BOP AND FOREIGN EXCHANGE RATE Flashcards
what is the definition of BOP
statement of all the international transactions of a country with the rest of the world over a period of time.
what is the BOP made out of
current account
capital and financial account
reserve assests
what makes up the current account in BOP
- payment for exports and imports of goods and services - (X-M) as export revenue are inflows of currency into the country while import expenditure are outflows of currency
- primary income - wages, rent, interest and profits flowing into and out of the country e.g US investments in sg that repatriate profits back to US and SG investments that do the same in the US
- secondary income - unilateral transfers of money as gifts or remittance can be govt grants and aids as well
what makes up the capital and financial acc in BOP
i) direct investments - sales and purchases of fixed assets like land, buildings and factories. FDI are long-term capital flows.
ii) portfolio investments - financial assets like stocks, bonds and other financial investment vehicles that are more liquid. These are short-term capital flows.
what are reserve assets
transactions in the official reserve by a countrys central bank.
how does the value of a currency appreciate
When there is an increase in the demand by the jap for sg exports for exp due to a rise in NY of the jap, this results in increased demand for SGD as the jap need SGD to pay for sg exports. DD curve shifts right and at the current exchange rate there is a shortage of SGD causing SGD to appreciate
what is a managed float exchange rate system
exchange rate is allowed to fluctuate according to market forces but between an undisclosed band. if the value falls or rises above the limit then the central bank will intervene by selling off currency or buying back currency with foreign reserves.
what are some causes or BOT deficit or surplus
- change in domestic GPL compared to foreign GPL
- change in the countrys exchange rate
- change in economic growth rate of trading partners
- govt policies
how does a change in relative GPL cause a BOT deficit
Countries may face BOT deficits if they have persistently high inflation that is more severe than that of TP. For e.g. if there is a supply chain disruption that causes the price of imported inputs of production to increase and the UCOP increases, firms only willing to produce at the same level of output if they are paid a higher price, this means that inflation increases as GPL increases. Assuming that PEDx is more than one than this increase in price will cause the Qd for exports to drop mtp leading to X decreasing. P of M is now relatively cheaper compared to local GAS so HHs switch to imports causing M to increase. Hence (X-M) decreases and if it was at eqm, it is now a deficit.
how does appreciation of a currency cause BOT deficit
When there is an appreciation of a country’s currency more units of foreign currency are required to buy 1 unit of domestic currency. This causes the price of exports in foreign currency to increase causing the demand for US exports to decrease so X revenue decreases. Since less units of foreign currency are required to buy one USD, P of imports decrease. Assuming PEDm more than 1 there will be a mtp increase in Qd so M expenditure increases. Hence (X-M) decreases
how does a change in economic growth rate cause BOT deficit
When key trading partner of a country enter into a recession, their national income falls leaving its population with less purchasing power and disposable income to spend on imports. Assuming that the TP imports normal goods then there will be a decrease in DDm and decrease in TP import expenditure. Hence the country will have less export revenue leading to a BOT deficit.
how does a BOT deficit affect consumers if its cause of an increase in imported consumer goods
In the SR, if the BOT deficit is caused by higher levels of consumption of imported consumer GAS then the increase in variety and higher levels of consumption of GAS will cause a material SOL increase.
In the LR, the BOT deficit may cause the material SOL of future generations to deteriorate. Since more is spend on imports than received from exports, countries may have to borrow to finance the imports. These countries are considered net borrowers and the debt incurred will have to be paid by future generations which sacrifice their consumption to do so. Since future generations cut back on their consumption of imports, mSOL decreases.
How does a BOT deficit affect consumers if it was due to increased exports of capital goods
For developing countries this could be good as the capital could be used to build infrastructure like railway, airports and seaports which improves the export capability of the country. In the LR this could allow the country to have a BOT surplus in the future which allows them to pay off their debts and not compromise on the future mSOL of its population.
Additionally, there could be an increase in the country’s capital stock provided that the increase in net in investment exceeds capital depreciation. This allows the productive capacity of an economy to increase. The increase in capital stock could cause capital deepening as the capital makes other FOPs more efficient, decreasing the UCOP for firms and increasing price competitiveness. With this, firms are now more willing to produce at the same output level and can accept lower prices to clear stock. Hence AS increases as represented by a downward shift in the AS curve, ceteris paribus, there will be an increase in national output which combined with lower GPL means that consumers consumer more GAS as they have increased PP so their mSOL increases
BOT deficit on consumers
net lenders, lending to TP to buy exports. over time, it gets back principal sum plus interest payments. earnings on interest add to countries gross NY. increase in PP of the people and mSOL rising.
how does a BOT deficit lead to negative macro outcome ( foreign reserves )
lead to a rundown of foreign reserves, if managed float system is used. rising BOT deficits means X decrease M increase. causing decreased demand and supply of the currency respectively. downward pressure on ER. central bank buys excess SS to maintain value of currency using foreign reserves. foreign reserves are limited, affecting their ability to maintain stability in the future. there will be speculation against the currency, causing capital flight. investors pull away their investments in the country by selling assets and moving funds away. further downward pressure on the ER causing it to depreciate. cause them to give up on managed float and turn to floating where their currency keeps depreciating.
