International Money & Finance

Lesson 1
 Welcome to Lesson 1 !!

Goals for today:

This will begin the IMF Endterm Course.

➢ Brief Exam Distribution Explanation

Remarks:
➢ Chapter 1: The Foreign Exchange Market

★ I will send these slides after the lesson + Practice Qs.

(WhatsApp). ➢ Chapter 2: The Balance of Payments

★ If you have any questions, feel free to ask in the + Practice Qs.

Zoom chat or ask to unmute yourself !! ➢ Start Chapter 3: Elasticity and Absorption Approaches to the

○ You can always send me follow-up questions Balance of Payments

+ Practice Qs.
via WhatsApp in our group chat☺
❏ Depends on how much time we have left !!

★ Practice exam questions per chapter covered.

Exam Analysis
 Course Overview

Lesson 1 Lesson 2 Lesson 3 Lesson 4

❖ Chapter 11 (cont.)
➢ Chapter 7 (cont.)
★ Chapter 1 ❏ Chapter 3 (cont.) ❖ Chapter 14
➢ Chapter 8
★ Chapter 2 ❏ Chapter 6 ❖ Chapter 15
➢ Chapter 4
★ Chapter 3 ❏ Chapter 7 ❖ Chapter 16
➢ Chapter 11

**Most important parts.

 Chapter 1:
Floating Regime
Exchange Rate Regimes
= CB does not interfere.
● Exchange rate adjusts in response
Intermediate Regime (Controlled float)
to changes in the supply and
= CB acts to influence rate; intervenes in
demand for a currency.
the event of undesirable fluctuations.

Fixed Regime
= CB keeps rate at official level
(instruments: forex interventions, interest
rate, capital controls).
❏ Includes: Monetary union (most
extreme), Currency Board, Pegged
 $/¥
Chapter 1: The Foreign Exchange Market
S

Definitions

#1 = Domestic (H) currency per unit of foreign

(F) currency
- E.g., $.0088 / ¥1 Example D

¥
#2 = F currency per unit of H currency What would happen if GJP ↑ ??
- E.g., ¥113.71 / $1 FLOATING REGIME
Disturbance:

!! We use definition # 1 !! - Happens at a given exchange rate !!

- Government spending increases JP’s domestic and foreign demand of goods.
(H currency per unit of F currency)
- JP imports increase → JP demand of USD increases → JP needs to supply more Yen
to purchase U.S. goods → Supply shifts right.
Equilibration:
At new supply, excess supply of Yen at old exchange rate. Yen depreciates until D = S.
 $/¥
Chapter 1: The Foreign Exchange Market
S

Definitions

#1 = Domestic (H) currency per unit of foreign

(F) currency
- E.g., $.0088 / ¥1 Example D

¥
#2 = F currency per unit of H currency What would happen if GJP ↑ ??
- E.g., ¥113.71 / $1 FIXED REGIME
Disturbance:

!! We use definition # 1 !! - Same as with floating regime !! Supply curve shifts right.

(H currency per unit of F currency) Equilibration:

- Disturbance: → JP demands Yen at exchange rate —> D shifts right → So D1 = S1.
- Equilibration:
- Excess Demand of Yen.
- Yen appreciates until D1 = S1.
Forex Participants & Actions 1. Retail Clients
➢ Businesses, international investors, MNCs, etc. who need to exchange to
1. Retail clients
operate their businesses.
2. Commercial banks ➢ Do not directly purchase or sell foreign currencies themselves.
3. Forex brokers ○ Usually place buy/sell orders with commercial banks.
4. Central banks

