Economics

4.5 and 4.6

4.5: ( exchange rates)

Exchange rate:

● Exchange rate is the value of a currency expressed in terms of another

currency.
● for example, if you travel from the US to the Philippines, and you would like
to exchange 100 US dollars for the equivalent in PHP (philippine pesos), you
would find out that one USD equals 51 PHP. So 100 US dollars would give you
5100 PHP.

floating exchange rate:

● It is a system where the value of the currency is determined by the forces of

supply and demand for that currency on the foreign exchange market.
● The currency would be allowed to float freely without any government
interference.

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 ● The demand curve on the diagram represents all banks or companies who
would be able and willing to buy pounds sterling in the foreign exchange
market using USD.
● The supply curve represents anyone in position of pounds sterling who
would be able and willing to exchange them for USD.
● The intersection of the supply and demand curve represents the equilibrium
point where the exchange rate is determined.
● In this case, 1 pound sterling equals 1.23 USD.

The demand for the pound sterling (GBP) comes from:

● People overseas who want to buy British exports

● People overseas who want to invest in the UK. This can either be a long-term
investment, or a short-term portfolio investment.
● People visiting the UK from abroad
● Speculators in foreign exchange
● Central banks

The supply of the pound sterling (GBP) comes from:

● People in the UK who want to buy imports

● People in the UK who want to invest overseas (foreign direct investment or
portfolio investment)
● People from the UK traveling abroad
● Speculators
● Central banks

● If there is any change in the factors that influence the decisions of these
people or institutions, then the demand and supply of GDP will change and
its price against other currencies will alter.

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Appreciation:

● It is when the forces of demand and supply increase the price of a currency.
The currency becomes worth more in terms of other currencies.

Depreciation:

● A currency has depreciated if it has lost value. It refers to the decline in the
value of a currency in terms of another currency.

● Here, you can see if the demand for GBP increases because American
citizens are importing more goods from the UK, the demand curve for GBP
will shift to the right. Therefore the value of GBP will appreciate in terms of
USD. For example, at one point in time, 1 GBP was equal to 1.55 USD, and
after appreciation 1 GBP equalled 1.70 USD.

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 ● Here, you can see if the supply of GBP decreases because British citizens are
buying fewer imports from the US, the supply curve for GBP would shift to
the left. Therefore the value of GBP has appreciated in terms of USD. For
example, at one point in time, 1 GBP was equal to 1.55 USD, and after
appreciation 1 GBP equalled 1.70 USD.

● Here, you can see if the demand for GBP decreases because there were
fewer American investors making investments in British banks after a

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 reduction in British interest rates, the demand curve for GBP would shift to
the left. Therefore the value of GBP has depreciated in terms of USD. For
example, initially 1 GBP was equal to 1.55 USD, and later 1 GBP equalled 1.40
USD.

● Here, you can see if the supply of GBP increases because British speculators
think that the dollar will appreciate more in the near future, the supply curve
for GBP would shift to the right. Therefore the value of GBP has depreciated
in terms of USD. For example, initially 1 GBP was equal to 1.55 USD, and
later 1 GBP equalled 1.40 USD.

Factors that affect exchange rates:

Balance of trade:

● is a measure of the difference between the total value of exports minus the
total value of imports over a period of time.

1. Trade (demand for imports and exports):

● Foreign demand for exports: affects the levels of demand for a currency.
Ghana is one of the leading producers of cocoa beans in the world. If the

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 United States' demand for cocoa beans increases, that will increase the
demand for the Ghanaian cedi (GHS). That could appreciate the value of the
GHS in terms of the USD.

● Domestic demand for imports: will change the levels of demand for a
currency. Consider the previous example. The population of Ghana is
enjoying greater income levels due to the increased global demand for cocoa
beans. If the residents of Ghana now use their higher income to demand
more pharmaceuticals from the United States, there will be an increase in
the supply of GHS to exchange for USD. This will shift the supply of the
Ghanaian cedi and depreciate the value of the GHS in terms of the USD.

