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.
what occurs to the current account equillbrium line when there is an increase in the world income?
the line shifts to the right
what occurs when domestic incomes rise but the real exchange rate remains constant?
this will lead to a rise in imports but the exports will remain the same as the exchange has remained the same. this will lead us to wander off the CA=0 line where we are in a current account defecit to the right of the line
what is the return on one unit of capital in the home country equivelent to?
investing in one unit of capital in the hojme country gives an annual return equal to the interest rate i.
what does investing in one unit of capital abroad equivalent to?
it is equivalent to the foreign interest rate plus the percentage change of the exchange rate
what does it mean for an investor to be risk neutral?
they are indifferent between having domestic or foreign government bonds in their portforlio ie i = iworld + [(Eexpected - E)/E]
what is the capital account determined by?
interest rate differentials
what is the function for the capital account>
CP = k( i - iworld) where i is the interest rate
what occurs to the capital account when the domestic interest rate falls?
the capital account is diminished
what does the line that balances domestic and international returns look like in the i-Y plane?
it it a horzontal line at the world interest rate
what is the foreign exchage market equillbirium determined by?
it is determined by the interaction between the current account and the capital account. it is in equillbrium when the current account surplus (defecit) exactly matches the capital account defecit (surplus)
why does the FE curve have a postive gradient?
it is because an increase in the income stimulates an increase in imports which deteriorates the current account. to match this we need to export more interest bearing assets so this can only be achieved by increasing the interest rate to make them more attractive
what is the coefficient k in the capital account equation mean and what is its affect on the FE curve and the CP curve?
it measures investors reactions to observesed excess returns, must be very large. this results in a very steep CP plane on the current account- income plane. the steeper the CP plane, the flatter the accompying FE line. under perfect capital mobility, the FE curve can be assumed to be horizontal
what is the important distinciton between the CP =0 line and the nearly horizontal FE curve?
on the CP = 0 line, the capital account will be in equillbrium whereas on the FE curve the capital account can only be in equillbrium if the current account is also in equillbrium. if the CA curve is in surplus or defecit then the capital account must be in defecit or surplus
what is the FE curve?
the FE curve identified combinations of income and the interest rate for which the foreign exchange market is in equillbrium
what is the formula for the general FE curve?
i= iworld + (m1/k) x Y -(x1/k) x Yworld - [(m2+x2)/k] x R
what is constantly shifting the FE curves postion?
the world interest rate
how does the k coefficent effect the gradient of the FE curve?
if k is very large then capital flows respond very strongly to opening interest differentials and the other coefficent becomes very low. therefore the slope of the curve becomes very samll and neither world income nor the real exchange rate has a relevant impact on the positions of the FE curve.
if k tends to infinity then what does the FE curve simplify to
the FE curve simplifies to i = iworld
what are the three endogenous variables in the FE-IS-LM model?
the interest rate, the exchange rate, the income
what is the only way for the FE curve to be in equillbrium?
it notes that the only way for the foreign exchange market to be in equillbrium is if the domestic interest rate is equal to the world interest rate
how can you find the equilibrium income level in the money market when the FE curve is in equilibrium?
once the equilibrium interest rate has been determined i the foreign exchange market, then the money market equilibrium tells us exactly where the equilibrium income level must be as it is determined by the interaction between the FE curve and the LM curve
how can we be sure that the IS curve, the equillibrium condition for the goods markets passes through the intersection of the FE and IS curve ( called A) and how can we be sure that the equillbrium conditions stated by the IS curve are compatible with the already predetermined levels of i and Y?
there is a whole series of IS curves for each exchange rate so there is always one IS curve that passes through A.
what is the formula for the IS curve to find real exchange rate?
R = [(1 - c + m1) / ( m2 + x2)] x Y - [( I + G + x1 x Yworld) / (m2 + x2)] + [ b / ( m2 + x2)] x i
what is the formula for the LM curve?
Y = M/k + (h/k) x i
what is the formula for the FE curve?
i = i world
how do we derive the equillibrium exchange rate formula
start at the interest rate equillbrium which is determined by the condition i = iworld. you then subsitute this interest rate equillbrium condition into the LM curve equation to get Y = M/k + [ (h/k) x i world ]. you then subsitute this income into the IS curve equation to get the equilibrium exchange rate formula
