CHAPTER 4 Flashcards
What does the balance of payments (BoP) represent?
An accounting record of a country’s involvement in international trade and capital flows.
What are the two main components of the balance of payments?
- Current account
- Financial account
What does the exchange rate denote?
The international exchange value of the domestic currency against another currency.
What are the components of the current account?
- Exports
- Imports
- Net income payments
- Net current transfers
What determines the level of imports (M)?
- Domestic income (Y)
- South African prices relative to foreign prices
- The exchange rate
- Trade policy
True or False: An increase in domestic income leads to an increase in imports.
True
What are the determinants of exports (X)?
- Foreign income (Yf)
- South African prices relative to foreign prices
- The exchange rate
How is the current account balance calculated?
Current account = (X - M)
What is a current account surplus?
Net inflow of funds in the current account.
What is a current account deficit?
Net outflow of funds in the current account.
What happens to the current account if the rand depreciates?
The current account will first deteriorate before it improves.
What are the two types of capital flows?
- Direct investment
- Portfolio investment
What is direct investment?
Setting up new companies or buying shares in companies with the objective to gain a meaningful say in management.
What factors influence capital flows?
- Relative interest rates on financial investments
- Relative rates of return on real investment
- Exchange rate
- Economic and political expectations
What is the effect of a BoP surplus on foreign reserves?
Increases foreign reserves.
What is the impact of a BoP deficit on the money supply?
Decreases the money supply.
What is the nominal exchange rate?
Price of one currency in terms of another.
Define depreciation in the context of currency.
Value of the rand weakens.
What is the chain reaction when the rand depreciates?
- Price of imports (M) increases
- Price of exports (X) increases
- Imports are discouraged and exports are encouraged
- Current account balance (X - M) increases
- Expenditure and production increases
- GDP and Y increase
What is the role of net factor payments (NFP) in the current account?
Income payments that consist of wages and capital, representing ‘invisible trade’.
What does the current account J-curve illustrate?
The initial deterioration and eventual improvement of the current account after a depreciation of the currency.
Fill in the blank: If the BoP is positive, it indicates a net _______ of funds.
inflow
Fill in the blank: If the BoP is negative, it indicates a net _______ of funds.
outflow
What is the nominal exchange rate?
Price of one currency in terms of another
Example: $1 = R14.72 (R1 = $0.068)
What does depreciation of a currency mean?
Value of the rand weakens
Example: $1 = R14.72 to $1 = R15.00
What does appreciation of a currency mean?
Value of the rand strengthens
Example: $1 = R14.72 to $1 = R14.50
What is the real exchange rate?
An adjusted exchange rate that takes differences between countries’ price levels into account
What is the effective exchange rate?
Expresses the value of the Rand relative to a ‘basket’ of important foreign currencies
What is a spot exchange rate?
The conventional exchange rate calculated for immediate transactions
What is a forward exchange rate?
The rate related to foreign exchange transactions to occur on some date in the future
How are exchange rates determined?
In the market for currencies, based on demand and supply
What is Purchasing Power Parity (PPP)?
Exchange rates account for differences in prices between countries
What is the Big Mac Index?
An index based on the theory of purchasing power parity, using the price of a Big Mac as a benchmark
What does a BoP surplus indicate?
Net inflow of funds, leading to an increase in demand for rands
What does a BoP deficit indicate?
Net outflow of funds, leading to an increase in supply of rands
What are floating exchange rates?
Exchange rates determined by the interaction of demand and supply in a free foreign exchange system
What are fixed (pegged) exchange rates?
Exchange rates set at a particular level by reserve bank intervention
What are dirty exchange rates?
A combination of floating and fixed exchange rates where the reserve bank moderates volatility
What causes exchange rates to appreciate?
Increase in demand for local currency due to exports or investment attractiveness
What causes exchange rates to depreciate?
Increase in supply of local currency due to imports or investment outflows
What is the BoP adjustment process?
Forces that eliminate disequilibrium in the balance of payments
What happens when BoP is in a deficit?
Outflow of foreign exchange leads to decreased money supply and increased interest rates
What is the IS-LM-BP model?
A model that includes the foreign sector to analyze economic relationships
What does the BP curve represent?
Shows combinations of Y and r consistent with BoP equilibrium
What does a shift in the BP curve indicate?
Changes in current account or financial account conditions
Fill in the blank: The Big Mac costs R33.50 in South Africa and US$5.66 in the United States. The implied exchange rate is _______.
5.92
True or False: A higher level of income requires a lower interest rate to maintain BoP equilibrium.
False
What is the impact of an increase in money supply on the LM curve?
Shifts the LM curve to the right
What is the relationship between BoP position and the BP curve?
A better BoP position shifts the BP curve to the right
What is the initial equilibrium condition in the context of the IS-LM-BP model?
IS = LM = BP
What happens in Phase 1 during an external disturbance?
X increase (IS right) → Y increase
What is the net effect of an increase in Y in Phase 1?
Y increase leads to M increase and CA deficit
What is the result of a BoP surplus in Phase 2?
LM shifts right due to money supply increase
How does an increase in Y affect the capital account?
CA deficit develops
What happens to the exchange rate during a BoP surplus?
Rand appreciates → X decrease & M increase
What is the effect of a BoP deficit on the LM curve?
LM shifts left due to a decrease in money supply
What is the net effect of a BoP deficit?
Y decreases & r decreases
What occurs when Y decreases due to a BoP deficit?
M decreases → CA surplus develops
What is the primary effect of expansionary monetary policy?
Repo decrease → MS increase → LM shifts right
What is the secondary effect of an increase in Y due to expansionary monetary policy?
MD increases → r increases → I decreases
Fill in the blank: If Y increases, CA ______ develops.
deficit
What is the net effect of primary and secondary monetary market effects in expansionary monetary policy?
Y increase, r decrease, CA deficit, FA deficit, BoP deficit
What is the primary effect of contractionary fiscal policy?
G decreases → Y decreases (IS shifts left)
What happens to the BoP when Y decreases due to contractionary fiscal policy?
CA surplus develops
How does the monetary market react to a decrease in Y?
r decreases → I increases → Y increases
What is the net effect of contractionary fiscal policy’s primary and secondary effects?
Y decrease, r decrease, CA surplus, FA deficit, BoP deficit
What is the effect of negative external disturbances on Y?
Y decreases due to decreased X
What is the effect of negative external disturbances on the current account?
CA deficit develops
What happens to the LM curve during negative external disturbances?
LM shifts left due to decreased money supply
Fill in the blank: During a BoP deficit, rand ______.
depreciates
What is the concluding effect of a BoP adjustment via exchange rates during a deficit?
X increase & M decrease → CA deficit reduced
What is the process that continues until BoP equals zero?
Adjustment effects through monetary supply and exchange rates
