Topic 8 BP and FXM - Balance of Payments and the Foreign Exchange Market summary PDF

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Sample Exam Questions: Balance of Payments and the Foreign Exchange Market Q1. i) Outline the major components of the balance of payments and ii) why the balance of payments statement balances. Definition: The Balance-of-Payments is a record of the economic transactions between the residents of one ...

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Sample Exam Questions: Balance of Payments and the Foreign Exchange Market Q1. i) Outline the major components of the balance of payments and ii) why the balance of payments statement balances. Definition: The Balance-of-Payments is a record of the economic transactions between the residents of one country and the rest of the world. Nations keep annual and quarterly (US) records. An international transaction in exchange for goods, services and assets between residents and individuals.  i)

Residents include business (not subsidiaries), government and individuals.

Major components of the balance of payments: 1) Current Account -

records the flow of goods and services and income & unilateral payments

-

This is divided into: 

Goods (eg cars, planes, wheat etc) - only a narrow term, only part of sales



Services (eg tourism, technical training, financial services)



Primary income (eg wages to non-resident workers, investment income)



Secondary income (gifts or grants to foreign individuals such as foreign aid)

1. Monetary value of international lows, transactional goods, services, income flows and unilateral transfers. 2. + credit = exports, - debit = imports 3. Government transfers =goods and service balance 4. Income balance = div/interest on investment abroad, compensation to employees 5. Unilateral transfers = Goods & services, private transfers

2) Capital Account -

records the annual change in financial flows (or the change in the claims of one country on the assets of another)

-

Measures financial flows or the change in the claims of one country on the assets of another. All international purchases or sales of assets 

Eg when people in the EZ by US goods, euro and other financial assets flow out



Because euros are only useful in buying EZ goods, we say that the US has a claim on EZ assets



Foreigners may hold these claims in a variety of forms such as currency, Stocks in EZ companies, government or corporate bonds



Private: Direct investment securities, bank claims and liabilities



Official statement transactions



Statistical discrepancy

3) Balancing Account -

Goods, services and resources traded internationally are paid for. Thus every movement of products is offset by a balancing movement of money or other financial asset

ii) Why the balance of payments statement balances A surplus in the current account is by definition offset by a deficit in the capital account -

If we export goods and services then we import the financial assets of foreigners

A deficit (sub-account) in the Current Account must be offset by a surplus in the capital account -

If Irish people import goods from the US, then we export our financial assets (euros)

CA surplus: Excess of exports Net receipt of foreign claims CA deficit: Excess of imports

Q2. Discuss why a balance of payments deficit on the current account is not necessarily a bad thing. -

Current account deficit means an excess of imports over exports; nation becomes a borrower of funds from rest of world

-

-

Is it good or bad for country to incur debt? 

Depends on whether the deficit used to finance more consumption or more investment



If used for investment, burden slight (Tech, capital – higher future productivity)



If used for consumption, no boost to future productivity



To meet debt service expense, future consumption must be reduced

Rapid growth of production & employment associated with growing trade & current account deficits

- Current account deficit indicates that the US did import more than export (Im>Ex). When importing goods into the country, there are more dollars transferred to another countries. With

those dollars, foreigners usually invest back the money in the US in the form of capital (FDI), not consumer goods. Thus, it can drive domestic economic growth. -

In deficit, more imports means more the US currency is more desirable outside the country. In a floating exchange rate system, the current account deficit can devalue the US Dollar currency and thus lower the level of deficit.

Consequences:

-



Terms of Trade



Employment level



Stability of international markets

Example of the US o

In 2014, the United States had a deficit as much as $410,628 million in its current account. For some people, it reflects the trade balance of the country is not in good situation but opinions differ.

o

No automatic or economic reasons why U.S. cannot sustain current account deficit indefinitely as long as foreigners desire to purchase U.S. assets

o

Consequence of current account deficit is growing foreign ownership of capital stock of U.S. and a rising fraction of U.S. income that must be paid as interest & dividends to foreigners Serious problem could emerge if foreigners lose confidence inability of U.S. to repay



To reduce deficit 

Stimulate foreign growth



Not always in the hands of the nation

Q3. Discuss why a balance of payments surplus on the current account in the long run may harm the economy. -

Current account surplus means an excess of exports over imports; nation becomes a lender to rest of world

-

We have sent more goods and services to other countries than they have sent to us. We have claims on their financial assets



In practical terms this means that EZ goods and services are competitive: foreigners are willing to spend their money on EZ products



EZ citizens are willing to hold claims on foreign assets in the form of foreign currency, stock, bonds. This is ok if the US has strong stable government and produce products that we want in the future

-

Slow output & employment growth associated with growing surpluses

-

During recession, saving & investment tend to fall; current account balance tends to rise; trade balance improves

Countries in recession are associated with trading account surplus – their unemployed cannot afford to increase imports.

Q4. Should governments intervene to reduce a deficit on the current account of the balance of payments? Government should only intervene if deficit is to finance increased consumption rather than to finance investment. Policies to reduce a current account deficit: 1. Devaluation of exchange rate (make exports cheaper – imports more expensive) -

Not in the case of the Eurozone due to loss of independent monetary policy.

