Related Notes：

# CH10 Balance of Payments

Summary accounts

• Merchandise trade balance = – $548 billion • Goods exports – goods imports • Trade balance = –$497 billion
• Exports of goods and services – imports of goods and services
• Income balance = $33 billion • Current account = -$531 billion
• Trade balance + income balance + unilateral transfers
• Capital account balance = $544 billion • The balancing factor: statistical discrepancy ## CH11 The Foreign Exchange Market and Exchange Rates ## 11.1 Functions of the Exchange Rate Markets Functions: • Transfer** of funds or purchasing power from one nation and currency to another • Provide credit for foreign transactions • Provide the facilities for hedging and speculation Participants: • Those needing currency to fund transactions • Commercial banks • Foreign exchange brokers ## 11.2 Equilibrium Exchange Rate Demand: • imports • Asset flows aboard supply: • Exports • Asset flows to the U.S. • Use of the dollar as the “international currency” ## 11.3 Types of Exchange Rates • Spot exchange rate • Forward exchange rate • Forward discount (below the spot rate) • Forward premium (above the spot rate) • Cross exchange rate • A-B, A-C—->B-C • Effective exchange rate • a weighted average of the exchange rates between the domestic currency and the nation’s most important trading partners Arbitrage is the purchase of currency in one market for immediate re-sell in another market. ## 11.4 Foreign Exchange Risk If domestic currency falls in value: • Contracted future foreign currency payments may become more expensive If domestic currency increases in value: • Contracted future foreign currency receipts may fall in value ## 11.5 Hedging* Hedging is the avoidance of a foreign exchange risk. Options: • Buy at the current spot rate and deposit the receipts in an interest earning account until the funds are needed. • Example: SR=$1/euro
• A U.S. importer are supposed to pay 100 in euros in three months. He expects dollar will fall in value. So he exchanges $100 at SR, and deposits 100 euro in a bank for three months. After three months, he would pay 100 euro for the contract and use interest to cover the fluctuation of exchange rate. • A U.S. exporter expects to receive 100 in euros in three months. He expects dollar will increase in value. So he borrows 100 euro, exchange it at SR and deposits$100 in a bank. After three months, he would repay the loan with the contract payment and use interest to cover the fluctuation of exchange rate.
• Typically this will entail paying a forward premium which increases the cost of the transaction.

## 11.6 Speculation*

Speculation is the acceptance of foreign exchange risk in the hope of making a profit.

Examples:

• If a speculator believes that the SR of a particular currency will rise, he will purchase the currency now and hold it on deposit in a bank for resale later.
• If a speculator believes that the SR of a particular currency will fall, he will borrow the foreign currency, immediately exchange it for the domestic currency at SR and deposits it in a bank to earn interest.

## 11.7 Interest Arbitrage

Interest arbitrage is the transfer of short-term liquid funds abroad to earn a higher rate of return.

• Uncovered interest arbitrage
• with exchange rate risk
• Covered interest arbitrage
• without exchange rate risk
• Uncovered interest parity
• s = r – r*
• Covered interest parity
• forward contract cost = r – r*

# CH12 Exchange Rate Determination

## 12.1 Overview of Exchange Rate Determination

• Relative rates of economic growth
• Relative rates of inflation
• Changes in interest rates
• Expectations

## 12.2 Trade of Elasticity Approach

• In this approach, the equilibrium exchange rate is the rate that balances imports and exports.
• If the nation has a trade deficit, its currency will depreciate.
• If the nation has a trade surplus, its currency will appreciate.
• How does the exchange rate affect trade balance?
• Marshall-Lerner condition
• J curve effect

The law of one price

• absence of barriers
• Specially, R=P/P*
• Absolute purchasing power parity does not hold in absence to perfect free trade.
• Transaction costs

• the change in the exchange rate is equal to the difference in the change in the price levels (rates of inflation) of the two countries.
• ΔR=ΔP-ΔP*

## 12.4 The Monetary Model of Exchange Rates

The monetary model of exchange rates holds that the exchange rate is determined in the process of equilibrating the domestic demand and supply of currency.

An increase in the U.S. money supply (assuming no change in other money supplies) will depreciate both nominal (spot) and real exchange rates.

• Nominal exchange rate
• Real exchange rate
• RE = NE * (P*/P)

## 12.5 The Asset Model of Exchange Rates

The asset model of exchange rates holds that the exchange rate is determined in the process of equilibrating the domestic demand and supply of financial assets.