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 2. Foreign direct investment (FDI):
● Inward FDI: is represented by a foreign firm making the purchase of at least
10% of a company in the domestic economy. The US is the number one
receiver of FDI in the world. An increase in investment from abroad would
increase demand for the USD, putting upward pressure on its value; or, in
other words, it would appreciate the USD.
● Outward FDI: is represented by a domestic company making an investment
in a foreign firm; for example, a US company making investments in China.
The US company would have to supply USD to buy the Chinese renminbi
yuan. This would put downward pressure on the value of the USD in terms of
Chinese yuan; or, in other words, it would depreciate the USD.

3. Portfolio investment:
● Portfolio investment abroad consists of foreign ownership of stocks, bonds,
and other financial instruments. Unlike FDI, portfolio investment does not
entail ownership of the businesses or ventures. Instead, it relates to the
selling or purchasing of stocks, bonds and other financial instruments.
● Inward portfolio investment is when an external or foreign entity invests in
stocks, bonds and other financial instruments. This will appreciate the
domestic currency as more of it will be demanded to purchase these
financial instruments.
● Outward portfolio investment is when investment capital flows out of the
country from a local entity to a foreign one in the form of purchasing their
stocks, bonds or other financial instruments. The increased supply of the
local currency will depreciate its value.

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 4. Remittances:
● Remittance is the transfer of money, usually from foreign workers to their
families back home. The US is the biggest sender of remittances in the world,
with over USD 150 billion sent all over the world in 2018.
● The inflow of remittances to the Philippines will increase demand for the
(PHP), putting upward pressure on its value; or, in other words, it would
appreciate the currency.
● The outflow of remittances from the US increases the supply of USD, putting
downward pressure on its value; or, in other words, it will depreciate the
USD.

5. Speculation:
● Speculation is the buying and selling of foreign currency in the hope of
making a profit from movements in its value.
● If speculators believe that a currency will fall in value, they will sell the
currency now with the hope of repurchasing it in the future, with the
expectation of a lower price. This will lead to an increase in the supply of the
currency, which will lead to a fall in its value.
● In this way, speculators work towards a 'self-fulfilling prophecy' because as
they sell the currency with the expectation that it will depreciate in the
future, the simple act of selling their holdings now will directly depreciate the
currency.
● One of the most famous examples of speculators making a considerable
amount of money was on 'Black Wednesday' in 1992. George Soros and
other speculators in the foreign exchange market effectively broke the Bank
of England and made billions of dollars' profit in one day.

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 6. Relative inflation rates:
● Inflation affects the prices of imports and exports and therefore the demand
for imports and exports, which in turn influences the exchange rate.
● The concept of relative inflation is used to describe the level of inflation of
one country in comparison to another country.
● A fall in relative inflation would have the opposite effect and the currency
would appreciate in value. This is because the demand for the currency
would increase as foreigners would want to buy more of the country's
exports and the supply of the currency would decrease as people would
want to buy fewer imports.
● Purchasing power parity theory states that the exchange rate will tend
towards a point where a given sum of money will buy the same amount of
commodities whatever currency that amount is changed into. This theory
suggests that relative prices are the only reason why exchange rates will
change

7. Interest rates:
● An increase in relative interest rates could lead to an increase in the demand
for the currency. This is because the country would become a more attractive
place for short-term portfolio investment and foreigners would need to
demand the currency in order to invest their money in the country.
● It could be possible to control inflation levels by increasing interest rates.
because this would make it more expensive for firms and households to
borrow money. A country might also have higher demand for its exports if it
has lower relative inflation levels, because the average prices would become
relatively lower. Both factors could appreciate the currency.