-

May be an option to print more money (e.g. US) - effects < cost

2. Reduce domestic consumption and spending on imports (e.g. tight fiscal policy/higher taxes) 3. Supply side policies to improve competitiveness of domestic industry and exports.

Q5. Why are countries likely to run surpluses in times of economic recession and deficits in times of boom? 

During recession, saving & investment tend to fall; current account balance tends to rise; trade balance improves



Often deficits are a healthy by product of a growing economy.



Recession: decrease investment, decrease consumption, decrease imports and therefore decrease the deficit (opposite for a boom)

Q6. Discuss the implications for the euro area of i) a strong euro and 2) a weak euro vis a vis its trading partners. i) 

Implications for a strong euro for the Eurozone Increasing value of currency = appreciation



Cause of a strengthening/strong euro: large current account surplus Exports > Imports, reduction in political risk increases investment in the euro zone, therefore increasing exports.

1. Inflation/ lack of it 

In 2017, the Euro appreciated by 7% in 3 months, yet inflation was stuck at 1.2%, yet theory suggests that when a currency appreciates, inflation should decrease due to the decrease in the price of imports, making domestic goods less attractive.

2. Exports (Losers) 

When the euro appreciates, exports become more expensive, thus resulting in a reduction in competitiveness.



Corporations/exporters do not enjoy the rising euro (material and semiconductor sectors)



Only areas of differenced products where consumers hold high willingness to pay will consumers be willing to pay a higher price for very specific goods.

Countries such as Germany, Belgium and the Netherlands appear less sensitive to currency movements. Countries within the Euro zone which are less open are more vulnerable to currency movements.

ii) 

Implications for a weak euro for the Eurozone (in comparison to US $) A currency may devalue/depreciate/weaken if there is an increase in political risk/increase in uncertainty (Greek crisis 2014)

1. Imports (winners) 

American consumers will find that imported consumables, such as fine wines and cheeses from France and Italy, have become more affordable. German cars, including Audi, Mercedes Benz, BMW, and Volkswagen, will all become less expensive at showrooms in the U.S



When the euro is weak, it means the dollar must be strong relatively speaking. Tourists and business travellers will see their dollar go farther while abroad. U.S. companies who regularly send employees to Europe for business will also benefit from cheaper accommodations. Ex-pats who live in European cities but earn dollars will also see their cost of living go down.

2. Exports (losers) 

U.S. companies that export to Europe will lose out as their products become more expensive for European buyers.



Investors in domestic companies that have large exposure to the European market should be wary.



Tourism may suffer as American destinations become more expensive for European citizens. While it is true that the industry has reported fewer European travellers visiting the U.S. each year for the past few years. Ex-pats from Europe living in America but earning euros will see their cost of living increase.

Q7.How does a depreciating/appreciating exchange rate impact on real economic variables. Use illustrations to support your answer.

The Exchange Rate and Inflation: The exchange rate affects the rate of inflation in a number of direct and indirect ways: 

Changes in the prices of imported goods and services – this has a direct effect on the consumer price index. For example, an appreciation of the exchange rate usually reduces the price of imported consumer goods and durables, raw materials and capital goods.  Commodity prices: Many commodities are priced in dollars – so a change in the sterlingdollar exchange rate has a direct impact on the UK price of commodities such as oil and foodstuffs. A stronger dollar makes it more expensive for Britain to import these items.  Changes in the growth of exports: A higher exchange rate makes it harder to sell overseas because of a rise in relative prices. If exports slowdown (price elasticity of demand is important in determining the scale of any change in demand), then exporters may choose to cut their prices, reduce output and cut-back employment levels.

Q8. Using illustrations, show and explain the impact of the following on the value of the €/$ exchange rate. Assume we are using indirect ER quotations and examining the impact on the demand and supply of euros.

Indirect Exchange Rate quotations: the price of one unit of domestic currency is expressed in terms of foreign currency e.g. €1/$1.13.

(i)

Inflation in the Eurozone is higher than in the US

Πez > Πus 

Inflation = higher P’s = decreased demand for EZ goods, decreasing exports and receipts



(shift € Demand curve left)



Due to higher prices, EZ imports will increase and so will payments



(Shift € supply curve right)

Effect: € depreciates against the $

(ii)

Eurozone interest rates are lower than in the US

iez < ius  There is a capital outflow from the Eurozone as people sell € in exchange for $ as it reaps a better return.  This results in an increase in the supply of

€

on the foreign exchange market (FXM)  Shifts the € Supply curve right Effect: € depreciates against the $

(iii)

Productivity in the Eurozone is lower than in the US EZ productivity < US productivity



Eurozone is less competitive in comparison

to

US imports as they are cheaper for EU citizens due to being highly productive. 

Increased imports of US goods 



Shift € supply curve right

Decrease in EZ demand/exports as they are more expensive in comparison/less competitive 

shift € demand left

Effect: € depreciates against the $

(iv) 

Eurozone raises tariffs against the US

Increase tariffs = Increasing price of imports for the US 

Shifting the € supply curve left

Decreasing exports as US residents will have less income to buy EZ goods -

Shifting € demand to the right

*The effect on the exchange rate may rise, fall or stay the same

Shift in demand (left) < shift in supply (left)

Shift in demand (left) > shift in supply (left)

= appreciation of €

= depreciation of €

Shift in demand (left) =shift in supply (left) = no change in FX...