• It is also known as the portfolio model

An increase in the U.S. money supply (assuming no change in other money supplies) will lower interest rates in the U.S. and shift investors from domestic to foreign assets and lead to a depreciation of the dollar.

## 12.6 Exchange Rate Dynamics

Exchange Rate Overshooting —- In adjusting to long run equilibrium values, exchange rates tend to “overshoot” the final equilibrium value.

• Suppose that the exchange rate is initially at $1/¥1. • At time A, the money supply in the U.S. increases causing the exchange rate to depreciate. • If the long run equilibrium exchange rate is expected to be$1.10/ ¥1, in the short run the exchange rate will overshoot this value.
• Over time, the dollar will fall to its long run equilibrium value.

# CH13 Automatic Adjustment with Flexible and Fixed Exchange Rates

How a deficit in a nation’s balance of payments is automatically corrected by price and income changes?

• In this chapter private international capital flows are assumed to be passive responses to cover temporary trade imbalances.
• Thus, a balance of payments deficit refers to or is synonymous with a trade deficit.

Adjustments to a trade deficit can take place automatically through price or income changes, or both, under a flexible or a fixed exchange rate system.

## 13.1 Adjustment with Flexible Exchange Rates

• Assumptions:
• only two nations
• no capital flows
• the demand for RMB will be driven by U.S. demand for goods and services, or imports.
• The supply of RMB will be driven by Chinese demand for U.S. goods and services, or exports.
• Over time the exchange rate will automatically move to its equilibrium value, meanwhile, the trade deficit will close.

### Elasticity

The elasticity of demand for foreign currency depends on the price elasticity of the demand for imports (ηM):

• ηM = (ΔQM/ QM) ÷ (Δ PM*/ PM* )

The elasticity of supply for foreign currency depends on the price elasticity of supply for exports (ηX).

• ηX = (ΔQX/ QX) ÷ (Δ PX* / PX* )

## 13.2 Stability of Foreign Exchange Market

unstable case

The demand exceeds the supply, the exchange rate will rise all the time.

### The Marshall-Lerner Condition

The unstable condition just depicted will be avoided if the Marshall-Lerner condition holds.

• M + ηX|> 1

### J-curve Effect

• A currency depreciation is expected to lessen a country’s trade deficit.
• This improvement may take time to occur.
• Initially, the depreciation may worsen the trade deficit since import prices will rise more quickly than the improvement in exports.
• This generates a J-shaped pattern to exchange rate movements.

## 13.3 Adjustment with Fixed Exchange Rates

Gold Standard

Adjustment to equilibrium under the gold standard occurs via the price-specie-flow mechanism.

If a trade imbalance exists, gold will flow from the country with a trade deficit to the country with a trade surplus.

The fall in gold supplies in the trade deficit country reduces its money supply and pushes its price level lower; the increase in gold supplies in the trade surplus country increases its money supply and raises its price level.

As the price level falls in the country with a trade deficit, exports of its goods and services will be encouraged; as the price level increases in the country with a trade surplus, exports of its goods and services will be discouraged. These changes in trade will decrease both the trade deficit and surplus leaving a situation of balanced international trade.

## 13.4 Absorption Approach

Domestic equilibrium

• Y = C + I + G + (X – M)

Define A (domestic absorption) = C + I + G and B (foreign absorption) = X – M. Then:

• Y = A + B
• or, Y – A = B

Analysis: (at full employment)

• A depreciation of the currency is expected to increase B.
• Forces that lead to a fall in domestic absorption (A).
• The depreciation increases prices and hence lowers domestic expenditures.
• The depreciation pushes people into higher tax brackets and hence lowers disposable income.
• So-called inflation tax

## 14.1 National Objectives & Policies

Objectives:

• Achieving internal balance
• Attaining external balance
• A sustainable rate of economic growth
• An equitable distribution of income

Policies:

• Macro-control policies
• Fiscal policy
• Monetary policy
• Exchange policies
• Direct controls

## 14.2 Monetary Policy with Fixed Exchange Rates

• Therefore, monetary policy is ineffective with fixed exchange rate.
• Impossible Trinity.

## 14.3 Fiscal Policy with Fixed Exchange Rates

• Therefore, fiscal policy is effective with fixed exchange rate.

## 14.4 Monetary Policy with Flexible Exchange Rates

• Therefore, monetary policy is effective with flexible exchange rate.

## 14.5 Fiscal Policy with Flexible Exchange Rates

• Therefore, fiscal policy is less effective than money policy with flexible exchange rate.