Balance of Payments, Currency, and Exchange Rates

1 Balance of payments , currency , and Exchange Rates 1 Balance Of payments The Balance of payments is composed of two categories: current account and the capital and financial account. The current account includes the merchandise trade exports and imports; service exports and imports, including transportation receipts and payments ; income receipts and payments ; and unilateral transfers, such as foreign aid, gifts, and investments by citizens. The capital and financial account includes private and public (official) transactions. Private capital transactions include the purchase and sale of nonfinancial assets and capital transfers, such as migrant transfers to and from a home country. Private financial transactions include direct investment, the purchase and sale of securities, and bank claims and liabilities.

2 Public financial transactions include official settlement transactions, such as government assets held overseas and foreign official assets held in the United States. Balance Of payments Statistics The United States has incurred a current account deficit comprised of a merchandise (goods) deficit, a services surplus, an income and receipts deficit or surplus, and a unilateral transfer deficit for the last two decades. The merchandise deficit has steadily grown as Eastern Asian countries, such as China, South Korea, Taiwan, and so on send most of the output to the United States. The service surplus has increased as firms provide banking, tourism, insurance, and other services. The income and receipts statistic has turned from a deficit to a surplus as income to foreigners from investments has exceeded the income to residents from foreign investments.

3 The unilateral transfer deficit has grown as aid to foreign nations has increased. The current account deficit has been offset by the capital and financial transaction surplus. This surplus has grown and results from tremendous levels of foreign investment in businesses and securities. Forward And Futures Markets Forward and futures markets are used to accomplish the objectives of hedging, speculation, and trading. Forward contracts occur between large entities, whereas futures contracts involve any size entity (for example, individuals, small firms, or large firms). Forward market trading occurs over the counter or via the telephone, whereas futures trading takes place on a physical Exchange , such as the International Monetary Market in Chicago. Contract sizes and delivery dates are negotiable in the forward market and standardized in the futures market.

4 Traders earn the bid/ask spread in the forward market, and they earn brokerage commissions in the futures market. Finally, contract settlement occurs on the expiration date in the forward market and daily (that Balance of payments , currency , and Exchange Rates 2 is, mark to market) in the futures market. Firms have four options when it comes to managing Exchange rate risk. They are as follows: do not hedge, hedge using forward or futures contracts, hedge using money market contracts, and hedge using option contracts. If they decide to hedge, then the choice is among forward/future contracts, money market contracts, or option contracts. Each of the hedges will accomplish the goal of eliminating Exchange rate risk. Forward/futures and money market contracts, however, lock you in so that you cannot take advantage of favorable changes in the spot market.

5 For example, if a firm hedged accounts payable using a forward contract and the applicable foreign currency depreciated in value, the firm could not take advantage of it because they are locked into the forward contract. The advantage of option contracts is that they do not require that you exercise the option. Depending on changes in the spot rate, the firm can either exercise the option or let it expire and then take advantage of favorable movements in the spot market. currency Values, Interest and Exchange Rates Many factors affect currency values. One of these factors is real interest Rates . Real interest Rates differ from nominal Rates in that they control for the effect of changing prices. In other words, the real interest rate is approximately the difference between the nominal interest rate and the inflation rate.

6 Holding other factors that influence Exchange Rates constant, if the real interest rate increases, outside investment increases as the higher Rates attract foreign investment. The demand for the home currency increases as investment increases and its value rises. The opposite is true if real interest Rates decrease. For example, one of the reasons that the dollar was strong through most of the 1990s and into the twenty-first century was relatively high real interest Rates in the United States. Exchange Value Factors Factors include the following: Foreign demand for exports Foreign demand for assets demand for foreign exports demand for foreign assets price level interest Rates real income Balance of payments , currency , and Exchange Rates 3 productivity trade restrictions As the foreign demand for exports increases (decreases), foreigners demand (supply) dollars, causing the dollar to appreciate (depreciate).

7 The same effect would occur with regard to the foreign demand for assets. In contrast, as the demand for foreign exports increases (decreases), the demand for dollars would decrease (increase), causing the dollar to depreciate (appreciate). A similar effect takes place for the demand for foreign assets. As prices increase (decrease), there is less (more) demand for goods/services and therefore, less (more) demand for dollars, causing the dollar to depreciate (appreciate). The opposite is true for interest Rates . As they increase (decrease), investment and the demand for dollars increases (decreases), resulting in a higher (lower) value for the dollar. As productivity increases (decreases), the same amount of production occurs with lower (higher) costs.

8 These changes decrease (increase) the price of exports, causing an increase (decrease) in exports, an increase (decrease) in the demand for dollars, and a higher (lower) value for the dollar. Trade restrictions tend to reduce imports because such restrictions make imports more expensive to consumers. Accordingly, the demand for foreign currency decreases relative to the demand for the dollar, causing the dollar to increase in value. The opposite is true if there is a reduction in trade restrictions. Automatic Adjustment Mechanisms The Balance of payments statistics require that debits equal credits. In other words, if a country has a trade deficit, it must be offset by foreign investment or the sale of domestic assets. Alternatively, if there is a trade surplus, then it must be offset by the purchase of foreign assets.

9 If a currency moves away from equilibrium value as a result of trade imbalances, theoretically, under fixed Exchange Rates , automatic adjustment mechanisms will restore equilibrium. Three schools of thought describe the adjustment process: Classical theory from the late nineteenth and early twentieth century suggests that adjustment occurs via price and interest rate adjustments. Keynesian theory from the 1930s asserts that income adjustments restore equilibrium. Balance of payments , currency , and Exchange Rates 4 Monetary theory emanating from the University of Chicago in the late 1960s argues that changes in the money supply play the primary role in restoring equilibrium. Described by Adam Smith in The Wealth of Nations (1776/1993), the invisible hand works best without government interference.

10 Government interference distorts the allocation of resources, and therefore, causes inefficient outcomes. Automatic adjustment mechanisms rely on the efficiency of the market to restore equilibrium. The problem for politicians is that they often do not have the time to wait for automatic adjustments mechanisms to do their magic. Also, depending on automatic adjustment mechanisms requires that the central bank not use monetary policy to promote full employment without inflation. In other words, if the adjustment mechanism imposes inflation or unemployment on the economy as part of the adjustment process, the central bank must accept it and not intervene with changes in monetary policy. The J-Curve Effect The J-curve describes the impact of a currency devaluation on a nation s trade deficit.