
infrastructure projects
• the transfer of capital into or out of the country
by migrants
• the forgiveness of international debt by the
government
• If inflows exceed outflows there is surplus in
capital account and vice versa.
• BOP= Current Account(CA)+ Capital Account (KA)
• An activity that brings money in the country is defined
as credit and vice versa as debit
Activity SG20.3

Complete the following multiple choice questions, providing a

reason for your answer.

1. The value of a country’s exports is listed in its balance of

payments account as:
a. a credit
b. a debit
c. a payment
d. an investment.

2. In the balance of payments, a net inflow of capital shows up

as a:
a. surplus in the capital account
b. deficit in the capital account
c. surplus in the current account
d. deficit in the current account.
 Floating exchange rates
and the balance of payments
• Under floating e the BOP is always in balance as the
e keeps on adjusting to clear the forex market,
hence
• A current account surplus must be exactly matched
by a deficit on capital and financial accounts, or vice
versa.
• This just says any unspent surplus on goods and
services must be spent buying assets.
• A foreign deficit is financed by running down net
foreign assets (lower assets or higher debt).
• Under fixed e BOP may not be zero and official
intervention is required. Q2
 International
• competitiveness
The competitiveness of one country’s goods in
international markets depends upon:
– the nominal exchange rate e
– relative inflation rates or relative prices.
• The real exchange rate
– measures the relative price of goods from
different countries when measured in a common
currency.
– Changes in the real effective exchange rate are
a good indication of what is happening to
competitiveness.
– Real e= (nominal e)*(foreign price/domestic
price)
– Real e= (nominal e)*(domestic price/foreign
price)
The purchasing power parity (PPP) theory states that
in the long run, the average value of the exchange rate between
two currencies depends on their relative purchasing powers.
Big Mac Index in the mid-1980s. was used to compare the price
of a McDonalds Big Mac burger in different countries. This has
been giving an indication of how far above or below a market
exchange rate is from the PPP rate.

Example :
e is given as 1US$ = 3.62MYR, or 1MYR = 0.28US$ (28 cents).
In the USA a Big Mac costs $4.79 and in Malaysia 7.63MYR, or at
the nominal exchange rate it costs 7.63/3.62 = $2.11 in
Malaysia.
The real exchange rate is
RER = (0.28 )(7.63)/(4.79)= 0.45 American Big Macs per
Malaysian Big Macs. It is cheaper in Malaysia. One can get
2.27 (4.79/2.11) Malaysian Big Macs for one US Big Macs. It tells
that ringgit is undervalued, so dollar value of ringgit will increase
from 28 to 63 cents.
7.63xe=4.79…………… e=4.79/7.63=0.63

Q1
RELATION BETWEEN THE REAL EXCHANGE RATE
(RER) AND NET EXPORTS (NX=X-Z)

The lower the RER, the cheaper are domestic goods

relative to foreign goods; this increases exports and
decreases imports so the following relationship exists
between the RER and net exports (X – Z), UK as
domestic and US as foreign country.
UK effective exchange rate
The effective
exchange rate (eer) is
a weighted average of
individual bilateral
exchange rates.
Sterling has fluctuated
against both the dollar
and the euro, but its
average or effective rate
is a little smoother than
the individual exchange
rates.
The eer is more similar
to the bilateral rate
against the euro than
the dollar, as the UK
mainly trades with other
European countries.
Real exchange rate &
competitiveness
Components of the balance of
payments
• The current account is influenced by:
– competitiveness
– domestic and foreign income
• The capital & financial accounts are influenced
by:
– relative interest rates
• which affect international capital flows.

• Perfect capital mobility means that a vast

quantity of funds flow from one currency to
another if the expected return on assets differs
across currencies.
• No capital mobility means that sale and
 Internal and external
balance
• Internal balance
– a situation for a country when aggregate
demand is at the full-employment level. This
also means that Y=AD=C+I+G+X-Z
• External balance
– a situation for a country when the current
account of the balance of payments just
balances, NX=0
• The combination of internal and external
balance is the long-run equilibrium for the
economy.
Shocks may move an economy away
from internal and external balance
 Concluding comments (1)
• The demand for domestic currency in the forex
market arises from exports and purchases of
domestic assets.
• The supply of domestic currency in the forex
market arises from imports and purchases of
foreign assets.
• Under a floating exchange rate regime demand
and supply determine the exchange rate.
• Under a fixed rate regime, the government
intervenes to maintain the exchange rate.
 Concluding comments (2)
• The real exchange rate adjusts the nominal exchange
rate for prices at home and abroad.
• An increase in the real exchange rate will lead to a
reduction in reduces competitiveness in international
markets.
• Purchasing power parity refers to the change in
nominal exchange rates required to keep the real
exchange rate constant.