Exchange Rate Determination:

Demand and Supply Analysis

 We’ve learned a lot about how to determine
exchange rates by applying no arbitrage
arguments.
 Thinking from a different perspective, exchange

rates are just prices: From economics 101, prices

are determined by the demand law.
 The demand and supply of a country’s currency are
driven by that country’s involvement in international
transactions.
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 Exchange Rate Determination:
Balance of Payments Analysis
 The resulting demand and supply of a country’s
currency due to the international transactions are
recorded in a country’s balance of payments
(BOP) data.
 To correctly interpret a country’s balance of

payments data, first we need to understand

balance of payments accounting. We start with
two examples.

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Examples About International Transactions

• Example 1: company A in the U.S. imports

$100,000 worth of bicycle frames from
Company B in China

cash
the U.S. bicycle frames China

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Examples About International Transactions

• Example 2: the Chinese government has

purchased $100,000,000 worth of U.S.
treasury bonds from the U.S. government

the U.S. T-bond

the U.S. China
cash

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 Balance of Payments Accounting
 Cash inflows will be recorded as credits with “+”
sign, implying a demand of domestic currency.
 Cash outflows will be recorded as debits with “-”
sign, implying a supply of domestic currency.

cash
Country A Commodity or asset country B

debit (-) credit (+)

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 Balance of Payments Accounting
Applied to the Two Examples
 In the first example, company A in the U.S.
importing $100,000 worth of bicycle frames
from Company B in China:
 This transaction results in a $100,000 debit

recorded in the U.S. balance of payment (BOP)

account, and a $100,000 (worth of CNY) credit
recorded in China’s BOP account, implying a
supply of $100,000 and a demand of $100,000
worth of CNY.

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 Balance of Payments Accounting
Applied to the Two Examples
 In the second example, the Chinese government
purchasing $100,000,000 worth of U.S. treasury
bonds:
 This transaction results in a $100,000,000 credit

recorded in the U.S. balance of payment (BOP)

account, and a $100,000,000 (worth of CNY)
debit recorded in China’s BOP account,
implying a demand of $100,000,000, and a
supply of $100,000,000 worth of CNY.

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 Balance of Payments Accounting:
Principle of double-entry bookkeeping
 The BOP record of a country’s international
transactions over a certain period of time is kept in
a way that accords with the principle of double-
entry bookkeeping.
 Double-entry bookkeeping: every credit (debit) in the
balance of payments account in one country is matched
by a debit (credit) in the balance of payments account
in another country
 “A country” here refers the government and
citizens of the country, as well as companies
controlled by the citizens of the country
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U.S. Balance of Payments Data in 2022
(in Billion Dollars)
Credits Debits
Current Account
1 Exports $4,409.5
2 Imports -$5,353.3
3 Unilateral Transfers $9.1 -$13.8
Balance on Current Account -$948.5
Capital Account
4 Direct Investment $351.6 -$435.8
5 Portfolio Investment $756.8 -$437.8
6 Other Investments $407.4 -$40.3
Balance on Capital Account $602.2
7 Statistical Discrepancies $271.4
Overall Balance -$74.9
Official Reserve Account $74.9

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 Balance of Payments Accounts
 The balance of payments (BOP) are composed of
the following:
 The Current Account
 The Capital Account
 Statistical Discrepancy
 The Official Reserves Account

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 The Current Account
 The current account is composed of
 Exports and imports of merchandises, i.e., tangible
goods, such as oil, wheat, clothes, computers, and so on
 Exports and imports of services, such as consulting,
royalties for patents, shipping fees, tourist expenditure,
and so on

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 US Balance of Payment Data:
the Current Account
Credits Debits
Current Account
1 Exports $4,409.5
In 2022, the
2 Imports -$5,353.3
U.S. imported
3 Unilateral Transfers $9.1 -$13.8 more than it
Balance on Current Account -$948.5 exported, thus
Capital Account
4 Direct Investment $351.6 -$435.8 running a
5 Portfolio Investment $756.8 -$437.8 current account
6 Other Investments $407.4 -$40.3
Balance on Capital Account $602.2
deficit of
7 Statistical Discrepancies $271.4 $948.5 billion.
Overall Balance -$74.9
Official Reserve Account $74.9

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 Trade Deficit vs. Trade Surplus
 If the debits exceed the credits in the current account, a
country is running a trade deficit, representing a reduction
in the country’s net wealth
 If the credits exceed the debits in the current account, a
country is running a trade surplus, representing an
increase in the country’s net wealth
 A country finances its current account deficits by running
capital account surpluses (or by drawing down its official
reserve assets).

