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Definitions The balance of payments is a form of state book keeping, where monetary inflows and outflows are recorded The number of transaction depends heavily on the exchange rate The exchange rate might be floating (based on S&D) or fixed Demand for a currency dependents on investment prospects in the home country 2

Balance-of-Payments (BoP) It is a record of a country’s all international monetary transactions over a specific period of time Includes both private and government transactions Inflows of money are recorded as credit (+) Outflows of money are recorded as debit (–) Every transaction is recorded twice BoP should be balanced, but in reality this rarely happens BoP is calculated quarterly and annually 3

BOP Components Current Account 4 ItemDebitCredit Balance on trade (goods & services) Imports (–)Exports (+) Net income flows (wages, investment income e.g. profit, interest, dividends) Outflows (–)Inflows (+) Net current transfers * (government contribution and aid & personal transfers e.g. remittances) Outflows (–)Inflows (+) * Unilateral transfers, where one party benefits economically and provides nothing in return

BOP Components (2) Capital Account 5 ItemDebitCredit Net transfers of capital (acquisition or sale of fixed assets e.g. land, funds of migrants, government funds for capital projects (CAP & Cohesion) Outflows (–)Inflows (+)

BOP Components (3) Financial Account 6 ItemDebitCredit Direct InvestmentOutflows (–)Inflows (+) Portfolio Investment (shares, bonds, government securities) Outflows (–)Inflows (+) Other short-term investment (trade credit, loans, bank deposits & currency) Outflows (–)Inflows (+) Reserves *Adding (–)Drawing (+) * Buying home currency at the foreign exchange market is considered a (–) from the reserve account, but a (+) in the BoP

Recording transactions Export of goods from UK UK granting government aid (goods) BG government loan ($) from IMF 7 DebitCredit Merchandise exports (current account)£ Short term investment (financial account)£ DebitCredit Unilateral transfer (current account)10 million Merchandise exports (current account)10 million DebitCredit Loan (financial account)50 million Reserves (financial account)50 million

Balance of BoP Current Account + Capital Account + Financial Account + Net Errors and Omissions = 0 Net Errors and Omissions stem from statistical mistakes, which are fixed before final calculation Current Account deficit = M > X To balance the deficit, governments can: Borrow Draw from reserves Sell assets abroad Raise the interest rate 8

Trade deficit 9

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Exchange rate (floating) Exchange rate is the price at which one currency trades for another In free exchange rate system, the price of the currency is defined by S & D When the exchange rate of the £ (vs. X) is high, people will be selling £ Too much £ (c-d) will cause depreciation of the currency When the exchange rate of the £ (vs. X) is low, people will be buying £ Too few £ (a-b) will cause appreciation of the currency Eventually there will be an equilibrium 11 €

BoP and exchange rate ? When the exchange rate of the pound is high, imports are cheaper – pounds are going to be in excess on the market: When the exchange rate is low, exports are cheaper – pounds are going to be in shortage on the market: The exchange rate should help BoP balance 12 Trade deficit Trade deficit Value of pound Trade surplus Trade surplus Value of pound

Shift in S & D for a currency Causes for depreciation: Fall in interest rates Rise of inflation at home, compared to inflation abroad Rise in incomes at home, compared to incomes abroad Better business climate abroad, compared to climate at home Speculation € Q of £ S1 D1 S2 D2

Fixed exchange rate Some governments prefer to stick to a fixed exchange rate, because: There is more certainty There is less speculation 14 Ex. ratePriceCostProfit £1=$1.50$ p20p £1=$2$ p – 5 p When the market price falls below the fixed one the difference is financed by: Borrowing – foreign currency loan to buy out excess pounds Drawing from reserves – use own currency reserves to buy out excess pounds Raising interest rates – to raise the demand for the currency

Drawbacks of a fixed exchange rate Do not work during economic recession – high interests rates reduce aggregate demand and hamper economic activity Fail in times of economic shock – during an oil crises, oil importing countries face pressure to devaluate their currencies – paying for the difference become too expensive Cannot resist massive speculation – if demand for the currency is too low for too long, financing becomes impossible 15

Intermediate regimes Adjustable peg – fixed in the short term, adjusted in several years Crawling peg – is adjusted frequently by small amount Joint float – group of currencies, using adjustable peg among each other and jointly float vis-à-vis other currencies (ERM) Exchange rate band – fluctuate within limits Managed float – free rate, but governments intervene to buy and sell in turbulent times 16

Currency board In a CB, the exchange rate is completely fixed to a reserve (anchor) currency The country maintains a reserve of % equivalent to the whole monetary base The government cannot print money BG adopted a CB in 1997, after experiencing hyperinflation Initially the lev was pegged to the DM, later on the the Euro IMF financed the CB 17

The Euro – a panacea? By adopting the euro MS enjoyed following advantages: No more conversion costs No uncertainty, stemming from floating currencies Lower inflation (strong confidence), guaranteed by ECB Increased investment coming in the EU 18

Sources Lecture is based on: The global financial environment in Sloman, J. and Jones, E. (2011) Economics and the Business Environment (3 rd ed) UK: Pearson 19