Week 4 – Balance of payments and exchange rates

1. Introduction

This week’s notes will explore the balance of payments and the exchange rate, in order to understand the
relationship between a country’s domestic economy and the international trading environment.

1.1 Topic Learning Outcomes

During this topic you should be able to achieve the following learning outcomes:

LO1. Understand the concept of the balance of payments

LO2. Explore the relationship between the balance of payments and exchange rates

LO3. Explore different exchange rate regimes and exchange rate interventions

LO4. Explain the implications for management practice of the foreign exchange market

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2. The balance of payments

“The Balance of Payments records one nation’s transactions with the rest of the world. This not only includes
the conventional flows of goods and services that make up international trade, but also cross-border payments
associated with the international ownership of financial assets and current transfers, including remittances by
workers from one country to another” (Chamberlin, 2007, p. 44). Flows of money between one country and
the rest of the world are inflows (credits) recorded with a positive sign on the balance of payments and outflows
(debits) recorded with a negative sign on the balance of payments (Sloman et al., 2019). The three main
elements of the balance of payments account are the current account, the capital account and the financial
account.

The current account consists of four elements:

• Trade in goods
• Trade in services
• Net income flows
• Current transfers (Chamberlin, 2007, p. 44)

As an illustration, Table 4.1 below shows the UK current account in 2007.

Table 4.1 UK Current account in 2007

Source: Chamberlin (2007)

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The current account balance is the balance of trade of goods and services, income flows and transfers of
money so that there is no surplus or deficit.

In the example above, there is a £37.7 deficit on the UK current account.

The capital account captures transfers of capital in and out of a country.

The financial account consists of the following main items:

• Direct investment
• Portfolio investment
• Other investments (Chamberlin, 2007, p. 46)

The capital account and the financial account are the counterparts to the current account and when all items of
the balance of payments account are considered, the balance of payments should balance, or in other words,
credits should equal debits. However, when considering the items of the balance of payments account, errors
and omissions may occur. In order to do that, an additional item is included in the capital and financial accounts,
which is a balancing item (or net errors and omissions item), intending to achieve the overall balance of the
balance of payments account. As can be seen in Table 4.2 there is a surplus of £37.7 on the UK capital and
financial account (including the balancing item). Overall, the capital account and financial account surplus
compensate for the current account deficit and the balance of payments balances.

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Table 4.2 UK Capital and Financial accounts in 2007

Source: Chamberlin (2007)

Figure 4.1 demonstrates the trend of the current account balance in the G7 countries between Q1 2011 and Q4
2020. In 2020, the G7 countries with a current account deficit were the UK, the U.S., France and Canada. What
this means is that the balance of trade in goods, trade in services, net income flows and current transfers is
negative, or in simple words that the countries imported more goods, services and capital than they imported.
On the other side of the spectrum are the EU19, Japan, Italy and Germany, with a positive current account
balance in 2020.

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Figure 4.1 Current account balance in G7

Source: OECD (2021)

3. Balance of payments and exchange rates

Exchange rates are the rates at which currencies trade for one another on the foreign exchange market. Table
4.3 lists the exchange rates of the British pound against other currencies, as quoted on April 09, 2021, by the
Bank of England. As you can see on the table, on April 09 the price of £1 was €1.1548 or ¥150.4689 or
CHF1.2703 or $1.3729.

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Table 4.3 Pound exchange rates, April 01, 2021

Source: The Bank of England (2021)

If we think of money as a commodity, then the exchange rate is the price of that commodity in terms of another
currency. If we think of money as a commodity, then it is easy to understand that what determines exchange
rates is the demand and supply of each currency. Exchanges rates are changing constantly and as Figure 4.2
demonstrates, exchange rates between currencies will vary in the long run.

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Figure 4.2 Exchange rate fluctuations

Source: Eurostat (2020)

Exchange rates between currencies will change and fluctuations between exchange rates may be considerable
depending on the relative strength of a currency against another currency. In order to be able to get a more
consistent understanding of the position of a currency in the foreign exchange market, it is better to consider a
currency against an average exchange rate of all other currencies. This average exchange rate is called the
exchange rate index. The weight of each currency in the exchange rate index will depend upon the strength of
each currency which is determined by the proportion of transactions carried out with the currency in the foreign
exchange market.

4. Nominal and real exchange rate indices

So, the exchange rate captures the price of one currency in terms of another currency. For example, as stated
earlier, on April 9, 2021, according to the Bank of England, the price of £1 was €1.1548. But what can be
bought with £1 or with €1.1548 in the UK and what can be bought with £1 or €1.1548 in a European country?

