The Balance of Payment And Exchange Rates

 The Balance Payment

Balance Trade refers to the difference between exports and imports of goods

Balance of Payments (BOP) refers to a system of accounts that measures transactions of goods, services, income and financial assets between domestic households, businesses, and governments and residents of the rest of the world during a specific time period.

Accounting Identities refers to the values that are equivalent by definition

• An accounting identity among nations: 

➢When people from different nations trade or interact, certain identities or constraints must also hold. ➢ three categories of the balance of payments transactions.

Current Account refers to a category of balance of payments transactions that measures the exchange of merchandise, the exchange of services and unilateral transfers

• Current account transactions

 ➢Goods/Merchandise trade exports and imports

      ✓Tangible items—things you can feel, touch and see 

➢Service exports and imports 

     ✓Intangible items that are bought and sold 

➢Unilateral transfers 

     ✓Gifts from citizens and from governments

➢Current Account Surplus

      ✓Net exports plus unilateral transfers plus net investment income exceeds zero 

➢Current Account Deficit

      ✓Net exports plus unilateral transfers plus net investment income is negative

      ✓A current account deficit means that we are importing more goods and services than we are exporting. 

     ✓A current account deficit must be paid by the export of money or money equivalent

Capital Account refers to a category of balance of payments transactions that measures flows of real and financial assets (including debt instruments)

The current account and capital account must sum to zero 

     ➢In the absence of interventions by finance ministries or central banks

      Capital account + Current account = 0

Official reserve account transactions

1. Foreign currencies 
2.  Gold 
3.  Special drawing rights (SDRs)
4.  Financial assets held by an official agency

3. Special Drawing Rights

• Reserve assets created by the International Monetary Fund for countries to use in settling international payment obligations
• IMF is an agency founded to administer an international foreign exchange system and to lend to member countries that had balance of payments problems 
• The IMF now functions as a lender of last resort.

4. Financial Assets held by an Official Agency

• Financial assets held by official agency such as the U.S. Treasury 
• Financial assets refer to assets that arise from contractual agreements on future cash flows

• Cash & cash Equivalent Refers to a item on the balance sheet that reports the value of a company's assets that are cash or can be converted into cash immediately. 
• Bank Deposits Refers to a contract between two or more parties whose value is based on an agreed-upon underlying financial asset or set of assets.
•  Derivatives Refers to a the money placed into banking institutions for safekeeping Cash & Cash Equivalents Loan & Receivables
•  Loan & Receivables Refers to non-derivative financial assets with fixed or determinable payments that are not quoted in an active market
• Stocks Refers to a share which entitles the holder to a fixed dividend, whose payment takes priority over that of common-stock dividends. 
• Bonds Refers to a fixed-income instrument that represents a loan made by an investor to a borrower (typically corporate or governmental). Certificate of Deposits
•  Certificate of Deposit Refers to a money market instrument which is issued in a dematerialized form against funds deposited in a bank for a specific period

Determining the Exchange Rates

• Foreign Exchange Market 

     ➢A market in which households, firms and governments buy and sell national currencies 

• Exchange Rates

     ➢The price of one nation’s currency in terms of another

Determinants Foreign Exchange Rates

Market determinants of exchange rates 

• Changes in real interest rates 
• Changes in productivity
•  Changes in product preferences 
• Perceptions of economic stability

The Gold Standard Monetary Funds

 Gold Standard refers to an international monetary system in which nations fix their exchange rates in terms of gold

➢All currencies are fixed in terms of all others, and any balance of payments deficits or surpluses can be made up by shipments of gold.

➢A balance of payments deficit

      ✓More gold flowed out than flowed in 

      ✓Equivalent to a restrictive monetary policy 

➢A balance of payments surplus 

     ✓More gold flowed in than out 

     ✓Equivalent to an expansionary monetary policy

Fixed Vs Floating Exchange Rates

Central banks can keep exchange rates fixed as long as they have enough foreign exchange reserves to deal with potentially long-lasting changes in the demand for or supply of their nation’s currency.

Floating Exchange Rates

• A floating exchange rate refers to currency in which the value of a currency fluctuates in response to supply and demand. The interplay of the market forces of demand and supply determine the currency’s value. Rather than government intervention, the currency’s value reflects public confidence in that country’s economy.

Fixed Exchange Rates

• A fixed exchange rate refers to a regime applied by a government or central bank that ties the country's official currency exchange rate to another country's currency or the price of gold. The purpose of a fixed exchange rate system is to keep a currency's value within a narrow band.