Monetary policy

The Balance of Payment, exchange rates and the determinants of trade balance

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The balance of payment

The balance of payments is the summary of all the external transactions of the residents of an economy in the couse of a year. Money leaving the country is a debit iterm in the accounts, and inflows are credits.

Government's objective: getting balance of payments in equilibrium - the money flowing into the economy should equal the outflows.

Persistend surplus/deficit can cause economic problems/harm other objectives. UK: value of imports exceeds imports so there is a defecit of trade = deficit in bop accounts.

Income flows can also be wages, interst and profits flowing in and out of economy and international transfers of money. Sum of all trade ans money flows is the current account of the balance of payments.Capital account records money flows from buying and seling assets, the transfer of money by migrants, overseas aid and dealings with the EU.3rd part of accounts records flow of direct invesment in business capital and flow of money going into shares, bonds and bank deposits. Sometimes called hot money - can quickly move location if relative interest/exchange rates differ.

Overall defecit on the balance of payments can be financed by running down official reserves of foreign currencies, borrowing from abroad or acting to stop the root cause. Weapons to influence imports and exports: monetary and fiscal measures, ability to alter the exchange rate. Inflow of investment can be increased by raising the interest rate. The BoP must be balanced. The problem lies in the cots of gettnig credits to equal debits.

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Balance of payments continued

BoP draws together commercial and financial aspects of international transactions. It records a country's tansactions with the resto of the world over a period of time, collecting book-keeping entities corresponding to commercial and capital flows between a country and the rest of the world.

Balance of trade

=Balance of goods and services

Balance of invisible items - Current account balance

- balance of unrequited transfers - Balance of capital  =BoP

- Balance of foreign exchange

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Current account balance = commercial transactions of one country with RoW, including balance of trade on goods and services and balance of unilateral transfers/unrequited transfers.

Balance of trade on goods and services: includes trade in merchandise and trade in invisibles. Trade in merchandise = income payments to or from overseas for services, i.e. tourism, dividends (payments for the use of capital) royalties (payments for use of know-how and interest payments on foreign debt

Balance of unilateral/unrequited transfers: payments/transfers paid to or received from overseas that are not directly related to business transactions - there is not real counterpart - i.e.what immigrant workers send abroad, payments to and from the EC budget, foreign aid, military transactions. 

All current account items describe transactions referring to the sale and purchase of goods and services and the balance on current account is often taken to be the most baic measure of a country's international transactions.

Rest of BoP= financial (borrowing and lending) ransactions between country and RoW. Borrowing by domestic households and firms = capital inflow. Lending by residents to overseas = capital outflow.

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There are long-term and short-term capital or financial transactions.

FDI outward (if residents of the domestic economy invest in RoW) or inward (if RoW invests in the domestic economy) is long-term, i.e. purchasing a foreign company. Long-term investments can be included in the current account balance rather than the capital account balance - they are recorded as commercial rather than financial transactions. The structure of BoPs is down to convention, rather than logic. 

Short-term transactions involve assets with less than one year's maturity - hot money promising quick returns.

Portfolio investment can fall into either category. Refers to type of investment that do not involve the transfer of a bundle of resources (technology/knowhow) but consist in buying a share of a foreign company or buying foreign currency. It is included under long-term capital flows - another how BoP categories are defined by convention. 

There are private and official accounts. The capital account balance KA only refers to private residents. The official interventions account summarises the dealings of monetary authorities., buying and selling foreign currencies in exchange for domestic currency. It is also often referred to as the balance of foreign exchange and is a channel through which the difference between the current account and capital flows is balanced.

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BoP conventions

Automatic re-equilibrium: the BoP must ben in balance - the current and capital balance  must sum zero. CA+KA = 0

A current acocunt surplus (exports > imports) must be matched by a capital account defecit. An excess of current receipts (exports, dividend and interest payments over current payments leads to an accumulation of international overseas assets by domestic households and businesses or to a build-up of international reserve assets. A country in this position is a net lender to RoW and records a capital account defecit or net outflow of capital (borrowing < lending).

Current account deficits (imports>exports) imply borrowing from abroad. Financial capital is flowing into the country. A country in this position pays more for current transactions (imports, dividend and interest payments) than it receivs from abroad. This leads to an import of capital or decrease in foreign currency reserves and a capital account surplus (borrowing > lending) so the country is a net borrower from RoW

BoP equilibrium derives from inclusion of clearing balances (variations in offical reserves). They are excluded from the definition of trade and capital balances so there can be deficits/surpluses on these balances (a current account surplus, a surplus on the capital balance = increase in foreign debt.

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BoP disequilibrium

BoP disequilibrium = relation between current account, capital flows and errors and omission, e.g. capital flight.

BoP surplus means foreigh currency inflows are greater than outflows. BoP deficit means monetary outlays exceed inflows. Deficits = financed through a net export of bonds (fixed interest security issued by governments, companies or banks), an equivalent increase in foreign exchange reserves or a combination of these measures.

BoP deficit/surplus is just equal to the change in the Foreigh Exchange Balance/Foreigh Exchange Reserve Holdings /OFF.