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 World Trade Deficits and Surpluses in 2019

Red: trade deficit

Blue: trade surplus
Grey: no data
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 The Capital Account
 The capital account records the international
transactions of assets among different countries.
 The Capital account is composed of

 Direct Investment
 Portfolio investments

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 The Capital Account, Direct Investment
 Direct investment occurs when investors builds a
new business in foreign countries, or acquire a
measure of control of foreign business
 For example, when Honda built an assembly

factory in Ohio, it was engaged in direct

investment in the U.S., which was recorded as
credit in the U.S. BOP account and as debit in
Japan’s BOP account.

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The Capital Account, Portfolio Investments
 Portfolio investments refer to sales and purchases
of foreign financial assets such as stocks, bonds
and options that do not involve a transfer of
control
 For example, when a Chinese company purchased

the U.S. equities, it was engaged in portfolio

investments in the U.S., which was recorded as
credit in the U.S. BOP account and as debit in
China’s BOP account.
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 US Balance of Payment Data:
the Capital Account
Credits Debits In 2022, the
Current Account
1 Exports $4,409.5
U.S. attracted a
2 Imports -$5,353.3 net foreign
3 Unilateral Transfers $9.1 -$13.8 investment of
Balance on Current Account
Capital Account
-$948.5 $602.2 billion --
4 Direct Investment $351.6 -$435.8 the rest of the
5 Portfolio Investment $756.8 -$437.8 world found the
6 Other Investments $407.4 -$40.3
Balance on Capital Account $602.2 U.S. to be a
7 Statistical Discrepancies $271.4 good place to
Overall Balance -$74.9
Official Reserve Account $74.9 invest.

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 Statistical Discrepancy
and Overall Balance
 Statistical discrepancy represents omissions and
mis-recorded transactions
 The Table in last slide shows a statistical discrepancy of
+$271.4 billion in the U.S. BOP account in 2022.
 The overall balance represents the cumulative
balance of payments (BOP) including the current
account and capital account, corrected by the
statistical discrepancy.
 A country is running BOP deficit (surplus) if the overall
balance is negative (positive).
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 Statistical Discrepancy
Credits Debits
Current Account
1 Exports $4,409.5 In 2022, the
2 Imports -$5,353.3 U.S. BOP
3 Unilateral Transfers $9.1 -$13.8 data are
Balance on Current Account -$948.5
Capital Account subject to a
4 Direct Investment $351.6 -$435.8 statistical
5
6
Portfolio Investment
Other Investments
$756.8
$407.4
-$437.8
-$40.3
discrepancy
Balance on Capital Account $602.2 of +$271.4
7 Statistical Discrepancies
Overall Balance
$271.4
-$74.9
billion
Official Reserve Account $74.9

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 The Overall Balance
Credits Debits In 2022, the
Current Account
1 Exports $4,409.5
U.S. was
2 Imports -$5,353.3
running a
3 Unilateral Transfers $9.1 -$13.8 BOP deficit
Balance on Current Account -$948.5 with the
Capital Account
4 Direct Investment $351.6 -$435.8
overall
5 Portfolio Investment $756.8 -$437.8 balance being
6 Other Investments $407.4 -$40.3
Balance on Capital Account $602.2
-$74.9
7 Statistical Discrepancies $271.4 billion :-
Overall Balance -$74.9
Official Reserve Account $74.9
$948.5 +
$602.2 +
21 $271.4 = -
 Balance of Payments and the
Exchange Rate
Credits Debits Exchange rate $
Current Account
1 Exports $4,409.5 P S
2 Imports -$5,353.3
3 Unilateral Transfers $9.1 -$13.8
Balance on Current Account -$948.5
Capital Account
4 Direct Investment $351.6 -$435.8
5 Portfolio Investment $756.8 -$437.8
6 Other Investments $407.4 -$40.3 D
Balance on Capital Account $602.2
7 Statistical Discrepancies $271.4
Overall Balance -$74.9 Q
Official Reserve Account $74.9

