Determination of Exchange Rates

& Balance of Payments

Reading: Chapters 3 & 5 (not

pg148-161)
 Lecture Objectives

 Determination of Exchange Rates

 Currency Forecasting
 Introduction to Balance of Payments
 Balance of Payments Accounting
 BOP & Exchange Rates

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 Determination of Exchange Rates
 Exchange rate determination is complex.
 The following exhibit provides an overview of the
many determinants of exchange rates.
 This road map is first organized by the three major
schools of thought (parity conditions, balance of
payments approach, asset market approach), and
secondly by the individual drivers within those
approaches.
 These are not competing theories but rather
complementary theories.

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Determination of Exchange Rates

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Parity Conditions Approach

 The theory of purchasing power parity is the most

widely accepted theory of all exchange rate
determination theories:
– PPP is the oldest and most widely followed of the
exchange rate theories.
– Most exchange rate determination theories have PPP
elements embedded within their frameworks.
– PPP calculations and forecasts are however plagued
with structural differences across countries and
significant data challenges in estimation.

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Balance of Payments Approach

 The balance of payments approach is the second

most utilized theoretical approach in exchange rate
determination:
– The basic approach argues that the equilibrium exchange
rate is found when currency flows match up current and
financial account activities.
– This framework has wide appeal as BOP transaction data
is readily available and widely reported.
– Critics may argue that this theory does not take into
account stocks of money or financial assets.

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Asset Market Approach

The asset market approach argues that

exchange rates are determined by the
supply and demand for a wide variety of
financial assets:
– Shifts in the supply and demand for financial
assets alter exchange rates.
– Changes in monetary and fiscal policy alter
expected returns and perceived relative risks of
financial assets, which in turn alter exchange
rates.

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Asset Market Approach

 The asset market approach assumes that whether foreigners are
willing to hold claims in monetary form depends on an extensive set
of investment considerations or drivers (among others):
– Relative real interest rates
– Prospects for economic growth
– Capital market liquidity
– A country’s economic and social infrastructure
– Political safety
– Corporate governance practices
– Contagion (spread of a crisis within a region)
– Speculation

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 Equilibrium Exchange Rate

$/€ Equilibriu
D m

S
$1.50

Qty
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 What Changes the Equilibrium Rate?

 Inflation rates:
 Higher domestic inflation means less demand for local goods
(decreased supply of foreign currency) and more demand for
foreign goods (increased demand for foreign currency).
 Interest rates:
 Higher domestic (real) interest rates attract investment funds
causing a decrease in demand for foreign currency and an
increase in supply of foreign currency.
 Economic growth:
 Stronger economic growth attracts investment funds causing a
decrease in demand for foreign currency and an increase in
supply of foreign currency.

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 What Changes the Equilibrium Rate?

 Political & economic risk:

 Higher political or economic risk in the domestic country
results in increased demand and reduced supply of foreign
currency.
 Changes in future expectations:
 Any improvement in future expectations regarding the
domestic currency or economy will decrease the demand for
foreign currency and increase the supply of foreign currency.
 Government intervention:
 Maintain weak currency to improve export competitiveness.

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Forecasting in Practice

Numerous foreign exchange forecasting

services exist, many of which are provided
by banks and independent consultants.
Some multinational firms have their own in-
house forecasting capabilities.
Predictions can be based on elaborate
econometric models, technical analysis of
charts and trends, intuition, and a certain
measure of gall.
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Forecasting in Practice

 Technical analysts, traditionally referred to as chartists,

focus on price and volume data to determine past trends
that are expected to continue into the future.
 The single most important element of technical analysis is
that future exchange rates are based on the current
exchange rate.
 Exchange rate movements can be subdivided into three
periods:
– Day-to-day
– Short-term (several days to several months)
– Long-term
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Forecasting in Practice

 The longer the time horizon of the forecast, the

more inaccurate the forecast is likely to be.
 Whereas forecasting for the long run must depend
on the economic fundamentals of exchange rate
determination, many of the forecast needs of the
firm are short to medium term in their time
horizon and can be addressed with less theoretical
approaches.

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 0

Forecasting in Practice

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 Currency Forecasting Project

 For each currency you can do the following:

 RPPP and IFE (long-term influences)
 Technical analysis (past trends)
 Asset market approach (ongoing relationships and changes?)
 Balance of payments approach
 Unbiased forward rate

 Then you conclude with your overall prediction based on

all of these methods and allocate funds to your trading
strategy.

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 Balance of Payments
 The BOP is a statistical record of the flow of all of
the payments between the residents of a country
and the rest of the world in a given year.
 Transactions are recorded on the basis of double
entry bookkeeping – by definition it has to
balance.
 Every “source” must have a “use”.