3. Forex Brokers 4. Central Banks

2. Commercial Banks
● Floating since 1973, but CBs
❏ Advantages:
➔ Carry out buy/sell orders from their retail regularly intervene to buy/sell their
❏ Collect buy/sell quotes for most
clients. currencies.
currencies & banks.
➔ Buy/sell currencies on their own account ● Under fixed exchange rate system…
❏ Best quotation is obtained quickly
(proprietary trading). ○ Must purchase their
and at very low cost.
➔ Directly w/other banks or through forex
❏ Disadvantage: currencies during excess
brokers.
❏ Small brokerage fee. supply, and sell the currency
➔ Merchant banks: buying/selling currencies
❏ Financial centres have a few authorised when there is excess demand.
for their customers in finance-type transactions.
brokers.
◆ Also for own proprietary reasons.
 Spot & Forward Exchange Rates
Forward Exchange Rate: Ft or Ft, t + 1
Spot Exchange Rate: St for time t
= Economic agents agree to exchange currencies at a specified time in
= Current exchange rate of two currencies
the future; avoids risk of St + 1

S denotes exchange rate (as we see in all other models) Assumptions:

+ Price and transaction date are certain.
Remember that S = Home per Foreign currency !!
+ No risk.
➢ If H currency depreciates, S ↑
○ E.g., $1.13 / €1 → $1.50 / €1 = more $ needed for €1 Forward Exchange Market Participants:
➢ If H currency appreciates, S ↓ 1. Hedgers (normally firms)
○ E.g., $1.13 / €1 → $1 / €1 a. Trades to get rid of a risky position (St + 1)
2. Arbitrageurs (normally banks)
a. Trading in riskless assets (CIP); exploit differences in St and Ft,t + 1
3. Speculators
a. Willing to take risks to exploit want Ft, t + 1≠ Et {St + 1}.

Example: What would happen if Ft, t + 1 > Et {St + 1} ??

 Spot & Forward Exchange Rates
Spot Exchange Rate: St for time t Forward Exchange Rate: Ft or Ft, t + 1
= Current exchange rate of two currencies
= Economic agents agree to exchange currencies at a specified time in
the future; avoids risk of St + 1
S denotes exchange rate (as we see in all other models)
Remember that S = Home per Foreign currency !!
➢ If H currency depreciates, S ↑
Assumptions:
○ E.g., $1.13 / €1 → $1.50 / €1 = more $ needed for €1 + Price and transaction date are certain.
➢ If H currency appreciates, S ↓ + No risk.
○ E.g., $1.13 / €1 → $1 / €1

Forward Exchange Market Participants:

Speculation solution:
1. Hedgers (normally firms)
- Investor has 1000 Euros
a. Trades to get rid of a risky position (St + 1)
- If 1-year F rate = $2 / 1 Euro
- And expected Spot rate = $1.50 / 1 Euro
2. Arbitrageurs (normally banks)

Speculator thinks the Dollar will be higher in value at (t + 1) a. Trading in riskless assets (CIP); exploit differences in St and Ft,t + 1
1. Sell 1000 Euro forward to get $2000 USD in the future. 3. Speculators
2. At (t + 1), use 2000 USD and change back into Euros at $1.50 / 1 a. Willing to take risks to exploit want Ft, t + 1≠ Et {St + 1}.
Euro.
3. 2000 / 1.50 = 1333.33 Euros
Example: What would happen if Ft, t + 1 > Et {St + 1} ??
4. Profit of 333.33 Euros
 Bilaterial Spot Rates Multilateral Spot Rates

Nominal (S) (Nominal) Effective

= the exchange rate use in this course !! ❏ Trade-weighted average of indices of nominal rates.
● Leave “nominal” out. ○ Index

Real (Sr)
➔ Corrects for price differences. Real Effective
➔ Sr = SP*/P = Trade-weighted average of indices of real rates
◆ P = H price of H goods bundle ● Index
◆ P* = Foreign price of foreign goods bundle ● Measures overall competitiveness.
➔ Number of H bundles per foreign (F) bundle.
➔ In terms of purchasing power/competitiveness (Ch 6).

Effective
Bilateral Rates ★ Measures performance of an exchange rate against a
- Between two countries. weighted average of foreign currencies.
★ Can also be divided into a nominal and a real price.
Covered Interest Parity (CIP) !! Arbitrageurs ensure Covered Interest Parity !!

