Economics 4 - CIIA
balance of payments, exchange rates, prices and interest rates
balance of payments, exchange rates, prices and interest rates
Set of flashcards Details
| Flashcards | 28 |
|---|---|
| Language | English |
| Category | Macro-Economics |
| Level | Other |
| Created / Updated | 20.04.2014 / 13.03.2015 |
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balance of payments
country's transactions with the rest of the world.
It reproduces the flows of goods and services, incomes, transfers
and capital.
the accounting system
currency inflows are recorded as credits (+) and currency
outflows as debits (-). transactions are recorded through
double-entry book keeping. balance of payments (BP) always
balances (total debits = total credits, BP=0).
which three major components does it include ?
the current account (CB) - records payments for traded goods and services, foreign
investment income and unilateral transfers.
the capital account (KA) - reports public and private investment and lengin activities.
official reservce account (ΔRA) - records changes in the cental bank's holdings of
foreign currencies.
each of these components may have a deficit or a surplus.
However, the sum of these parts is balanced, so the change in the
reserve account must equal the sum of CB and KA.
BP = CB + KA - ΔRA = 0
CB + KA = ΔRA
If ΔRA = 0 - CB and KA balances have to sum up to zero
CB + KA = 0
balance of payments (BP) = A + B + C + D + E + F = 0
A = Merchandise trade balance
B = Services trade balance (A+B = NX)
C = Net factor income (NIRA)
D = Net unilateral transers
E = capital account balance
F = official reserve transactions balance (-ΔRA)
BP = A + B + C + D + E + F = 0 (total debit = total credit)
capital account (KA)
records cross-border changes in holdongs of shares, property, bank deposits
and loans, bonds. One distinguish between long-term and short-term capital flows.
What are short-term and long-term investments ?
- long-term is foreign direct investment. acquisition of assets abroad with a view
of controlling the management. corporate takeovers, establishment of subsidiary production facilities
or purchases of foreign property.
- short-term is mainly speculative purchases and sales of financial assets.
nominal exchange rate S is the price of one unit of foreign currency in
terms of domestic currency.
SCHF/USD=0.88254, this way of quoting is said in American terms
or in direct terms.
European (indirect) terms is the inverse, the price of a unit of
domestic currency in units of foreign currency.
SUSD/CHF = 1.13309.
In interbank market, European terms are conventionally used
for all currency quotations except the British pound and the
Australian and New Zealand dollars.
However the norm in theoretical analysis is in American terms.
What are the participants in foreign exchange market?
- exporters who have foreign currency sales
- importers who have to pay for goods and services in for. currency
- portfolio managers who purchase and sell for. cur. assets and rec.
for. cur. interest payments and div.
-foreign brokers who earn profis by matching orders
- commercial banks who borrow in var. curr. for their own needs and customers
- currency speculators
- central banks that conduct exchange interventions
spot transactions:
price agreement today and settlement at most two business
days later.
forward transactions:
price agreement today and settlement at some point
in specified future date (up to 10 years)
- How we call when forward value of a foreign currency (in terms of the
domestic currency) is higher/lower than its spot rate?
-
higher: at a premium
lower: at a discount
appreciation/depreciation
When does the domestic currency appreciate/depreciate ?
- appreciates when S is lower
- depreciates when S is higher
the real exchange rate can be defined as the price of a
representative basket of foreing goods and services compared
to the cost of a domestic basket.
Sreal = S * PF / P
P = price of domestic basket in domestic currency
PF = price of foreign basket in foreign currency
- If prices of the two baskets are the same then Sreal = 1
- An increase in the relative price of domestic goods in terms of
foreign goods implies a real appreciation of the domestic currency.
Such changes in relative prices will change the demand for exports
and imports and affects the current account.
What are the four kinds of exchange rate systems?
- free floating
- managed floating
- target-zone arrangement
- fixed-rate system
free floating:
- exchange rates determined by currency supply and demand (clean float)
- no inverventions by central banks
managed floating:
central banks intervene to smooth exchange rate fluctuations (dirty float)
unofficial pegging, leaning against the wind - preventing short- and
medium-run fluctuations caused by random events whose effects are expected to be temporarly.
target-zone arrangements
- countries specify a margin around fixed central exchange rates
- credible announcements do not require interventions. Still the willingness
and ability of the central bank to defent the target is important.
fixed-rate system
- fixed parity against another currency (example Argentina to USD)
What is imported inflation ?
