L25/L26 - Balance of Payments and The Exchange Rate Flashcards
What is an appreciation in the pound?
A rise in the external value of the pound (i.e. a rise in the exchange
rate)
What is a depreciation in the pound?
A fall in the external value of the pound (i.e. a fall in the exchange
rate)
Where does the demand for money arise from?
All international transactions that generate a receipt of foreign exchange.
i. e.
- UK Exports
- Income Payments and Transfers
- Capital Inflows
- Reserve Currency
What are the different types of Exchange Rate markets?
- Spot Market
- Forward/Futures Market
What’s a spot market?
Traded for immediate delivery
What’s a forward/future market?
Contracts for future delivery
What is implied via the demand for one source of currency?
There is a supply of another currency.
And if there’s a supply of pounds. Implies a demand of dollars.
What causes the shifts in demand and supply that lead to changes in
exchange rates?
- a rise in the domestic price of exports
- a rise in the foreign price of imports
- Changes in price levels
- Capital movements
If the price level of one country is rising relative to that of another
country, the equilibrium value of its currency will be falling relative to
that of the other country.
Why have Exchange rate been volatile?
View that PPP theory explains it.
Theory holds that a currency will tend to have the same purchasing power when it is spent in its home country as it would have if it were converted to foreign exchange and spent in the foreign country
exerts a strong influence on exchange rates in the long
term
What is a fixed exchange rate system? (like Bretton Woods system)
Authorities intervene in the foreign exchange market to maintain the exchange rate within a specified range.
What is a flexible (or floating) exchange rate regime?
Exchange rate is market-determined by supply and demand for the currency.
What is Exchange Rate Overshooting? (
- Dornbusche’s observation
- Differences in interest rates between countries can trigger large capital flows (since investors seek to place their funds where returns are highest)
- Causes swings in exchange rate between the two countries
(Graph shown on notes)
What is the Openness Index?
About how open an economy is.
OI = X+ IM/GDP x100
What is the Uncovered interest rate parity?
Used to explain interest rate differentials between countries.
It = It* + Change in Et
Where:
It is domestic interest rate
It* is foreign interest rates
Change (Triangle) in Et refers to change in exchange rates
What makes up the balance of Payments?
- The Current Account
- The Capital Account
- The Financial Account
What is the Current Account?
Records international flows of goods, services, income and transfer payments.
i.e:
Trade in Goods and Services
Investment Income
Transfers
What is the Capital Account?
Records transactions involving capital.
i. e
- Debt forgiveness, Inheritance Taxes, Sales of Tangible and Intangible Assets
What makes up the Trade Balance?
Balance between trade in goods and services
What makes up the Income Balance?
Balance between Investment Income and Transfers
How is the Current Account divided?
Into 3 main sections:
1) Visible Account
2) Invisible Account
3) Current Transfers
How can you balance the current account?
By matching it with a balance on the capital and financial accounts of equal magnitude.
So, it overall balances out.
e.g:
If current account in positive, then capital account must be in minus
If all in positive then Surplus
If all in negative then Deficit
What do persistent deficits or surpluses involve?
Persistent Deficits or Surpluses, involve a build-up or run-down of a country’s net foreign asset
Nothing inherently good or bad about surpluses or deificits on current account
When could a current account deficit be healthy?
It could be a healthy sign when indicates a country is borrowing from abroad to finance investment in Real economic growth
When could a current account deficit be unhealthy?
Unhealthy if it involves borrowing to finance unproductive projects
What are some examples of crisises?
Mexican Crisis (1994) Asian Crisis (1997) Russian Crisis (1998) Argentina Crisis (2001-2) Iceland Crisis (2008)
What’s the most common reason for a balance of payments crises?
- It’s because investors in a specific economy revise their analysis of an economy’s prospects and come to believe that the level of international borrowing is unsustainable.
- At this point, capital inflows turn into outflows as foreigners try to get their money out and also domestic residents try to move their funds abroad.
- If the exchange rate is pegged by the domestic government, there will be a run on official foreign exchange reserves and this
will put pressure on the domestic authorities to change their monetary and/or fiscal policies. - If the currency is floating, the exchange rate will fall sharply and
this will lead to a sharp increase in domestic inflation. - The existence of a current account balance of payments deficit
tells us only that an economy ís total spending exceeds its total
income and that it has a capital inflow.
What are the causes of Balance Of Payment crises?
- It could be political instability or the introduction of wasteful government spending plans.
- Sharp fall in market prices of the countries main export commodity
- General rise in world interest rates that sharply increases the costs of servicing foreign debts
What are the roles of the IMF?
- Provision of foreign currencies (via quotas)
- Provision of world liquidity
- The SDR (Spatial Drawing Right): Basically own currency
- IMF Stabilisation Programme (Follows the Washington Consensus)
i. e Liberalisation of economy, Fiscal and Monetary Contraction. If a country asks for a loan.
What groups suffer from the after-effects of BoP crises?
- International banks and other investors who to the country thats in problems as their investment has fallen sharply
- Domestic residents when their incomes fall and wealth too
What are the critiques of IMF Policies?
- IMF loans and the
conditions attached help to bailout international investors do little to help the adjustment pains felt by domestic residents - IMF Stabilisation programme in general
What are the critiques of the IMF Stabilisation programme?
- IMF programmes inappropriate
- IMF programmes inflexible
- IMF support inadequate and too expensive
- IMF dominated by major industrial countries.
What are the different Exchange Rate regimes?
- Free Float
- Gold Standard
- Adjustable Peg
- Managed Float
What are the features of a gold standard regime?
- Automatic intervention
- Fixed Exchange Rate
What are the features of a Free Floating system?
- No intervention
- Floating exchange rate
What are the features of an Adjustable Peg?
- Some discretionary intervention
- Fixed Exchange Rate
What are the features of a managed floating system?
- A managed floating system
- Some discretionary intervention