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We call the price of one currency for another the nominal exchange rate. But when we want to measure the
value of a currency in terms of purchasing goods and services in a foreign country, we use the real exchange
rate (Catão, 2007). The real exchange rate captures the rate at which goods and services in one country
exchange for goods and services in another country. The real exchange rate also accounts for the prices of
goods and services in the two countries (e.g. prices of goods and services, labour costs, export prices). The real
exchange rate is calculated using the following formula:

𝑃𝑋
𝑅𝑒𝑎𝑙 𝐸𝑥𝑐ℎ𝑎𝑛𝑔𝑒 𝑅𝑎𝑡𝑒 = 𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐸𝑥𝑐ℎ𝑎𝑛𝑔𝑒 𝑅𝑎𝑡𝑒 ×
𝑃𝑀

where 𝑃𝑋 is the price of exports measured in the domestic currency and 𝑃𝑀 is the price of exports in the foreign
currency. An illustrative example demonstrating the meaning of the real exchange rate is what is called the Big
Mac index, which is an index listing the price of a Big Mac across various countries (Figure 4.3). As the index
demonstrates, the price of the same commodity (the Big Mac) varies considerably across countries.

Figure 4.3 The Big Mac index

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Source: Statista (2021)

5. Floating and fixed exchange rates

In a free foreign exchange market, the rate of exchange between two currencies is determined by demand and
supply. When there is excess demand for a currency, the exchange rate will raise while when there is
oversupply of the currency, the exchange rate will fall, until the point where demand equals supply. But how

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is demand and supply for currency generated? If you want to go on holiday to a foreign country, you will go
to the bank to obtain some currency from that country. Or if you want to buy property in a foreign country,
you will require the currency of the foreign country to buy the property. Similarly, if you are an investor or a
trader of goods between two countries. For example, if you want to import equipment from a foreign country,
your supplier may require you to pay in the foreign country’s currency. Banks or foreign exchange will supply
the foreign currency.

To understand how the foreign exchange market works to determine the exchange rates, let’s take the example
of two countries, the UK and the U.S. Figure 4.4 demonstrates the forces that determine the rate of exchange
between the currencies of these two countries. The tables show the demand curve for Sterling by the U.S. and
the supply curve for Sterling by the UK. Note that the supply curve for Sterling by the UK is sloping upward.
This is the case because the higher the exchange rate, the more Sterling will be supplied. On the other hand,
the demand for Sterling by the U.S. is slopping downward. This is the case because the lower the dollar price
for Sterling the more Sterling will be demanded.

If the price (exchange rate) for pounds was at $1.40 then we could have an excess supply in the number of
pounds (a-b on the figure). At this point, the price for pounds would have to drop to equate supply with demand.
Similarly, if the price (exchange rate) for pounds was at $1.20 then we would have an excess demand for
pounds (c-d on the figure). At this point, the price for pounds would have been raised in order to equate demand
with supply. These movements in the price (exchange rate) for pounds would have to take place until the price
gets to $1.30 where demand for pounds equals supply.

Figure 4.4 Excess supply of pounds

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Source: Sloman & Sutcliffe (2019)

The foreign exchange market is influenced by other economic factors besides the demand for and supply of
currency. For example, changes in domestic interest rates or in the rates of inflation in a country’s economy,
or in domestic income compared to incomes abroad, or in investment prospects in the country compared to
investment prospects abroad, or speculation about the exchange rates may cause the exchange rates to
depreciate or appreciate. A currency depreciates when its price in the free foreign exchange markets falls. On
the other hand, a currency appreciates when its price in the free exchange rate market rises. Depreciations and
appreciations of a currency will cause the demand and supply curves for the currency to shift. For example,
Figure 4.5 below demonstrates an outward shift of the supply curve between the Euro and the pound and an
inward shift of the demand curve. These shifts represent a depreciation of the pound causing the price of the
pound to fall from €1.40 to €1.20.

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Figure 4.5 Shifts in the demand and supply for currency

Source: Sloman & Sutcliffe (2019)

6. Exchange rate interventions

Governments may choose to allow exchange rates to float freely, or they may choose to intervene and fix the
exchange rates or manage the float of the exchange rates and allow rates to float within certain bands.
Governments that choose free-floating exchange rates are showing confidence in the foreign exchange rate
market to determine the exchange rates based on demand and supply for the currency. On the other hand, the
purpose of managing the exchange rates float or fixing exchanges rate is to avoid erratic exchange rate
fluctuations which may have catastrophic impacts on the economy. Exchange rate interventions aimed at
reducing uncertainty in the market and at creating a more stable environment for economic activities.