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Exhange Rates

Exchange rate = price of one currency related to another and is determined by demand and supply. Changes in market conditions lead to a currency appreciating or depreciating in a free market. 

Main participants in foreign exchange markets = end users (businesses and tourists) but central banks may also influence current exchange rate. Market is also influenced by market makers who hold stocks of foreign currencies. There are also speculators and poeple who profit by transferring money between currencies.

An economy can choose between fixed exchange rates that can only be altered by agreement with trading partners or floating rates determined by strength of demand and supply. Dissatisfaction with both systems led to managed exchange rates - BoE maintained the pound at the level it deemed appropriate. Low exchange rate = dearer imports and can lead to inflation / Strong currency can damage exporters and employment.

demand for pounds = supply of foreign currency and vice versa. Trade in goods/services influences the value of the pound - exports falling will lower demand for pounds and its value will fall. Changes in the exchange rate also influence level of imports/exports. Inflows from abroad strengthen the pound and outflows weaken it. If Britain joins the EMU the govt will no longer be able to lower the exchange rate to incrase British exports' competitiveness. Exchange rates will cease to be an economic objective or a tool of macroeconomic management.

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Exchange Rates

There are two ways to measure exchange rate: e=domestic currency value unit of foreign currency = value of one US$in £s

or ER = foreign currency value of one unit of domestic currency  = value of £1 in US$.

 If £1 = $1.5 then e=0.66 and ER = 1.5 (1/0.66 = 1.5 so £1 = $1.5

e and ER are relative prices of two currencies (exchange rates). If foreign currency value of one unit of domestic currency falls = depreciation. Vice versa = appreciation, which is equivalent to a rise in ER and a fall in e.

Depreciation :2009:£1 = $1.5  e=0.66  ER = 1.5. 2010 £1 = $1.2 e=0.83 ER= 1.2. Between 2009 and 2010, the £ has depreciated against the dollar: e has risen and ER has fallen

Appreciation: 2009: £1 = $1.5 e = 0.66 ER =1.5; 2010: £1 = $2.0 e = 0.50 ER = 2.0. Between 2009 and 2010 the £ has appreciatd against the US$: e has fallen and ER has risen. These are nominal exchange rates.

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Exchange rates

Real exchange rates measure the prices of goods and services relative to another country. Real exchange rate is a price index of typical tradeable goods and services of one country. To do this we need to measure price levels in the same currency.

Real exchange rates are defined in terms of nominal exchange rates and price levels.

Real exchange rate = Pwxe = Pw xe = Pw x 1

                                      PA      PA          PA    ER - where Pw is the price level in the rest of the world, PA the price level in country A.

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Export demand

Export demand has two main determinants: a. the level of economic activity and income in the rest of the world, designated by Yw, the aggregate income in the rest of the world; b. the relative price competitiveness of goods and services produced in country A compared with the rest of the world. We call the international competitiveness IC of country A's products.

If we take the structure of trade relations betwen Country A an RoW and we also asume that at any moment in time there is a given composition of world trade, an increase in income of the rest of the world as well as an increase in country A's international competitiveness will mean demand for country A's exports rise.

Insert equation here

Depreciation means domestic currency value of one unit of foreign currency (e) increases - domestic currency price of exports increases (export production becomes more profitable for domestic producers) and the foreign currency value of one unit of domestic currency (ER) falls - the foreign currency price of exports falls (exports become cheaper for foreign buyers). This affects IC positively, only if there is not a countervailing inflationary pressure on PA (through price increases on imported inputs).

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Export demand

Another factor = value of export earnings, measured in terms of export volume times per-unit price of export goods. How will a depreciation affect the volume of exports produced and sold?

Depends on two factors: will domestic producers respond to an increase in domestic currency price of exports by producing more? Willingness and capacity of domestic producers to expand their production of export goods and services in response to an increase in domestic currency price of exports is the price elasticity of the supply of export goods.

Next, will foreign buyers respond to the fall in the foreign currency price of export goods by buying more? The willingness of foreign buyers to buy more export goods (from the point of view of the domestic economy is the price elasticity of the demand for export goods abroad. Depending on these price elasticities, changes in the per-unit price of export goods affects the volume of export production and the value of export earnings.

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Import demand

Given structural and political factors, 2 main economic determinants of import demand Z are: 1 the level of aggregate domestic income (Y) and 2 the level of international competitiveness (IC).

If aggregate domestic income Y increases, there will be an increase in import demand because 1, higher incomes means spending on consumer imports will rise. 2, the higher levels of economic activity produce higher aggregate domestic income and imply a higher demand for imported inputs into production (raw materials). 

An increase in international competitiveness of domestic production means domestic products are cheaper than foreign products (or of higher quality), implying that the relative prices of imported goods rise. An incrase in international competitiveness of country A may mean consumers switch from foreign to domestic products so long as the latter are in sufficent supply. So Y up = 7 up; IC up  = Z down.

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Depreciation = imports become more expensive. there is likely to be a switch of expenditure by UK buyers away from imported good to adomestic substitute.

Level of switch depends on price elasticity of demand for imported good - responsiveness of UK buyers to increase in price of US good. this depends on the tastes and preferences of UK buyers and extent to which domestic producers can expand production.