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 8. Relative growth rate:
● The relationship between a country's growth rate and the value of its
currency is not direct, but it can be strong. Economic growth can influence
the exchange rate.
● On the one hand, a strong exchange rate can be a sign of a strong economy.
Foreign investors would have higher levels of confidence, and that could be
an incentive for inflows of FDI and portfolio investments. With greater
demand for the currency, there would be upward pressure on its value.
● On the other hand, highly valued currencies can make exports more
expensive and imports cheaper. As net exports are a determinant of
aggregate demand, a strong currency may cause lower levels of GDP.

9. Central bank intervention:

● Directly or indirectly, government activity affects the value of a currency. In
particular, the government’s policy towards intervention in the foreign
exchange market is a key factor, as well as the central bank’s attitude to
building up reserves of foreign currency.
● For example, China holds over USD 3 trillion and Japan over USD 1 trillion in
their Forex currency reserves. If those countries want to lower the value of
their currencies, they will buy foreign currencies with their own currencies,
thus increasing the supply of their own currencies on the Forex market.
● If they would like to increase the value of their own currencies, their central
banks will buy their own currencies back with the currency reserves in euros
(EUR) or dollars (USD) and, in this way, they would decrease the supply of
their own currencies on the Forex market.

Consequences of changes in the exchange rate:

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 ● changes in the exchange rate would impact many areas of a country‘s
economy.
● this includes:

1. Inflation rate:
● The impact of a change in the currency of a country will depend on the
nature of its economy.
● On one hand, a country that relies on imports of essential raw materials, as
India does with oil, will be negatively affected by currency depreciation, as
resource prices will be relatively more expensive. This can lead to a common
problem known as cost-push inflation, which is typical for any
resource-dependent country that has to import oil.
● Whether a producer will pass on the higher cost of imported raw materials to
its consumers depends very much on the elasticity of demand for its product.
● In Figure 1 below, with the increase in the cost of production, due to the
depreciation of the currency, the SRAS1 would shift leftwards to SRAS2. The
price level would increase from PL1 to PL2 and the economy would produce
below its full potential at Yrec.

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 ● On the other hand, a depreciation may influence net exports (X – M) by
increasing the demand for exports and decreasing the demand for imports.
As net exports are a determinant of aggregate demand, the depreciation of a
currency may be the cause of demand-pull inflation in an economy.
● If we consider the Keynesian model in Figure 3, we can see that, depending
on where an economy finds itself, demand-pull inflation may occur if the
economy is operating close to the full employment level. If the economy is
sitting at Y1, the shift of AD1 to AD2 would not cause inflation. The inflationary
pressure from PL1 to PL2 would occur if there was a shift of AD2 to AD3.

2. Economic growth:
● Changes in currency values have a significant impact on economic growth,
especially if the country is overly reliant on trade. A depreciating currency is
good for exports but it is not so good for imports, and vice versa. Therefore,
in theory, aggregate demand should increase when the value of the currency
falls. However, in practice this is not always what happens.
● Currency stability instils confidence in investors and producers who want to
trade with other countries. As with inflation, rapidly changing exchange rates
damage confidence and make planning for the future difficult.

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 3. Employment:
● If a currency appreciates, exports become more expensive, so the quantity
demanded for exports may decrease, depending on their elasticity. This
means that unemployment may increase in the exporting country. On one
hand, jobs would be lost in the export industries because of the potential
decrease in quantity demanded. On the other hand, there could be an
increase in employment for domestic industries which could take advantage
of cheaper prices for imported raw materials and components.
● Alternatively, if a currency depreciates, prices of exports become less
expensive, so the quantity demanded for exports may increase, depending
on their elasticity. This means that unemployment may decrease in the
exporting country. Jobs would be created in export industries because of the
potential increased quantity demanded driven by the lower prices. At the
same time, there could be an increase in employment in import substitution
industries due to the higher prices of imports.
● However, if a country is heavily dependent on imported raw materials, the
cost of production would increase, and unemployment would rise due to a
left shift of the SRAS curve. In Figure 5 unemployment could be represented
by the distance YP to Yrec.