Arbitrageurs… Exact version

…exploit discrepancies between r differences in S and F. ❖ 1 + r = 1 / S · (1+r*) · F

Discrepancies = forward discount/premium. Approximation

= x 100 (as a %)
Forward premium: F exchange rate quote for that currency
represents an appreciation compared to the S quotation.
Forward discount: F exchange rate quote for that currency
represents a depreciation compared to the S quotation.
● r = r* + (F - S) / S
○ (F - S) / S → familiar ??
○
● Can use this for simplification !!
○ Also assume r* and depreciation is relatively low.
!! Spot & Forward rates move together !!
 How does arbitrage ensure CIP?

CIP: r = r* + (F - S) / S
What if r* increases?

WE KNOW:

Low interest rate

= better to BORROW.

High interest rate

= better to SAVE/INVEST
 WE KNOW:
How does arbitrage ensure CIP?
Low interest rate
= better to BORROW.
CIP: r = r* + (F - S) / S
What if r* increases? High interest rate
= better to SAVE/INVEST

r < r* + (F - S) / S
SPOT MARKET
● Arbitrageurs borrow H currency, convert it to
foreign currency, and then invest it in the foreign
country.
● Better to use Spot market to invest in foreign
country.
● Current demand of foreign currency (increased
foreign Spot demand + increased H Spot supply).
○ Foreign currency Spot appreciation.
○ H currency Spot depreciation.
r < r* + (F - S) / S
FORWARD MARKET
● To pay back loans to H country…
○ Investor must enter into a forward contract to change foreign
currency back to H currency.
● Supply of Forward currency in foreign country increases to AVOID RISK.
○ Foreign country needs to SUPPLY forward currency since all the
investors have entered into a contract with them.
● Foreign currency Forward depreciation.
○ Home currency F appreciation
(F - S) / S decreases until r = r* + (F - S) / S
 WE KNOW:
How does arbitrage ensure CIP?
Low interest rate
= better to BORROW.
CIP: r = r* + (F - S) / S
What if r* increases? High interest rate
= better to SAVE/INVEST
Numerical Example:
Spot rate: 1 X / 1 Y
H country = currency X= r = 2%
Foreign country = currency Y = r* = 4%
Investors have: 100,000 X
1. Investors invest in currency Y → Exchange 100,000 of currency X to Y at Spot rate.
a. Spot demand of foreign currency increases → foreign Spot appreciates (H country Spot depreciates → S↑
2. Investors enter into a forward contract with 100,000 Y currency.
a. Foreign country needs to repay investor in the future with (100k plus 4% interest) converted
back into currency X at Forward rate.
b. Foreign supply of Forward currency Y increases → Forward foreign depreciation
i. Home country Forward appreciation (F ↓)
(F - S) / S decreases until CIP restored.
 Let’s Practice !!
1. Which of the following is equal to the real exchange rate?
1. P / (P* S)
2. P* / (P S)
3. S P / P*
4. S P* / P

Open Questions

2a. What is the exact formula of CIP? Define the symbols you use.

2b. Assume the conditions underlying CIP hold. Now the foreign interest rate goes DOWN. Provide the chain of economic causalities that restores CIP.

2c. Explain precisely how such a common shock affects the spot and forward exchange rates in the long run.
 Let’s Practice !!
1. Which of the following is equal to the real exchange rate?
1. P / (P* S)
2. P* / (P S)
3. S P / P*
4. S P* / P

Open Questions

2a. What is the exact formula of CIP? Define the symbols you use.
The exact version of CIP is 1+r = 1/S ∙ (1+r*) ∙ F, where r is the domestic interest rate, S is the spot exchange rate, r* the foreign interest rate and F the
forward exchange rate.

2b. Assume the conditions underlying CIP hold. Now the foreign interest rate goes DOWN. Provide the chain of economic causalities that restores CIP.
r > r* + (F - S) / S → investors borrow foreign currency to invest in H Spot currency (H spot demand increases; appreciation). → To pay back loans to
foreign country → supply of forward currency in H country to avoid risk→ Forward currency depreciation in H country → (F - S) / S increases until
r = r* + (F - S) / S → CIP holds.