 The two main components are:

 Current Account
 Capital/Financial Account

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Balance of Payments

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 Current Account (CA)
 This is record of a country’s trade in goods and
services in the current period.
CA = Exports (X) – Imports (M)

 It is divided into 4 sub-categories:

 Goods trade
 Services trade
 Income
 Current transfers

 The sum of the four sub-categories = CA balance

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 Capital Account (KA)
 This includes all short- and long-term
transactions pertaining to financial assets.
KA = Capital Inflow (cr) – Capital outflow (dr)
 The two main components:
 Capital account.
 Financial account (direct, portfolio, other).

 KA balance = Sum of capital account and

financial account.
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 Official Reserves
 Records the purchase or sale of official reserve assets by the
central bank. These assets include
 Commercial paper, Treasury bills and bonds
 Foreign currency
 Money deposited with the IMF
 This account shows the change in foreign exchange reserves
held by the central bank.
The Balance of
 Since the BOP must balance Payments Identity

CA + KA + ∆ RFX = 0
 CA + KA = – ∆ RFX
 For floating rate regime countries, such as the U.S., official
reserves are relatively unimportant.
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 Statistical Discrepancy (E&O)
 The identity CA + KA = – ∆ RFX assumes that all transactions
are measured accurately.

 Inaccurate recording of transactions (errors & omissions),

results in the above equality not holding. For BOP to balance,
CA + KA + E&O = – ∆ RFX
 Assuming changes in official reserves, errors are approximately
zero:
Current Account = (–) Capital Account
 This will hold approximately for floating rate countries

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CA ≈ -KA

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 BOP in Total

 A surplus in the BOP implies that the demand for the

country’s currency exceeded the supply and that the
government should allow the currency value to
increase – in value – or intervene and accumulate
additional foreign currency reserves in the Official
Reserves Account.
 A deficit in the BOP implies an excess supply of the
country’s currency on world markets, and the
government should then either devalue the currency
or expend its official reserves to support its value.

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 Accounting Principles
1. Any transaction resulting in a payment to foreigners is
entered in the BOP accounts as a debit and is given a
negative sign.
2. Any transaction resulting in a receipt from foreigners is
entered as a credit and given a positive sign.
3. Current Account records transactions involving exports and
imports of goods and services
4. Capital Account records transactions involving the purchase
and sale of assets.
5. Double-Entry book keeping: Every international transaction
automatically enters twice, once as a credit and once as a
debit.
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 Examples of Transactions
 Credit Transactions (+ve):
 Provision of goods and services to non-residents
 Income receivable from non-residents
 A decrease in foreign financial assets
 An increase in foreign financial liabilities
 Debit Transactions (-ve):
 Purchase of goods & services from non-residents
 Income payable to non-residents
 An increase in foreign financial assets
 A decrease in foreign financial liabilities

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 Examples of Transactions
 An Australian company exports goods worth US$1 million to
the United States:
 Export of goods is credit for the current account.
 Increase in foreign asset (US$1 million) is debit for capital account.
 Australian company then coverts US$ into A$ and buys
government bonds back in Australia:
 Decrease in foreign asset is credit for the capital account.
 Increase in government liability is debit for official reserves account.
 Australian individual imports a sports car from Europe:
 Increase in foreign liabilities is credit for the capital account.
 Import of goods is debit for current account.

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BOP & Macroeconomic Variables

A nation’s balance of payments interacts

with nearly all of its key macroeconomic
variables.
Interacts means that the BOP affects and is
affected by such key macroeconomic
factors as:
– Gross Domestic Product (GDP)
– Exchange rate
– Interest rates
– Inflation rates
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 BOP & Exchange Rates

A country’s BOP can have a significant

impact on the level of its exchange rate and
vice versa.
The relationship between the BOP and
exchange rates can be illustrated by use of a
simplified equation that summarizes the
BOP (see next slide).

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 BOP & Exchange Rates

(X – M) + (CI – CO) + (FI – FO) + FXB = BOP

Where:
X = exports of goods and services
Current Account Balance
M = imports of goods and services
CI = capital inflows Capital Account Balance
CO = capital outflows
FI = financial inflows Financial Account Balance
FO = financial outflows
FXB = official monetary reserves

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 BOP & Exchange Rates

Fixed Exchange Rate Countries

– Under a fixed exchange rate system, the
government bears the responsibility to ensure
that the BOP is near zero.
Floating Exchange Rate Countries
– Under a floating exchange rate system,
surpluses/deficits influence exchange rate.

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Trade Balances & Exchange Rates

 A country’s import and export of goods and

services is affected by changes in exchange rates.
 The transmission mechanism is in principle quite
simple: changes in exchange rates change relative
prices of imports and exports, and changing prices
in turn result in changes in quantities demanded
through the price elasticity of demand.
 Theoretically, this is straightforward, in reality
global business is more complex.

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Trade Balances & Exchange Rates

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