Today, most developed countries have a (relatively) free exchange rate, with several of these countries applying
some control of their exchange rate, through management or regulation. However, the majority of the emerging
countries continue to exercise considerable control to the exchange rates, often fixing (pegging) their exchange

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 rates to the currency of another country, usually to a country with a strong
economy (in many cases, the U.S.) (IMF, 2019). Table 4.4 below provides an outline of exchange rate
arrangements in IMF member countries and territories between 2010 and 2018. As the table demonstrates, in
2018, 34.4% of IMF members had adopted a floating exchange rate regime and the majority of members
adopted some soft peg regime.

Table 4.4 Exchange rate arrangements, 2010-2018

Source: IMF (2019)

An example of an exchange rate mechanism it the EU’s Exchange Rate Mechanism II (ERM II), which is a
mechanism put in place “to ensure that exchange rate fluctuations between the euro and other EU currencies
do not disrupt economic stability within the single market, and to help non-euro-area countries prepare

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themselves for participation in the euro area” (European Commission, n.d.). According to the ERM II the
currencies of the non-EU European countries which participate to the mechanism are allowed to fluctuate
against the Euro within set limits.

Both floating and fixed exchange rates involve advantages and disadvantages. Fixed exchange rates reduce the
uncertainty and the risk involved in international trade and investment associated with currency exchange is
reduced. Also, fixing the exchange rate or allowing it to flow within certain limits, limits speculations about
the exchange rates. Fixed exchange rates constrain governments from pursuing short-term, ‘irresponsible’ and
opportunistic macroeconomic policies. On the other hand, fixed exchange rates may create conflicts between
macroeconomic policy objectives and exchange-rate policy objectives. They may create problems of
international liquidity, for example, if there is no adequate liquidity to expand trade. They may limit the
domestic economy’s ability to adjust to shocks – this is because market mechanisms are quicker than
government mechanisms in allowing adjustments to shocks. Also, speculation may be strong if there is belief
that the fixed exchange rate is not maintainable (Sloman & Sutcliffe, 2019).

Free-floating exchange rates on the other hand allow for automatic correction when there are shifts or shocks
and with free-floating exchange rates there are no issues with international liquidity. Also, a country’s economy
is protected against external economic events, and governments have flexibility to choose domestic policy. On
the other hand, free-floating exchange rates are unstable. In the short run, shifts or shocks to the demand and
supply curves for the currency will have a greater impact on the exchange rate. Also, free-floating exchange
rates are open to speculation. The free-floating nature of this type of exchange rates creates uncertainty for
trade and investment, creating an impact on international trade and investment (Sloman & Sutcliffe, 2019).

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References

Bank for International Settlements (2012) Real effective exchange rates – The BIS methodology. Available at:
https://www.bis.org/ifc/events/6ifcconf/takats_pres.pdf [Accessed: 02/04/2021].

Catão, L. A. V. (2007) Why real exchange rates? Finance & Development. 44(3). Available at:
https://www.imf.org/external/pubs/ft/fandd/2007/09/basics.htm [Accessed: 12/04/2021].

Chamberin, G. (2007) The Balance of Payments. Economic & Labour Market Review, 3(9), pp. 44-51.

European Commission (n.d.) ERM II – the EU’s Exchange Rate Mechanism. Available at:
https://ec.europa.eu/info/business-economy-euro/euro-area/introducing-euro/adoption-fixed-euro-conversion-
rate/erm-ii-eus-exchange-rate-mechanism_en [Accessed: 12/04/2021].

Eurostat (2020) Exchange rates and interest rates. Available at: https://ec.europa.eu/eurostat/statistics-
explained/index.php?title=Exchange_rates_and_interest_rates&oldid=479803 [Accessed: 12/04/2021].

IMF (2019) Annual report on exchange rate arrangements and exchange restrictions. Available at:
https://www.imf.org/en/Publications/Annual-Report-on-Exchange-Arrangements-and-Exchange-
Restrictions/Issues/2019/04/24/Annual-Report-on-Exchange-Arrangements-and-Exchange-Restrictions-
2018-46162 [Accessed: 12/04/2021].

James, J., Marsh, I.W. & Sarno, L. (2012) Handbook of exchange rates. Wiley, U.S., New Jersey.

OECD (2021) Current account balance. Available at: https://data.oecd.org/trade/current-account-balance.htm

[Accessed: 31/03/2021].

Sloman, J., Garratt, D., Guest, J. & Jones, E. (2019) Economics for Business. Pearson Education, Limited, UK,
London.

Statista (2021) Global price of a Big Ma as of January 2021, by country. Available at:
https://www.statista.com/statistics/274326/big-mac-index-global-prices-for-a-big-mac/ [Accessed:
12/04/2021].

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The Bank of England (2021) Daily spot exchange rates against Sterling. Available at:
https://www.bankofengland.co.uk/boeapps/database/Rates.asp?Travel=NIxASx&into=GBP [Accessed:
09/04/2021].

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