As U.S. citizens import or invest overseas, we see supplies of $ in the FX

22 market
 Balance of Payments and the
Exchange Rate
Credits Debits Exchange rate $
Current Account
1 Exports $4,409.5 P S
2 Imports -$5,353.3
3 Unilateral Transfers $9.1 -$13.8
Balance on Current Account -$948.5
Capital Account
4 Direct Investment $351.6 -$435.8
5 Portfolio Investment $756.8 -$437.8
6 Other Investments $407.4 -$40.3 D
Balance on Capital Account $602.2
7 Statistical Discrepancies $271.4
Overall Balance -$74.9 Q
Official Reserve Account $74.9

As U.S. exports or receive foreign investments, we see demands of $ in

23 the FX market
 Balance of Payments and the
Exchange Rate
Credits Debits
Current Account Exchange rate $
1 Exports $4,409.5
P S
2 Imports -$5,353.3
3 Unilateral Transfers $9.1 -$13.8
Balance on Current Account -$948.5
Capital Account
4 Direct Investment $351.6 -$435.8
5 Portfolio Investment $756.8 -$437.8
6 Other Investments
Balance on Capital Account
$407.4 -$40.3 D
$602.2
7 Statistical Discrepancies $271.4
Overall Balance -$74.9 Q
Official Reserve Account $74.9
The overall balance deficit means there exists excessive supply of dollar
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 Balance of Payments and the
Exchange Rate
Credits Debits
Current Account Exchange rate $
1 Exports $4,409.5
P S
2 Imports -$5,353.3
3 Unilateral Transfers $9.1 -$13.8
Balance on Current Account -$948.5
Capital Account
4 Direct Investment $351.6 -$435.8
5 Portfolio Investment $756.8 -$437.8
6 Other Investments
Balance on Capital Account
$407.4 -$40.3 D
$602.2
7 Statistical Discrepancies $271.4
Overall Balance -$74.9 Q
Official Reserve Account $74.9
If the government does not intervene, dollar will depreciate to the level where
25 demand equals supply, implying zero overall balance
 The Balance of Payments Identity
In the following analysis, ignore statistical
discrepancy for simplicity.

When there is no government intervention,

BCA + BKA = 0
where
BCA = balance on current account
BKA = balance on capital account

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 U.S. Balance of Payments:
the Official Reserve Account
Credits Debits
Current Account Although the
1 Exports $4,409.5 U.S. allows its
2 Imports -$5,353.3 currency to “float
3 Unilateral Transfers $9.1 -$13.8 independently”
Balance on Current Account -$948.5
Capital Account against other
4 Direct Investment $351.6 -$435.8 currencies, the
5 Portfolio Investment $756.8 -$437.8 U.S. government
6 Other Investments $407.4 -$40.3
Balance on Capital Account $602.2
still maintains
7 Statistical Discrepancies $271.4 nonzero, albeit
Overall Balance -$74.9 small, official
Official Reserve Account $74.9
reserve account
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 The Official Reserve Account
 If a government wants to intervene in the FX market,
first it has to keep an official reserve account:
 The official reserve account is used to accommodate a
country’s international payment gap indicated by the overall
balance
 In 2022, the U.S. decreased its official reserve holdings
by $74.9 billion to take care of the BOP deficit of the
same amount.
 By decreasing its reserve holdings, the U.S. generated
cash inflows which will be recorded as credit with
positive sign in its reserve account.
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 Government Intervention
Credits Debits
Current Account Exchange rate $
1 Exports $4,409.5
P S
2 Imports -$5,353.3
3 Unilateral Transfers $9.1 -$13.8
Balance on Current Account -$948.5
Capital Account
4 Direct Investment $351.6 -$435.8 D’
5 Portfolio Investment $756.8 -$437.8
6 Other Investments
Balance on Capital Account
$407.4 -$40.3 D
$602.2
7 Statistical Discrepancies $271.4
Overall Balance -$74.9 Q
Official Reserve Account $74.9
By increasing the demand of dollar, the U.S. government prevents dollar from an
29 immediate depreciation.
 Government Intervention
Credits Debits
Current Account In the U.S.
1 Exports $4,409.5 Balance of
2 Imports -$5,353.3 Payment Data
3 Unilateral Transfers
Balance on Current Account
$9.1 -$13.8 in 2022, we
-$948.5
Capital Account verify that
4 Direct Investment $351.6 -$435.8 -BRA= -
5 Portfolio Investment $756.8 -$437.8
6 Other Investments $407.4 -$40.3 $74.9 =
Balance on Capital Account $602.2 Overall
7 Statistical Discrepancies $271.4
Overall Balance -$74.9 Balance =
Official Reserve Account $74.9 BCA + BKA
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 The Balance of Payments Identity
Take into account the government intervention, the BOP
identity is written as BCA + BKA + BRA = 0
where
BCA = balance on current account
BKA = balance on capital account
BRA = balance on the reserves account

