L25 - The Balance of Payments and Exchange Rates - Part 1

Question 1

What are the two exchange rate markets

Answer 1

• Spot market –> A spot rate is a contracted price for a transaction that is taking place immediately (it is the price on the spot).
• Forward Market –> is the settlement price of a transaction that will not take place until a predetermined date in the future; it is a forward-looking price. Forward rates typically are calculated based on the spot rate.

Question 2

What is the rise and fall of the external value of the pound called?

Answer 2

• A rise in the external value of the pound (i.e. a rise in the exchange rate) is called an appreciation of the pound.
• A fall in the external value of the pound (i.e. a fall in the exchange rate) is called a depreciation of the pound.
• Note: Because the exchange rate expresses the value of one currency in terms of another, when one currency appreciates, the other must depreciate.

Question 3

What is the exchange rate?

Answer 3

The exchange rate between two currencies is the amount of one currency that must be paid in order to obtain one unit of another currency.

Question 4

How is the exchange rate determined?

Answer 4

• The exchange rate is just a price, albeit a very important price.
• Since it is determined in a competitive market in which there are many buyers and many sellers, we can analyse its behaviour using the demand and supply analysis.
• Note: Because one currency is traded for another in the foreign exchange market, it follows that a demand for foreign exchange (dollars) implies a supply of pounds, while a supply of foreign exchange (dollars) implies a demand for pounds.
• The demand for pounds arises from all international transactions that generate a receipt of foreign exchange:
• UK exports
• Income payments and transfers
• Capital inflows
• reserve currency –> amount of foreign currency kept by the central bank
• The sources of supply of pounds in the foreign exchange market are merely the opposite side of the demand for pounds.

Question 5

What does the the graph of foreign exchange look like?

Answer 5

• spot market
• With Price of £1 in $ on the y-axis and the quantity of pounds in the x-axis
• downwards line of demand for pounds and upwards line of supply for pounds
• the demand curve is negatively sloped because if the pound were to depreciate, an importer from another country would need less pounds to buy something, so as long as demand is elastic importers will import more UK goods which will lead to a increase in the number of pounds needed
• For the supply curve is the opposite, when the pound appreciates foreign exports become cheaper for UK buyers so more are sold and a greater quantity of pounds is spent on them, thus more pounds will be offered in exchange for dollars

Question 6

What causes a flexible exchange rate?

Answer 6

The simplest answer to this question is changes in demand or supply in the foreign exchange market.

• e.g. is the demand for the pound exceed supply, the pound will appreciate, till equilibrium ( also as the pound appreciates the amount needed to by foreign goods is also reduced)
• if supply for the pound exceeds demand the pound will depreciate till equilibrium

Question 7

What causes the shifts in demand and supply that leads to changes in exchange rates?

Answer 7

• 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.
• The degree of exchange rate variability experienced since the advent of floating in the early 1970s has been bigger than was expected.

Question 8

Why have exchange rates been volatile?

Answer 8

• This question remains at the centre of debate and controversy among researchers and policy commentators.
• Purchasing power parity (PPP) theory holds that over the long term the average value of the exchange rate between two currencies depends on their relative purchasing power.
• The 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.
• Note: PPP exerts a strong influence on exchange rates in the long term, but there are often significant deviations from PPP in the shortto medium term.

Question 9

Where did the exchange rates regimes evolve from?

Answer 9

• Exchange rate regimes evolves from gold standard to multiple regimes: fixed (Bretton Woods system), flexible and those in-between.
• Under fixed exchange rates the authorities intervene in the foreign exchange market to maintain the exchange rate within a specified range.
• To do this, they must hold sufficient stocks of foreign exchange reserves.
• Under a flexible [or floating] exchange rate regime the exchange rate is market-determined by supply and demand for the currency.
• Fluctuations in exchange rates can be understood as fluctuations around a trend value that is determined by the purchasing power parity (PPP) rate.
• Today’s exchange rate regime is generally one of free floating, which means that demand and supply forces are free to determine the exchange rate.
• However, some central banks do intervene in the market from time to time to try to influence their country’s exchange rate.

Question 10

What does the supply of pounds actually mean?

