EXCHANGE RATE AND BALANCE OF PAYMENTS

International Finance Lecture EXCHANGE RATE AND BALANCE OF PAYMENTS After studying this unit, you will be able to: Describe the foreign exchange market, define the exchange rate, and distinguish between the nominal exchange rate and the real exchange rate Calculate the real exchange rate Explain how the exchange rate is determined day by day Explain the factors that influence the demand for and supply of rand Show the demand for and supply of rand graphically, and indicate equilibrium in the foreign exchange market Evaluate the effect of changes in the demand for and supply of rand on the equilibrium exchange rate, and show it graphically After studying this unit, you will be able to: Discuss the long-run trends in the exchange rate and explain interest rate parity and purchasing power parity Discuss the balance of payments accounts and explain what causes an international deficit Calculate the various balances of the balance of payments Compare the alternative exchange rate policies and explain their long-run effects Themes of this unit: 1.Currencies and Exchange Rates 2.The Foreign Exchange Market 3.Changes in Demand and Supply: Exchange Rate Fluctuations 4.Financing International Trade 5.Exchange Rate Policy Currencies and Exchange Rates Foreign currency is obtained in exchange for domestic currency in the foreign exchange market The nominal exchange rate is the value of one currency in terms of another currency The Foreign Exchange Market Exchange Rates Economic agents who supply or demand foreign exchange • Exporters – Suppliers of goods to foreign buyers receive payments in foreign currency that they exchange for local currency thus they tend to supply foreign currency onto the local foreign exchange market • Importers – These require foreign exchange to pay for the goods that are acquired from elsewhere in overseas • Foreign investors – Foreign investors buy SDG in other to acquire assets such as buildings in the Sudan or shares in Sudanese businesses • Speculators – They operate in the foreign currency market in order to make profit by buying and selling the foreign exchange Exchange rate regimes • Copeland identifies three broad categories: – Floating rates – fixed rates and – managed floats • The International Monetary Fund classifies exchange rate arrangements into eight categories: Exchange rate arrangements in the 185 IMF member countries No Exchange rate arrangement 2007 2008 No separate legal tender 5.32 5.32 Currency board 6.91 6.91 Conventional peg 33.5 32.45 Peg with horizontal band 2.66 1.60 Crawling band 0.53 1.06 Crawling peg 3.19 4.26 Managed floating 25.53 23.4 Independently floating 18.62 21.28 IMF (2009), Annual Report of Exchange rate arrangement and exchange rate restrictions, International Monetary Fund, Washington, D.C Exchange Rate regimes since 1940 Source: People’s Bank of China, 2009 Exchange Rate Structure • Unitary • Dual • Multiple – Most countries are moving towards a unitary exchange rate market for sake of market efficiency among others 10 The Effective Exchange Rate The effective exchange rate is the average exchange rate of the rand against a basket of currencies Questions About the Exchange Rate The Foreign Exchange Market Demand and supply in the foreign exchange market determine the exchange rate The Demand for One Money Is the Supply of Another Money Demand in the Foreign Exchange Market The exchange rate World demand for South African exports Interest rates in South Africa and other countries The expected future exchange rate The Law of Demand for Foreign Exchange Exports Effect Expected Profit Effect Demand Curve for South African Rand Supply in the Foreign Exchange Market The exchange rate South African demand for imports Interest rates in South African and other countries The expected future exchange rate Demand Curve for South African Rand The Law of Supply of Foreign Exchange Imports Effect Expected Profit Effect Supply Curve for South African Rand Market Equilibrium The equilibrium exchange rate makes the quantity of rand demanded equal the quantity of rand supplied Changes in Demand and Supply: Exchange Rate Fluctuations Changes in the Demand for South African Rand World Demand for South African Exports South African Interest Rate Relative to the Foreign Interest Rate The Expected Future Exchange Rate Changes in the Supply of South African Rand South African Demand for Imports South Africa’s Interest Rate Relative to the Foreign Interest Rate The Expected Future Exchange Rate Changes in the Exchange Rate An Appreciating South African Rand: 2002–2006 A Depreciating Rand: 1999–2001 Financing International Trade International trade, borrowing, and lending are financed by using foreign currency A country’s international transactions are recorded in its balance of payments Balance of Payments Accounts The balance of payments consists of a: current account capital transfer account financial account change in net gold and other foreign reserves An Individual’s Balance of Payments Accounts Borrowers and Lenders Debtors and Creditors Current Account Balance Net Exports The current account balance is similar to net exports and is determined by the government sector balance plus the private sector balance Where Is the Exchange Rate? Exchange Rate Policy An exchange rate can be flexible, fixed, a crawling peg To achieve a fixed or a crawling exchange rate, a central bank must intervene in the foreign exchange market Flexible Exchange Rate Fixed Exchange Rate Crawling Peg The People’s Bank of China in the Foreign Exchange Market Why Does China Fix Its Exchange Rate? ... foreign exchange market, define the exchange rate, and distinguish between the nominal exchange rate and the real exchange rate Calculate the real exchange rate Explain how the exchange rate is... demand for and supply of rand Show the demand for and supply of rand graphically, and indicate equilibrium in the foreign exchange market Evaluate the effect of changes in the demand for and. .. alternative exchange rate policies and explain their long-run effects Themes of this unit: 1.Currencies and Exchange Rates 2.The Foreign Exchange Market 3.Changes in Demand and Supply: Exchange Rate