Of course, the above formula degenerates to

BCA + BKA = 0
when there is no government intervention.
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 The Official Reserves Account:
More Examples
 Although a country can use its official reserve holdings to
support its currency, the currency might be subject to
dramatic depreciation once the country has run out of its
reserves.
 For example, as the run on the baht started in the early

1997, the Thai central bank initially tried to defend its

currency by drawing down on its reserve holdings.
 After running out its reserves, Thai central bank was

forced to let baht “float” against dollar, which initiated

the Asian currency crisis.
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 The Official Reserves Account:
More Examples
 Conversely, by building up its official reserve
holdings, the government can prevent its currency
from immediate appreciation.
 Following the persistent purchases of the U.S. treasury bonds
and assets, China has built up an enormous amount of official
reserve holdings, which reaches over two trillion dollar by the
end of 2022.
 Building up official reserves will generate cash outflows.
Hence it increases the supply of domestic currency and will be
recorded as debits in the country’s BOP account.

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 The Official Reserve Assets
 Gold was the predominant international reserve
asset before 1945
 After 1945, international reserve asset comprises:

 Gold
 Foreign exchange
 Special drawing rights (SDRs)
 Reserve positions in the International Monetary Fund
(IMF)

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 The Foreign Exchange Reserves
 Currency Composition of the World’s Foreign Exchange Reserves
(Percent of Total)
Currency 2006 2008 2010 2012 2014 2016 2018 2020 2022
U.S. dollar 65.0 63.8 62.2 61.5 65.2 65.4 61.7 59.0 58.4
Euro 25.0 26.2 25.8 24.1 21.2 19.7 20.7 21.2 20.5
Chinese yuan - - - - - 1.07 1.89 2.25 2.69
JP yen 3.46 3.47 3.66 4.09 3.55 3.96 5.20 6.03 5.51
British pound 4.52 4.22 3.94 4.04 3.70 4.34 4.42 4.69 4.95
Australian dollar - - - 1.46 1.60 1.69 1.62 1.82 1.96
Canadian dollar - - - 1.43 1.75 1.94 1.84 2.07 2.38
Source: International Monetary Fund

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 Questions about Central Bank Reserve
Diversification
 Do you think that central banks should diversify their
official reserves among assets denominated in different
currencies? Why? If yes, what would be the practical
difficulties?
 What would be the effects of official reserve diversification
on the U.S. treasury bonds?
 Do you think that central banks should diversify their
official reserves among different types of assets, even
though they are still denominated in dollars? Why? If yes,
what would be the potential problems?

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Balances on the Current (BCA) and Capital
(BKA) Accounts of the United States

Source: IMF International Financial Statistics Yearbook, various issues

37
Balances on the Current (BCA) and Capital
(BKA) Accounts of United Kingdom

Source: IMF International Financial Statistics Yearbook, various issues

38
Balances on the Current (BCA) and Capital
(BKA) Accounts of Japan

Source: IMF International Financial Statistics Yearbook, various issues

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Balances on the Current (BCA) and Capital
(BKA) Accounts of China

Source: IMF International Financial Statistics Yearbook, various issues

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 Questions about CNY
 What would be the consequences if China
allows CNY to appreciate dramatically?
 Besides letting CNY to appreciate, does China
have any other option(s) to cut its trade
surpluses with the US? if yes, compare the
alternative option(s) with the option of simply
letting CNY to appreciate.

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