Answer 10

• supply of pounds by people who are seeking dollars is the same as the demand for dollars by holders of pounds
• its therefore merely the opposite side of the demand for dollars e.g.:
• UK residents seeking to buy foreign goods
• paying share to US shareholders
• FED sterling reserve –> wants to sell the pounds for another currency as it deems the sterling-denominated assets offer a poor return

Question 11

What is a problem with fixed or pegged exchange rates?

Answer 11

• With fixed exchanged rates and an undervalued currency, the monetary authorities will be acquiring reserves (always exchanging domestic currency for foreign to bring down the price)
• With an overvalued currency, the monetary authorities will be losing reserves (as constantly buying domestic currency with foreign reserves)
• If nothing is done to alter the situation the currency will have to be devalued sooner or later, and if a flight from the currency occurs devaluation may be forced on the authorities sooner rather than later

Question 12

What is a floating rate regime or a managed float regime?

Answer 12

A floating exchange rate is a regime where the currency price of a nation is set by the forex market based on supply and demand relative to other currencies. This is in contrast to a fixed exchange rate, in which the government entirely or predominantly determines the rate.

Question 13

What is a foreign exchange market like?

Answer 13

• is like any other competitive market

- the forces of demand and supply lead to an equilibrium price at which quantity demanded is equal to quantity supplied

Question 14

How can a rise in the domestic price of exports cause a change in the exchange rate?

Answer 14

• Say if there ways a rise in the sterling cost of a UK product
• The effect on the demand for pounds depends on the elasticity of of foreign demand for the UK products
• INELASTIC - then more will be spent the demand for pounds to pay the bigger bill will shift the demand curve right so the pound to appreciate
• ELASTIC - the total amount spent will decrease and thus fewer pounds will be demanded, the demand curve will shift left adn the pound will depreciate

Question 15

How can a rise in the foreign price of imports cause a change in the exchange rate?

Answer 15

• suppose there is an increase in the dollar price of a US product
• if UK demand is elastic - spend fewer dollars for US product than they did before, therefore supply less pounds, this will shift the supply curve left and the pound will appreciate
• If UK demand was in elastic - spend more dollars for US product, therefore supply more pounds which would shift the supply curve to the right depreciating the pound

Question 16

How can changes in the price level cause a change in the exchange rate?

Answer 16

• so a change in all prices caused by inflation
• What matters here is the change in the UK price level relative to the price levels of its trading partner
• If UK inflation is higher than the UK,
• UK exports are becoming more expensive in US markets, while imports from the US are cheaper in the UK this will shift the demand curve for the pound to the left and the supply curve to the right.
• Each change causes the dollar price of the to depreciate

Question 17

What are the two short-term capital movements that can have an effect on the exchange rates?

Answer 17

1. change in interest rates

2. speculation about a country’s exchange rate

Question 18

How can a change in interest rates have an effect on the exchange rate?

Answer 18

• International traders hold transaction balances just like domestic traders
• these balances are usually lent out on a short-basis rather than being left a non-interest-bearing deposit
• Naturally, caeteris paribus, the holders of these balances will tend to lend them in those market where interest rates are higher
• Thus if a country has higher short-term interest rate than others, they will see a inflow of short-term capital as an effort to take advantage of the higher rate –> this will increase the demand for the country’s currency and it tends to appreciate
• if these short term rates were to fall there will most likely be a sudden shift away from the country as a location for short-term fund and there will tend to be a depreciation of the currency

Question 19

How can speculation about a country’s exchange rate have an effect on the exchange rate?

Answer 19

• If foreigners expect the pound to appreciate they will rush to buy the assets denominated in pounds if they expect the pound to depreciate they will be reluctant to buy or to hold UK financial assets

Question 20

How can Long-term capital movements cause a change in the exchange rate?

Answer 20

• largely influenced by long-term expectations about another country’s profit opportunities and the long-run value of its currency.
• A US firm would be more willing to purchase a UK firm if it expected that the profits in pounds would buy more dollars in the future years than investment in a US factory
• This could happen if the UK business earned greater profits than the US alternative, with the exchange rate remaining unchanged
• It could also happen if the profits were the same, but the US firms expected the pound to appreciate relative to the dollar

Question 21

How can Structural changes cause a change in the exchange rate?