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 4. Current account balance:
● The current account refers to the part of the balance of payments that
consists of the balance of trade, the income balance and current transfers
between a country (or monetary union) and the rest of the world.
● A net exporter's current account balance will be positively affected by a
currency depreciation in the long run, but only if the demand for its exports
and imports is relatively elastic.

● It also depends on the approach that exporters take to the depreciation of

the currency. For example, exporters may decide to keep the export price the
same by raising the domestic price, and therefore take higher profits. A net

importer may also see their trade deficit improve somewhat.

5. Living standards:
● The impact of fluctuations in currency exchange rates changes significantly
depending on the perspective of the country. Let us consider the United
States.
● In the US, if the dollar gains value, it will make imports cheaper. This will
allow the average citizen to buy more fruit and vegetables from abroad,
which will improve their living standards. Considering that the US is the
richest country in the world, a portion of its society would benefit from this.
● However, if the dollar is strong, companies would be inclined to outsource
jobs abroad. That would most likely mean fewer jobs for workers in the US.
This would lower their living standards. Manufacturing jobs would be lost to
developing nations when companies move their factories abroad to take
advantage of lower costs of production.

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 ● With a strong dollar, foreign trips would become cheaper and the American
citizens who could afford international travel would benefit from it. That
would improve their living standards.

key words:

● Cost-push inflation: Occurs when the costs of production rise for a country,
or when short-run aggregate supply falls.
● Pegged: a peg is where the government fixes the prices of currency within a
small bond to the value of another currency.
● Revaluation: an increase in the value of a currency, in terms of another, in a
fixed exchange rate regime.
● Devaluation: a decrease in the value of a currency, in terms of another, in a
fixed exchange rate regime.

Fixed exchange rate regime:

● A regime where the value of a currency in terms of another is fixed or

pegged. The central bank could also peg the currency to a basket of
currencies or gold.
● Fixed exchange rate regimes are an attempt by the central bank to stipulate
the exact value of the exchange rate in terms of another currency. As the US
dollar is the most traded currency in the world, it tends to be the one chosen
by governments.

Devaluation and revaluation:

● In a fixed exchange rate system, the value of the currency is not allowed to
change based on the open-market forces of supply and demand for that
currency. Instead, the central bank of a country constantly monitors those
forces and intervenes in the Forex by buying and selling currency reserves, as

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 well as adjusting monetary policy in order to maintain the fixed value of the
currency.
● When a stronger currency is needed, a revaluation is engineered by the
monetary institution, and when a weaker currency is needed, we refer to it as
devaluation. A revaluation is equivalent to an appreciation in a floating
exchange rate system, and a devaluation is the equivalent of a depreciation
in a floating exchange rate system.

Maintaining fixed exchange rates:

● Between 1956 and 1997, Thailand operated a fixed exchange rate, in which
they pegged the Thai baht (THB) to the US dollar, first at a rate of 1 USD to 20
THB, and then in 1973 at 1 USD to 25 THB. This allowed Thailand to have a
strong currency and import cheap raw materials, creating a stable business
environment for many decades.

● As shown in Figure 2, as Thai businesses import relatively cheap raw

materials, they sell the baht for US dollars, causing a shift in the supply of
baht from S1 to S2 and a downward pressure on the currency from THB 1 =
USD 0.04 to THB 1 = USD 0.03.

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 ● In order to keep the Thai currency strong, the Thai central bank will respond
with a purchase of baht from the market in exchange for dollars. This shows
as a shift in demand from D1 to D2 in the market for baht (left panel), and a
shift in supply from S1 to S2 in the market for dollars (right panel).

Managed float exchange rate system:

● The managed float exchange rate system is a system in between the floating
and the fixed exchange rate system. It allows the currency to fluctuate based
on the forces of supply and demand in the market, but the fluctuation is
confined within a set range with an upper and lower limit.
● The main goal of a managed exchange rate is to avoid significant fluctuations
in a short period of time. Foreign currency reserves are essential for the
central bank to be able to control the value of its own currency. Most
currencies in the world are managed. This is the case because a managed
float system can provide a sense of stability and trust among trading
partners.

