Lecture 4: payments among nations and exchange rates

Balance of payments accounts

A country’s international transactions are recorded in the Balance of Payment (BOP).

The BOP has two three accounts:

1. Current account (CA): trade in goods and services, income transfers
2. Financial account (FA): foreign investment
a. Everything about capital flow, foreign investment.
3. Official reserves account (OR): central bank transactions
a. Whenever you have some transactions you need to exchange on for the other.

Balance of payments identity

Each international transaction has to be recorded twice in the BOP: once as a credit item, once as a debit item.
● Credit items (+): money flowing into the country; demand for domestic currency.

● Debit item (-): money leaving the country; demand for foreign currency.
○ Money outflow, there will be lower demand for domestic currency.

Leads to the ‘balancing’ of all accounts (BOP identity):

CA + FA + OR= 0

The sum of the 3 accounts will be 0.

Because of double-entry bookkeeping:

A + FA + OR = 0 → CA = – FA– OR

Current account balance = net foreign investment

CA > 0 → Country is a net lender
● Positive, money money inflow than outflow. You have a surplus. And you can lend it

CA < 0 → Country is a net borrower

● Negative meaning that there is a current account deficit, you are a net borrower.

-FA + OR: is about capital flows, investments. There is a - and that means money outflows,
CA balance is also linked to domestic savings and investment.

A country can do two things with its savings (S): investment domestically (Id) and invest abroad (If).
Thus a country’s net foreign investment (If) is:
If = S – Id
Therefore:
CA = net foreign investment = S – Id

You have money and you see if you have money in your account., they are used for domestic investment and
international investment.
● It measures net foreign investing, which equal domestic savings - domestic investment.

International investment position

International investment position: The stock of a nation’s international assets and foreign liabilities at a specific point
in time. It measures if:

● A country is a creditor if its net stock of foreign assets is positive.

● A country is a debtor if its net stock of foreign assets is negative.

Official settlement balance: Balance of current account and financial account:

B = CA + FA
CA + FA + OR = 0 → B + OR = 0

Balance of payments can be written as official settlement balance + official reserve amount = 0

B > 0 → OR < 0 → official reserve asset holdings of a B < 0 → OR > 0 → official reserve asset holdings of
country have increased or foreign official holdings of the country have fallen or foreign official holdings of
the country's assets have fallen. the country's assets have increased.

B is positive and OR is negative, minus means money OR is a positive, means that there is money inflow,
outflows so the central bank hold more foreign means that the central bank holds more domestic
currencies and less domestic currencies currency.

Exchange rates

(Nominal) exchange rate

Exchange rate = price of one currency in terms of another (relative value of two currencies).
E.g. $/EUR (the price of EUR)
● This expresses the price of the Euro, meanings 1 euro equals how many units of one dollar
● The relative value of 2 different currencies.

Changes in the exchange rate imply that one currency gains value relative to the other one
(appreciation/depreciation).

Effective exchange rate weighted average of the values of a country’s currency relative to various (major) currencies.

We have a basket of currencies and we calculate the average and see which one is higher or lower

Spot rate = price of buying or selling a currency at this moment.

● What is the real rate?

Forward rate = price of buying or selling a currency at a specific date in the future.
● Forward, we discuss today at what level of exchange rate we make the transaction
● DETERMINED today

NOTE: Forward rate ≠ Future spot rate. The former refers to a future rate locked in today, the latter to the rate
prevailing in the future spot market.

Spot rate > forward rate: Foreign currency is cheaper in Spot rate < forward rate: Foreign currency is more
the future than today → Foreign currency is selling at a expensive in the future than today → Foreign currency
forward discount. is selling at a forward premium.

If we see that its lower in the future it means that We think that foreign currency will be stronger in the
foreign currency will be lower in the future (Expect) future.

Nominal and real exchange rate

Nominal exchange rate (e) = the relative value of two currencies .
● We compare the value of the 2

Real exchange rate (ε) = the relative value of two currencies adjusted for differences in prices in the two countries.
● Measures the relative price of one country vs another country.

𝐻𝑜𝑚𝑒 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦 𝐹𝑜𝑟𝑒𝑖𝑔𝑛 𝑝𝑟𝑖𝑐𝑒

𝐹𝑜𝑟𝑒𝑖𝑔𝑛 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦
* 𝐻𝑜𝑚𝑒 𝑝𝑟𝑖𝑐𝑒
 Real Exchange Rate

ε > 1: foreign products are more expensive than ε < 1: foreign products are cheaper than domestic
domestic products (e.g. ε = 1.3 → foreign products are products (e.g. ε = 0.8 → foreign products are 20%
30% more expensive) cheaper than domestic products.)

An increase in ε implies:
● Foreign prices have increased relative to domestic prices and/or
● The foreign currency has become more expensive.

Implies that the home country’s products have become more competitive compared to the foreign country’s
products.

Analog for a fall in ε: Foreign products have become more competitive compared to home products.

Real exchange rate increases: foreign products become more expensive, you lose competitiveness.
Nominal the value of a currency, the price and real exchange rate the price level.

Exchange rate movements

Changes in supply and demand for different currencies can come from international trade and international
investment.

● Exports of products or capital imports create demand for the domestic currency and supply of foreign
currency: the domestic currency appreciates (e↓).

○ When we export products we sell products to a foreign country, they need to pay, they exchange their
currency or domestic currency, there is a higher demand for the domestic currency it appreciates
○ Higher demand = higher value= currency appreciates

● Imports of goods from abroad or capital export create demand for the foreign currency and supply of
domestic currency: the domestic currency depreciates (e↑).

○ When you import buy products, you pay and you exchange your home currency into foreign current,
the demand for foreign currency increases, when there is a demand it becomes more expensive and
it increases
Arbitrage in the foreign exchange market

If the exchange rate between two currencies differ in different locations, one can make a profit by buying a currency
where it is cheap and selling it where it is expensive (arbitrage).

● Buy where its cheap and sell where its more expensive

This changes the demand and supply of the currencies and will make the two exchange rates converge.

Triangular arbitrage: The same holds true for the exchange rate between three (or more) currencies:

Supply and demand forces ensure that also the cross rates will be consistent with each other

If you get a cheap currency and exchange where its cheaper, the profit margin will decrease as you go.