2c. Explain precisely how such a common shock affects the spot and forward exchange rates in the long run.
After the shock, we still have 1+r = 1/S ∙ (1+r*) ∙ F – CIP is restored, so there is no reason for investment changes, and no reason for S and F to change.
 Our Progress
So Far☺

★ Chapter 1: The Foreign Exchange Market

★ Chapter 2: The Balance of Payments
★ Start Chapter 3: Elasticity and Absorption Approaches to
the Balance of Payments
+ Depends on how much time we have left !!

Let’s keep going !!

 Chapter 2: Balance of Payments Components

Balance of Payments BoP Main Accounts

1. Current Account (CA)
2. Capital (Financial) Account (K)
Balance of Payments
3. Official Reserves Account (ORA)
= recording of all economic transactions between
the residents of the reporting (H) country and residents of
1. Current Account (CA)
other countries during a given time period (usually one
= sum of the visible trade balance and the invisible balance.
year) in H currency.
★ Purchases/sales between residents of the same country Visible trade balance: X of goods and expenditure on M of goods which can be
are excluded. visibly seen crossing frontiers.

Invisible balance: X of services and payments made for M of services (e.g.,

Economic transactions: Purchases/sales of goods,
shipping, tourism, insurance, banking).
services, or financial assets (e.g., bonds and equities).
1. Goods account: Trade in goods (merch trade or visible trade)
2. Services account: Trade in services (transport, communication, banking)
3. Income account: Investment incomes (interest, profits, and dividends)
4. Unilateral transfers account: Transfer payments (gifts, EU contribution)
 Balance of Payments Components
1. Current Account (CA) 2. Capital (Financial) Account (K)

= Describing H country’s revenue stream = Changes in assets and liabilities of the private & public sector (no CB).

● Trade in goods. ★ Foreign direct investment (FDI) .

● Trade in services. ★ Portfolio investment.
● Investment incomes. ★ Other capital investment.
● Transfer payments. ★ Patents and copyrights.

Capital outflows = Increase in H country’s holding of foreign assets.

3. Official Reserves Account (ORA)
Capital inflows = Decrease in H country’s holding of foreign assets.
= Transactions (asset & liability changes) of the CB.

❏ Rises and falls in forex reserves Official Settlements Balance (OSB)

❏ E.g., buying up the national currency on the forex

❏
market.
Borrowing funds/repayment of loans to global
BoP = CA + K + ORA
organisations (e.g., the IMF). …incorporating statistical error for any differences between
❏ Selling gold. credits and debits in each account.
 OSB, NIIP, and GDP

Official Settlements Balance (OSB)

= CA + K
● If OSB is negative → Excess supply of H currency on forex market. → Over supply pressures H currency to depreciate.

With a Floating Exchange Rate… This pressure materialises → transactions at new S → ORA = 0 and BoP (OSB) = 0

With a Fixed Exchange Rate… CB intervenes to maintain S by either (1) Buying H currency with official reserves (ORA + 1); (2)
Raise the interest rate (K will increase → BoP (OSB) improves until = 0)

Net International Investment Position (NIIP)

= Total value of H-owned foreign financial assets - Total value of financial liabilities to foreign residents.
= Net foreign assets (NFA) = Net foreign wealth (NFW) = - (Net foreign debt; NFD) = - (Net external debt; NED)
➢ Decreases with a CA deficit → why ??

GDP in an Open Economy → Y = C + I + G + XN

1. We all know this one !! Open economy adds in Net Exports (XN = exports - imports = X - M)
2. With taxes (disposable income) → Yd = C + I + G + X - M - T
3. Private savings = S = Yd - C Rewrite equation as (X − M) = (S − I) + (T − G)
 OSB, NIIP, and GDP

Official Settlements Balance (OSB)

= CA + K
● If OSB is negative → Excess supply of H currency on forex market. → Over supply pressures H currency to depreciate.