Overvalued and undervalued currencies:

● In order to know whether a currency is overvalued or undervalued you will

need to understand the currency's equilibrium when the forces of supply and
demand are free to operate. When a currency's value is above that
equilibrium, the currency would be considered overvalued. When a
currency's value is below that equilibrium, the currency would be considered
undervalued.
● Overvalued currencies can make imports cheaper, benefiting developing
nations in industrializing and modernizing their economies. However, they
can also make exports more expensive, hurting domestic industries and
increasing competition.

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 ● An undervalued currency can make exports cheaper, giving domestic
industries an advantage against foreign competitors. This could lead to
economic growth, but it may also create hostilities and potential protectionist
policies.
● The Economist's Big Mac Index, published over thirty years ago, provides
insight into the debate on currency undervaluation. The theory of purchasing
power parity suggests that long-run exchange rates tend towards a value
where there is no advantage to buying a good overseas.
● The Big Mac burger from McDonald's is used as an example of a product that
should be exactly the same price anywhere in the world. So, for example, if a
Big Mac costs 5 euros in Paris and USD 5 in New York, the exchange rate
between the euro and the dollar will move towards parity so EUR 1 = USD 1.
There is no benefit in an American changing USD 5 into euros to buy a Big
Mac because there is now purchasing power parity.
● The Economist's Big Mac Index looks at the cost of a Big Mac around the
world and identifies whether the long-term exchange rates are currently out
of line by comparing whether it is cheaper or more expensive to buy a Big
Mac in another country. If the Big Mac in one country is cheaper, it suggests
that the country's currency as a whole is undervalued and the expectation is
that it will increase in the future.

4.6: ( balance of payments)

Key words:

● Current account deficit: when revenue arising from the sale of exports,
inflowing income and transfers is less than funds flowing overseas to pay for
imports, outgoing income and transfers.

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 ● Capital account surplus: a surplus on the capital account arises when the
money flowing in from the ownership of capital and other assets is greater
than the money flowing overseas
● Financial account surplus: A surplus on the financial account arises when the
money flowing in from all financial transactions and direct investment
between countries, and changes in currency reserves held by central banks,
is greater than the money outflows.

Balance of payments:

● The balance of payments is a record of all monetary inflows and outflows of

a country. Think of it like your bank account, with money coming in and
money going out. It is extremely important information for policy makers,
investors and economists.

Surplus and deficits on an account:

● The three main components of the balance of payments are the current
account, the capital account and the financial account.
● The balance of payments (BoP) is made up of two halves: BoP = Current
account + Capital account + Financial account = 0
● The current account records transactions in goods and services. It records
money flowing overseas to pay for imports, and money flowing into the
country in exchange for selling exports. The current account also includes
income flows and transfers, such as foreign aid.
● The capital account and financial account record transactions in
income-producing assets. The income earned from the assets is recorded in
the current account.
● If a country imports more than it exports, it will have a current account deficit
of, for example, $1000. How will the country pay for the deficit? One

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 possibility is to borrow $1000 from abroad. This transaction will be recorded
on the financial account.
● Therefore, any deficit on the current account will be offset by a surplus on
the capital and financial account surplus.
● Current account = – (Capital account + Financial account)

Credit and debit items:

● When money leaves a country it is called a debit. This includes money leaving
a country for investment, imports, aid to other countries, purchase of foreign
businesses, and so on. Money coming into a country is referred to as a credit.
Credits include the purchase of assets, businesses, property and
domestically produced goods by people in other countries.
● Countries are often concerned about imbalances on the balance of
payments. If a country has a current account deficit, it must by definition
manage a capital account surplus or financial account surplus.