Answer 21

• structural change is an all purpose term for a change in technology, the invention of new products, or anything else that effects the pattern of comparative advantage.
• For example, when a country’s products do not improve in quality as rapidly as those of some other countries toe changes occur
• First that country’s consumers’ will slowly shift their purchases away from domestic products and towards those of foreign competitors –>will increase the supply of the country’s currency on the foreign exchange market
• Secondly, foreigners will find that country’s exports less attractive and will buy fewer of them –> reduce the demand for the foreign currency
• thus the currency will slowly lose value on that market

Question 22

If a currency has a higher purchasing power in its own country what is it said to be?

Answer 22

• said to be undervalued
• There is then an incentive to sell foreign exchange and buy the domestic currency in order to take advantage of this higher purchasing power (that is, the fact that the goods seems cheaper) in the domestic economy.
• This will put upwards pressure on the domestic currency

Question 23

If a currency has a lower purchasing power in its own country what is it said to be?

Answer 23

• said to be overvalued
• there is then an incentive to sell the domestic currency and buy foreign exchange in order to take advantage of the higher purchasing power (cheaper goods) abroad
• This will put downwards pressure on the domestic currency

Question 24

How do you calculate the real exchange rate?

Answer 24

• While the actual ( also called the nominal) exchange rate tells how much foreign currency can be exchanged for a unit of domestic currency
• the real exchange rate tells how much of the goods and service in the domestic country can be exchange for the goods and services in a foreign country:
• real exchange rate= nominal exchange x (domestic price index/foreign price index)
  OR
• real exchange rate= (nominal exchange rate) x (PPP index)
• if nominal exchange rate always adjust to changes in purchasing power, the real rate would be constant.
• the real rate and the nominal exchange are highly correlated in the short term –> but while the nominal rate is volatile as it respond to new information there is some evidence that the real exchange rate return to some average level
• this implies that PPP holds in the long run

Question 25

What is exchange rate overshooting?

Answer 25

• Differences in interest rates between countries, arising from differences in monetary and fiscal policies among other factors, can trigger large capital flows as investors seek to place their funds where
  returns are highest.
• These capital flows will in turn result in swings in the exchange rate between the two countries.
• Some economists argue that this is the fundamental reason for the wide fluctuations in exchange rates that have been observed

Question 26

How does exchange rate overshooting work?

Answer 26

• A relative rise in domestic interest rates will cause a capital inflow and appreciation of the home currency –> people start buying more sterling to buy UK assets to benefit from the increased interest rate
• When UK interest rates rise above foreign rates, equilibrium occurs when the rise in value of the pound sterling in foreign exchange markets is large enough that investor will expect further depreciation that just offsets the interest premium from investing fund in sterling-denominated assets
• A policy that raises domestic interest rates above world levels will cause the external value of the domestic currency to appreciate enough to create an expected future depreciation that will be sufficient to offset the interest differential
• This could lead to a higher exchange rate after depreciation in the long run
• However we need to consider lots of things happen in the world simultaneously –> this may not work if it caused long-run inflation to rise
• overshooting of the pound beyond its PPP rate would put exports and imports under temporary but severe pressure as UK goods are more expensive than imported goods
• this resulting all in demand for the UK good would open up a recessionary gap

Question 27

How do you calculate Openess?

Answer 27

• Open economy macroeconomics is the study of economies in which international transactions play a significant role.
• How open is an economy is measured by openness index:
• openness index = 100 x (Exports +imports)/GDP
• International considerations are especially important for open economies like the UK, Germany or the Netherlands.
• Domestic macroeconomic policy in such countries cannot ignore the
  influence of the rest of the world especially via:
  1 the exchange rate
  2 interest rate differentials.

Question 28

How can you calculate the interest rate differential between two countries?

Answer 28

The interest rate differentials between countries are explained by:
- interest rate parities –> the theory in which the interest rate differential between two countries is equal to the differential between the forward exchange rate and the spot exchange rate.
- Interest rate parity plays an essential role in foreign exchange markets, connecting interest rates, spot exchange rates and foreign exchange rates.
The uncovered interest rate parity can be expressed as:
i{t} = i{t} + ∆e{t}
where i{t} and i{t}are domestic and foreign interest rates and ∆e{t} refers
to changes in exchange rates.