1. Balance of Payments and Foreign Exchange
International Economics
Chapter 6
Balance of Payments
and Foreign Exchange

2. Chapter 6 Balance of Payments and Foreign Exchange
6.2 Foreign Exchange Market and Exchange Rates
6.3 Exchange Rate System

3. 6.1 Balance of Payments
A balance of payments (BP) sheet is an accounting record of all monetary transactions between a country and the rest of the world.
These transactions include payments for the country's exports (X) and imports (M) of goods, services, and financial capital, as well as financial transfers.
The BP summarizes international transactions for a specific period, usually a year. Some countries also keep such a record on a quarterly basis.

4. 6.1 Balance of Payments
A credit transaction is one that results in a receipt of a payment from foreigners.
A debit transaction is one that leads to a payment to foreigners.
Double entry accounting system
Each credit entry is balanced by a debit entry, and vice versa. So the recording of any international transactions leads to two offsetting entries.

5. The balance of payments consists of two primary subaccounts:
the current account (CA)
the capital and financial account (KA)

6. 6.1 Balance of Payments
The current account (CA) refers to the monetary value of international flows associated with transactions in goods and services, factor income, and unilateral transfers.
the balance of trade
the difference between a country's exports of goods and services and its imports of goods and services.
net factor income
the money received from investments made abroad;
the money sent by individuals working abroad, known as remittances, to their families back home.
net unilateral transfer
Private transfer payment
Government transfers

7. 6.1 Balance of Payments
The capital and financial account (KA) reflects net change in national ownership of assets.
The capital account
capital transfers
the transfer of ownership on fixed assets
the transfer of funds received to the sale or acquisition of fixed assets
the transfer of goods and financial assets by migrants leaving or entering a country
debt forgiveness
the acquisition or disposal of non-financial and non-produced assets
The financial account
foreign direct investment
portfolio investment
other investment
reserve assets
Except reserve assets which are public-sector transactions, all other components of the capital and financial account are categorized into private-sector transactions.

8. 6.1 Balance of Payments
The overall BP sheet will always balance when all types of payments are included
Imbalances are possible on individual components of the BP.
trade balance
exports of goods and services minus imports of goods and services
current account balance
capital and financial account balance
overall BP balance
the current account plus the capital and financial account except for reserve assets
Most frequently, when we mention an imbalance in the BP, we actually refer to the current account balance.

9. 6.1 Balance of Payments
Automatic Adjustment of the Balance of Payments
Price-Specie Flow Mechanism
Under a gold standard
a positive balance of trade => gold inflow => a rise in money supply => higher prices of goods and services => a fall in export, a rise in import => a neutral balance
Criticisms:
The classical linkage between changes in a country’s gold supply and changes in its money supply no longer exists.
The full employment on which the quantity theory of money holds is not common.
In a modern industrial world, prices and wages are sticky in a downward direction.

10. Chapter 6 Balance of Payments and Foreign Exchange
6.2 Foreign Exchange Market and Exchange Rates
6.3 Exchange Rate System

11. 6.2 Foreign Exchange Market and Exchange Rates
The foreign exchange market is a worldwide decentralized over-the-counter financial market for the trading of currencies. It is the largest and most liquid financial market in the world.
Levels of access:
the inter-bank market, made up of the largest commercial banks and securities dealers.
smaller banks
large multi-national corporations
large hedge funds
some other financial institutions.
National central banks also participate in the foreign exchange market to align currencies to their economic needs.

12. 6.2 Foreign Exchange Market and Exchange Rates
The exchange rate between two currencies specifies how much one currency is worth in terms of the other.
Direct Quotation v.s. Indirect Quotation
Appreciation v.s. Depreciation
Types of Foreign Exchange Transaction
Spot transaction
Forward transaction
Currency swap

13. 6.2 Foreign Exchange Market and Exchange Rates
Supply of and Demand for Foreign Exchange

14. 6.2 Foreign Exchange Market and Exchange Rates
Determinants of Exchange Rates
Economic Factors
Economic policies
Government budget deficit or surplus
Balance of trade levels and trends
Inflation levels and trends
Economic growth and health
Productivity of an economy
Market Psychologies
Flights to quality
Long-term trends
Buy the rumor, sell the fact
Economic figures
Technical trading considerations

15. Chapter 6 Balance of Payments and Foreign Exchange
6.2 Foreign Exchange Market and Exchange Rates
6.3 Exchange Rate System

16. 6.3 Exchange Rate System
The exchange rate system is the way a country manages its currency in respect to foreign currencies and the foreign exchange market.

17. Types of Exchange Rate Regime
6.3 Exchange Rate System
Types of Exchange Rate Regime
Floating exchange rate
A type of exchange rate system wherein a currency's value is allowed to fluctuate according to the foreign exchange market.
In cases of extreme appreciation or depreciation, a central bank will normally intervene to stabilize the currency. Thus, the exchange rate system of floating currencies may more technically be known as managed floating.
Fixed exchange rate (pegged exchange rate)
It matches a currency's value to the value of another single currency or to a basket of other currencies, or to another measure of value, such as gold.
Currency board
A monetary authority which is required to maintain a fixed exchange rate with a foreign currency.