The higher the supply elasticity the more likely the switch. The value of imports in the domestic currency will fall if the demand falls enough to outweigh the fact that price per unit in pounds has increased. Expenditure on imports measured in £s will fall if the price elasticity of import demand (the ration of the percentage fall in quantity to the percentage increase in price) is relatively high. 

If the price effect is dominant (fall in quantity demanded is not sufficient to make up for the fact that the per-unit price has increased - the value of imports measured in domestic currency (expenditure on imports) will increase).

The higher the price elasticities of supply and demand, the greater the reduction in expenditure on imports and the more likely will a depreciation of the domestic currency reduce the value of imports measured in domestic currency.

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Relationship between external and internal balance

The external balanceof teh economy can be defined as a desirable current account balance.,meaning te external balance is not necessarily the same as a zero account balance as a country can run a current account deficit for some time. But since current account deficits must be financed by using up country reserves of international assets (foreign exchange) and/or by increasing borrowing from overseas, future interest payments will incease and further deteriorate the current account.

Assuming the ecnoomy is in external balnce (current account is 0) the internal balance of an economy refers to the leel of employment that is compatible with a certain policy-determined rate of inflation.

Maintaining an internal and external balance can be difficult - there can be a polciy conflict, i.e. if there is a given level of exports in country A and the govt adopts an expansionary fiscal polcy to stimulate the economy and reduce unemployment. This could lead to an increase in import demand and, with given exports, to a deterioration in the balance of trade.

The govt could decide to focus on the external balance where there is a balance of trade deficit, adopting a restrctive fiscal policy to reduce import demand. But this would result in a fall in import demand and a fall in domestic expenditure more generally. Domestic production and output would fall as well as demnad for imports. A policy to improve the balance of trade by reducing imports could be costly in terms of increased domestic unemployment.

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Relationship between external and internal balance

Insert Swan-Salter diagram here (named after two Australian economists).

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Swan-Salter diagram

Measuring the level of international competitiveness (IC) on the vertical axis and the level of aggregate domestic expenditure (AE) on the horizontal axis. The FF curve = combinations of IC and AE consistend with internal balance. The slope of the curve is negative. So from the point of view of the internal balance, if the level of domestic aggregate expenditure is high,a high degree of internal competitiveness and therefore a high level of demand for exports by the rest of the world in addition to domestic demand might generate excess demand. This would generate inflationary pressures and undermine internal balance. the higher the level of domestic expenditure, the lower must be the level of international comptitiveness to preserve internal balance. If domestic pressure is low, a high level of international competitiveness is needed to avoid high levels of unemployyment.

The ** curve = combinations of the level of aggregate domestic expenditure AE and international competitiveness IC consistent with external balance. The ** curve has a positive slope because from the point of view of the external balance, if the level of aggregate domestic expenditure is high, the level of international competitiveness must be high too otherwise the current account will deteriorate. This reflects the idea that a higher level of domestic output and employment can be made compatible with maintaining the external balance, so long as international competitiveness incrases. The lower the level of aggreagate domestic expenditure, the lower can be the level of international competitiveness that is consistent with the external balance. Points to the right of ** = situations where the current account is in deficit (the level of domestic expenditure is too high to maintain external balance, given IC). Points to the left of ** represent situations wher ethe current account is in surplus (exports exceed imports).

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Swan-salter diagram

Taking both curves together - four policy zones reflecting combinations of internal and external balance.

Zone 1: excess-demand inflation (to the right of FF) and current account surplus (to the left of **)

Zone 2: excess demand inflation (to the right of FF) and current account deficit (to the right of **)

Zone 3: unemployment (to the left of FF) and current account deficit (to the right of **)

Zone 4: unemployment (to the left of FF) and current account surplus (to the left of **).

At point A, at which FF and ** intersect the economy is in both internal and external balance. What happens where this isnot the case Beginning with points D and E, in both situations  the ecnonmy is already at the equilibrium level for international competitiveness IC. Therefore policies need to focus on the level of domestic expenditure AE. At point D, expansionary fiscal and/or monetary policies are needed to move the economy horizontally to the right towards point A. At point E, restrictive fiscal and/or monetary polciciesa re needed to move the ecnonmy to the left toward point A.  Generaly, policies that affect the level of domestic expenditure are represented by horizontal movements to the right or left. At points B and C, the level of domestic expenditure coincides with AE, that is, with the level of domestic expenditure compatible with a. To move the economy upwards from B to A, policies are  requred that raise the level of international competiitveness to IC such as a currency depreciation that will not be eroded by inflation.

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Swan-salter diagram

To move the economy vertically downwards from C to A, policies are required to lower the level of international competitiveness to IC such as currency appreciation. Policies that affect the level of international competitiveness are represented by vertical movements up and downwards.

Points F and G are more problematic - they require a combination of policies affecting the level of domestic expenditure and policies affecting the level of international competitiveness,i.e. to move the economy from G to A would require a combination of expansionary fiscal and/or monetary policies (horizontal move to the right) and policies to improve international competitiveness (vertical move upwards).

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