Components of the balance of payments:

1. The current account: The current account is a record of all the money coming
into and going out of a country for trade in goods and services, income flows
and transfers. There are 4 components of the current account.
● Balance of trade in goods: This is the visible balance, where tangible goods
are traded between countries. When a country imports goods, the import
expenditure leaves the country and is recorded as a debit on the current
account. When a country exports goods, money enters the country and this
is recorded as a credit on the current account.
● Balance of trade and services: This is the invisible balance, consisting of the
balance of trade of legal services, hospitality, consultancy, and so on. This
sector is a major earner for developed nations for a number of reasons. As

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 countries grow and develop, they move away from primary and secondary
industries towards tertiary industries that have the ability to generate large
amounts of surplus value. In turn, these countries provide these same
services to those countries that have yet to develop a sophisticated service
sector.
● Income: Income refers to the factor payments for the factors of production.
You might own property in another country and receive rent that is credited
to the current account of the country you live in. This component also
includes investment income in the form of, for example, dividend payments
when you own shares of a company. It is not the same as when the purchase
of an asset is made, which is covered by the financial account, but refers to
only the income derived from owning that asset, such as earning interest on
bonds.
● Current transfers: A transfer on the current account refers to a payment
between one government and another that is not in exchange for any good
or service. An example is foreign aid.

2. The capital account: The capital account is a record of all the transfers of
ownership of capital and other assets between countries. There are 2
components of the capital account.
● Capital transfers: Capital transfers consist of transactions involving transfers
of ownership of fixed assets, transfers of funds linked to the buying and
selling of fixed assets, or debt forgiveness.
● Transaction in non-produced, non-financial assets: Non-produced assets
largely cover intangibles, such as patented entities, leases or other
transferable contracts, and payments of goodwill. For example, a lease is a
contractual arrangement between a landlord and a tenant. A company in
country A can sell a lease that it owns to another company in country B. This

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 will be recorded as a credit on country A's capital account and a debit on
country B's capital account.

3. The financial account: The financial account is a record of all financial

transactions and direct investment between countries, and currency reserves
held by central banks. There are 4 main components of the financial account.
● Foreign direct investment (FDI): Foreign direct investment is the purchase of
a firm, or part of a firm, by a firm from another country. When companies do
this, they become multinational corporations. When only part of a firm is
bought, it must be at least 10% of the shares of the company to be
considered a foreign direct investment.
● Portfolio investment: Portfolio investment refers to the purchase and sale of
financial capital. This includes shares, bonds, derivatives, the trading of
commodities and currencies. This only considers the transfer of funds when
a purchase is made, not the income derived from that investment (such as
dividends from owning shares, which is included under the current account).
● Reserve assets: These are the foreign currency reserves held by central
banks. These should include paper money, deposits, government bonds and
securities.
● Official borrowing: Official borrowing occurs when the government borrows
(debit) or lends (a credit item) money from the IMF, World Bank, or the
government of another country.

Interdependence between the accounts:

● The balance of payments accounts are interdependent, with each account

equaling zero when combined. This is due to double-entry accounting, where
every recorded value in one account is equal and opposite in another. Take
your own personal accounts, for example. You have money coming in during

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 the month (credit) and you have money going out each month (debit). If
there is a surplus in personal accounts, it can be used as savings or used to
pay back debts. If there is a deficit, it must be shown where the extra money
came from.
● The balance of payments accounts work similarly, except that income flows
are in different currencies, which limits where money can be spent. For
example, if a relative sends you USD 200 each month, you are limited to
spending it in the US. The same concept applies to the balance of payments,
where income flows are in different currencies.
● For example, buying a Japanese car in the US for USD 10,000 results in a
debit on the US current account and a credit on Japan's current account. To
acquire the foreign currency needed for the purchase, someone with
Japanese yen needs to sell their yen for dollars. The Japanese person or firm
now has dollars, which they can use to invest in the US to earn interest.
● The current account, capital, and financial accounts are interdependent, with
a change in one account causing an opposite, but equal, change in another.
In this case, the double-entry for Japan will be a credit on their current
account and an equal debit on their financial account.

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