Balance of Payments and Exchange Rate Systems L7 Flashcards
1
Q
Balance of payments
A
- A summary of a country’s economic transactions with the rest of the world over a specific period,
2
Q
Components of Balance of Payments
A
- Current Account transactions
- Capital (or “Financial”) Account transactions
- Official Reserves Account transactions
3
Q
Official Reserves Account transactions
A
- Official international reserves – gold and foreign currency-denominated assets
4
Q
Capital (or “Financial”) Account transactions
A
- Capital inflow/outflow
- Capital flight
- Real assets
- Financial assets
- Short-term financial assets
5
Q
Current Account transactions
A
- Export and imports: balance of trade
- Interest and dividend receipts and payments
- Unilateral transfer payments between countries (e.g., grants, gifts or aid)
6
Q
Short-term financial assets
A
example: money market securities
7
Q
Financial assets
A
bank deposits, loans, corporate and government bonds, equities
8
Q
Real assets
A
factories, real estate, FDI
9
Q
Capital inflow
A
when foreigners invest in domestic assets
10
Q
Capital outflow
A
when residents invest in foreign assets
11
Q
Capital flight
A
large-scale rapid movement of financial assets or capital from one country to another
12
Q
Free Floating
A
- Exchange rates determined solely by the market forces of supply and demand
- Limited Government intervention
- Central banks may intervene occasionally to stabilise excessive fluctuations
- (i.e., U.S., Japan, Sweden, Australia)
13
Q
Exchange rate systems around the world
A
- Floating currencies
- Managed floating
- Fixed/pegged currencies
- No separate legal tender
- Target zone
- Crawling pegs
- Special arrangements
14
Q
Managed floating
A
- countries whose Central Banks intervene enough that the IMF can’t classify them as freely floating (i.e., Argentina, Brazil, Columbia, and South Africa)
15
Q
fixed/pegged currencies
A
- A currency ties it’s value to another or a basket of currencies
- (i.e., IMF’s SDR and the Chinese yuan pre-2005)
- Often implemented using a currency board
- The central bank intervenes in the foreign exchange market to maintain the fixed rate.
16
Q
fixed exchange rate
A
- the governments attempts to maintain exchange rates within 1% of the initially set value
17
Q
No separate legal tender
A
- Adopt a currency
- (i.e., Ecuador, El Salvador and Panama have adopted the U.S. dollar
18
Q
Target zone
A
- forex rate is kept within band
- The central bank intervenes if the exchange rate moves beyond the upper or lower limit.
19
Q
Crawling pegs
A
- a fixed exchange rate which is allowed to fluctuate within a band of rates, which are adjusted regularly
20
Q
Special arrangements
A
- Where a regional central bank controls the forex rate system for several countries i.e. Euro
21
Q
Types of monetary intervention
A
- Sterilised intervention
- Non-sterilised intervention
22
Q
Sterilised intervention
A
- An intervention in the foreign exchange market that is offset by an open market transaction in the domestic market to restore the money supply.
- e.g. Central bank buys foreign exchange, while selling government bonds, keeping the domestic money supply steady
23
Q
Non-sterilised intervention
A
- The buying and selling of foreign exchange by a central bank without any offsetting
- Buying Foreign Currency:
increases the domestic money supply - Selling Foreign Currency:
reduces the money supply.
24
Q
Intervention tools
A
- Money supply/interest rates
- Attempt to restrict capital movements
- Tax/subsidize international trade to influence demand for foreign currency
25
Direct intervention
- Central banks use their currency reserves to buy/sell a specific currency in the foreign exchange market creating upward/downward pressure on that currency
26
indirect intervention
- A central bank increases/decreases interest rates, thereby attracting/restricting foreign demand for the home currency to buy high-yield securities.
27
Direct effects of central bank intervention
- monetary policy triggers in(de)flation and alters interest rates
- Can effect supply/demand
- Effect is argued negligible due to small amount (i.e., $20 billion versus $4 trillion overall trade in aday)
28
indirect effects of intervention
- affects the exchange rate through expectations
- interventions can reinforce central bank credibility reducing uncertainty and market volatility.
29
Currency risk in Alternative Exchange rate systems
- Floating rate systems: high ER volatility => high currency risk
- Target zones: less than floating but can be big due to devaluations/revaluations
- Pegged/fixed: latent volatility, currency boards frequently collapse
30
Advantages of Fixed/pegged currencies
- Stable exchange rates reduce uncertainty for international trade and investment
- Can control inflation if pegged to a stable currency
31
Disadvantages of Fixed/pegged currencies
- Limits monetary policy flexibility
- Requires large foreign exchange reserves to maintain the peg
32
Advantages of Floating/flexible currencies
- Allows for independent monetary policy (e.g., interest rate changes).
- Automatically adjusts to economic conditions (e.g., trade imbalances)
33
Disadvantages of Floating/flexible currencies
- High volatility (currency risk) may create uncertainty for businesses and investors.
- Can lead to imported inflation if the currency depreciates too much
34
Advantages of Managed (Dirty) floating
- Reduces excessive volatility while keeping market flexibility.
- Provides some monetary policy independence
35
Disadvantages of Managed (Dirty) floating
- Uncertainty due to unpredictable central bank interventions.
- Requires continuous monitoring of foreign exchange markets
36
Mundell-Fleming Trilemma
only two of the following three are possible simultaneously
- Perfect capital mobility (no capital controls)
- Fixed exchange rates
- Domestic monetary policy autonomy
37
Fixed Exchange Rate + Free Capital Mobility (No Independent Monetary Policy)
- Trade-off: cannot set its own interest rates freely (e.g., Hong Kong)
38
independent Monetary Policy + Free Capital Mobility (No Fixed Exchange Rate)
- Exchange rates fluctuate, which can create currency volatility (e.g., US, UK)
39
Fixed Exchange Rate + Independent Monetary Policy (No Free Capital Mobility)
Trade-off: restriction on capital movement to prevent market forces from disrupting the exchange rate (e.g., China before 2005)