- inflation due to an increase in the price of imports.
as the price of imports increase, prices of domestic goods
using imports as raw materials also increase, causing an increase
in the general prices of all goods.
- a large depreciation of domestic currency
What are sterilised and non-sterilised central bank interventions ?
sterilised:
fixed-rate system
- fixed parity against another currency (example Argentina to USD)
- only one currency can be fixed and only fix the nominal rate.
- real exchange rate keep fluctuating, depending on internat. inflation differentials.
- foreign country's monetary policy must be replicated.
- pressure come up when targeting e.g. a lower finlation rate, exchange rate
could change rapidly.
- Realignments can solve a persistent current account surplus or deficit,
but if currency devalues/revalues too often, it loses credibility.
Situation: depreciation pressures to a chronic current-accoutn deficit,
authorities can do following things to resist devaluation of the currency.
- cental bank can intervene in foreign exchange markets to support the currency
- can raise the domestic interest rate
- combination of reduced gov. expenditure and increased taxes can lead to a lower national
income and thus lower imports. this leads to low inflation, it will lessen the need for devaluation.
- control wages and prices, this often causes distortions and redcues the efficiency of an economy.
What is the inconsistent triangle ?
only two of these options are available simultaneously.
- Free capital mobility
- fixed exchange rates
-national monetary policy autonomy
monetary unions
- several countries share a single currency and central bank
- each member must accept the group's joint inflation rate and base interest rate.
- if the member countries are subjected to shocks, it's obvoius that a
single monetary policy is optimal
PPP (purchasing power parity)
- if market forces are allowed to operate freely, any given good tend to have
the same prive worldwide when measured in the same currency.
- tube of toothpase PCHF = 2.80 and PUSD = 1.10.
- the law of one price states that the foreign and domestic prices should
be the same. exchange rate would be 2.80 / 1.10 = 2.5454
logic behind the law of on price is that divergent prices induce arbitrage through
international trade.
-
what are tradables and non-tradables ?
tradables: raw materials and agricultural commodities
- law of one price tends to be valid for tradables, specially for financial assets, e.g. Nestle
shares should be traded approx. the same price in NY
non-tradables: real estate and majority of services.
non-tradables are characterised by high transaction costs (e.g. hairdresser in NY)
- law of on price does not hold for non-tradables
PPP
absolute PPP
1= St * PtF / Pt = Sreal,t
relative PPP
(relationship between the change in the exch. rate and
the inflation rate)
St-1,t ≈ πt-1,t - πF t-1,t
- depreciationm of domestic curr. is equal to inflation differential between home and for. country.
- if domestic inflation is higher than foreign, inflation differential is positive, relative exchange rate is positive, domestic currency depreciates.
- relative PPP does not hold in the short term, looked developed countries with low inflation differentials at least.
- PPP shows it strengths in the long run compared to
ΔSCHF/USD - πCH- πUSA
echange rates and interest rates
- arbitrage opportunites in financial markets matter for
exchange rate movements
- equally safe assets in different countries should pay
the same rates of return
- countries with higher interest rates should see their
currencies depreciate relative to low-interest rate currencies.
an investor check for arbitrage possibilities what does he do?
check what higher return he gets when he
- either invest in domestic market or
- buy foreign currency, invest at foreign interest rate and sell the terminal value of his deposit forward.
- as many investors will do that, this will lead to equilibrium.
NF = (Ft,t+1 / St/ * (1+iF,t) = (1+it) = N
after arbitrage CIP (covered interest parity) can be written as:
FPt = Ft,t+1 - St / St
it ≈ iF,t + FPt
relative forward foreign exchange rate premium
currency with lower interest rates must be at a forward premium against high-interest rate currencies.
example: CHF/AUD : CH low interests, AUS high
CHF/AUD with FP
uncovered interest parity
investor does not cover himself with a forward contract.
- current exchange rates are determined by interest rate differentials and by expectations about the future exchange rate.
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