With a Floating Exchange Rate… This pressure materialises → transactions at new S → ORA = 0 and BoP (OSB) = 0

With a Fixed Exchange Rate… CB intervenes to maintain S by either (1) Buying H currency with official reserves (ORA + 1); (2)
Raise the interest rate (K will increase → BoP (OSB) improves until = 0)

Net International Investment Position (NIIP)

= Total value of H-owned foreign financial assets - Total value of financial liabilities to foreign residents.
= Net foreign assets (NFA) = Net foreign wealth (NFW) = - (Net foreign debt; NFD) = - (Net external debt; NED)
➢ Decreases with a CA deficit → why ?? Deficit has to be financed by either selling assets to foreigners OR borrowing funds (NIIP ↓)

GDP in an Open Economy → Y = C + I + G + XN

1. We all know this one !! Open economy adds in Net Exports (XN = exports - imports = X - M)
2. With taxes (disposable income) → Yd = C + I + G + X - M - T
3. Private savings = S = Yd - C Rewrite equation as (X − M) = (S − I) + (T − G)
Let’s Practice !!
1. Which parts sum up to make the total balance of payments (obviously defining the capital account as in the course)?
1. Current account, capital account and official reserves account.
2. Current account, capital account, and financial account.
3. Trade account, current account, and capital account.
4. Trade account, capital account and official reserves account.

2. Bulgaria follows a fixed exchange rate regime. Assume that it does not intend to change this and that Bulgaria has a balance of payments deficit
of 1000 levs (lev is the Bulgarian currency). Consider the following statements:
I. If the Bulgarian central bank only uses reserves to maintain the regime, it buys levs with reserves.
II. Bulgaria must have exported fewer goods than it has imported.
Which of the following is true?
1. Both statements are correct.
2. Statement I is correct, II is wrong.
3. Statement I is wrong, II is correct.
4. Both statements are wrong.

3. Consider the following statements on exchange rate regimes: 1. Both statements are correct.
I. Under fixed exchange rates, the official reserves account (ORA) is in balance. 2. Statement I is correct, II is wrong.
II. Exchange rate risk is zero in the Eurozone. 3. Statement I is wrong, II is correct.
4. Both statements are wrong.
Let’s Practice !!
1. Which parts sum up to make the total balance of payments (obviously defining the capital account as in the course)?
1. Current account, capital account and official reserves account.
2. Current account, capital account, and financial account.
3. Trade account, current account, and capital account.
4. Trade account, capital account and official reserves account.

2. Bulgaria follows a fixed exchange rate regime. Assume that it does not intend to change this and that Bulgaria has a balance of payments deficit
of 1000 levs (lev is the Bulgarian currency). Consider the following statements:
I. If the Bulgarian central bank only uses reserves to maintain the regime, it buys levs with reserves.
II. Bulgaria must have exported fewer goods than it has imported.
Which of the following is true?
1. Both statements are correct.
2. Statement I is correct, II is wrong.
3. Statement I is wrong, II is correct.
4. Both statements are wrong.

3. Consider the following statements on exchange rate regimes: 1. Both statements are correct.
I. Under fixed exchange rates, the official reserves account (ORA) is in balance. 2. Statement I is correct, II is wrong.
II. Exchange rate risk is zero in the Eurozone. 3. Statement I is wrong, II is correct.
4. Both statements are wrong.
 That’s it for today !!

Thank you so much for attending ♡

Recap of today:
Remarks:

➢ Chapter 1: The Foreign Exchange Market
+ Practice Qs.
➢ Chapter 2: The Balance of Payments
+ Practice Qs.
+ Practice exam questions per chapter covered.
★ I will send these slides via WhatsApp.
★ If you have any questions, feel free to message me.
★ Tomorrow we will briefly cover Chapter 2, do
Chapter 3, Chapter 6, and start Chapter 7 !!
+ More practice Qs :))