exchange rates and the balance of payments Flashcards
what is a closed economy?
an economy that does not trade or interact financially with other countries. the global economy is a closed economy
what is an open economy?
an open economy trades with other countries. most national economies are open economies
what is the most common measure of openness?
the ratio of exports or imports to income
what is the trend for openess?
there is a postive trend for openess , with countries becoming more open over time
what is another measure of openess that is not export to income ratio?
the volume of transactions in the foreign exchange markets
what is a credit item on the balance of payments?
any transaction that requires the purchase of domestic currency is a credit item on the countries balance of payments
why must the sum of all credit items equal the sum of all debit items?
this is due to the fact that one can only purchase domestic currency if someone else is willing to supply it
what are the three subaccounts of the balance of payments?
there is the current accout which mainly records the cross border transcactions in goods and services, the capital account which records private financial transactions and the official reserves accounts which records changes in the central banks foreign exchange reserves
what is the advantage of recording private capital flows and the change in official net foreign assets seperately?
it reveals at a glance whether foreign exchange market transactions were due to market forces alone or whether they included the central bank as a buyer or a seller.
there are two main reasons why this is useful:
1) it gives a notion of the balance of payments imbalances
2) it shows the extent the price in the foreign exchange market ie the exchange rate, was left to market forces alone
what is a balance of payments surplus?
it is defined as the balance generated by the private, non-official involvement in the foreign exchange market. it is equal to the official reserves account with a negative sign
BP surplus = - OR
it is a hypothetical situation where the country would have a surplus on the balance of payments provided the central bank had not participated in the foreign exchange market
what occurs under a ideal system of flexible exchange rates?
the central bank does not intervene in the foreign exchange markets and the official reserves account is zero
under a flexible foreign exchange market, what is the balance of payments reduced to?
as the OR=0 , the balance of payment is reduced to BP = CA + CP = 0 or CA = - CP
what is the formula for the current account equillbrium?
Y = (x1/m1) Yworld + [(x2+m2)/m1] R where Y world is the world income, R is the real exchange rate
what is the import function?
m1 x Y - m2 x R where Y is the income and R is the real exchange rate
what is the export function
x1 x Yworld + x2 x R where Yworld is world income and R is the real exchange rate
why does the exchange rate for our exports have a postive coefficent?
if our exchange rate depreciates against other countries then the other countries currencies appreciate against ours so this makes our exports cheaper therefore they want to purchase more of them
what occurs to the current account equillbrium line when there is a real depreciation to the currency?
a real depreciation will shift the CA= 0 line to the right as if our currency depreciates that means the real exchange rate increases as foreign currencies can now purchase more of the domestic currency. this means imports will decrease and the exports increase.
