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Chapter 3 - The balance of payments and the effective exchange rate. The objectives of this chapter are: The objectives of this chapter are: To define the balance of payments, to examine the australian balance of payments statistics, to illustrate the relation between the balance of payments and the foreign exchange market,...
Chapter The Balance of Payments and the Effective Exchange Rate Objectives • To study the structure of the balance of payments • To illustrate how the BOP is related to the FX market • To introduce the concept of the effective exchange rate Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 3-2 Definition • The balance of payments (BOP) is a systematic record of all economic transactions between the residents of the reporting country and the rest of the world over a specified period of time Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 3-3 Important elements in the definition • • • • Rest of the world Economic transactions Resident Flows versus stocks Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 3-4 Important elements in the definition (cont.) • The BOP records changes in assets and liabilities • Figures may or may not be seasonably adjusted Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 3-5 Structure of the BOP • The BOP consists of the current account and the financial account Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 3-6 Components of the current account • Merchandise account (trade balance) • Net services • Current transfers Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 3-7 The financial account • Records official and non-official net financial flows • A balancing item is added to account for errors and omissions Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 3-8 The Australian BOP: Current account (AUD Million) Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 3-9 The Australian BOP: Financial account (AUD Million) Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 3-10 Deteriorating current account (high domestic inflation) 10 11 -40 -80 -120 -160 -200 Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 3-22 Factors affecting the current account (cont.) • Trade restrictions: One reason for imposing trade restrictions, such as tariffs and quotas, is the desire to protect the current account Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 3-23 Factors affecting the financial account • Taxes: Taxes that are imposed on capital gains and/or income from dividends and interest payments may adversely affect the financial account This is because foreign investors no longer find it attractive to invest in the underlying country’s securities (cont.) Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 3-24 Factors affecting the financial account (cont.) • Capital controls: Capital controls are imposed typically to deal with a chronic weakness in the balance of payments (cont.) Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 3-25 Factors affecting the financial account (cont.) • The expected change in the exchange rate: If a currency is expected to appreciate, the expected rate of return on investment in securities denominated in that currency will be higher, attracting capital flows Thus, a country’s financial account will improve if that country’s currency is expected to appreciate Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 3-26 The effective exchange rate • The effective exchange rate is an index of a weighted average of the nominal exchange rates against the currencies of major trading partners Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 3-27 The EER equations The following equations are used to calculate the EER: m Et = ∑ wiVi ,t i =1 m Et = Π(Vi ,t ) wi i =1 Vi, t Si,t Si ,0 Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa (cont.) 3-28 The EER equations (cont.) The following equations are used to calculate the weights: wi Xi Mi wi m m Xi Mi i wi i Xi Mi m Xi i * i w wi m wi Mi i Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 3-29 What does the RBA in practice? • The RBA calculates a nominal effective exchange rate called the trade-weighted index (TWI) (cont.) Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 3-30 What does the RBA in practice? (cont.) • As the name implies, the index is calculated on the basis of the (bilateral) trade shares of Australia’s major trading partners (cont.) Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 3-31 What does the RBA in practice? (cont.) • Until October 1988 the TWI was calculated as an arithmetic weighted average, but since then the RBA has shifted to using a geometric weighted average • Major trading partners are those accounting for at least 90 per cent of Australia’s trade (exports plus imports) Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 3-32 The weights used by the RBA to calculate the TWI Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 3-33 The RBA’s trade-weighted index, January (1970 = 100) Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 1-34 The real exchange rate • The real exchange rate is the nominal exchange rate adjusted for differences in prices or inflation rates: Q( x / y ) Py S ( x / y) Px Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 3-35 The real effective exchange rate • The real effective exchange rate can be calculated from the real bilateral exchange rates: Qt Qt m Qi ,t ∑ wi Qi ,0 i m i Qi ,t Qi ,0 wi Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 3-36 ... 40 30 20 10 -1 0 10 11 -2 0 -3 0 -4 0 -5 0 Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 3- 21... inflation) 10 11 -4 0 -8 0 -1 20 -1 60 -2 00 Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 3- 22 Factors... PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 3- 12 Derivation of the demand and supply curves • The demand for foreign exchange is equivalent