Determination of Exchange Rates

& Balance of Payments

Reading: Chapters 3 & 5 (not pg148-161)
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Lecture Objectives
Determination of Exchange Rates
Currency Forecasting
Introduction to Balance of Payments
Balance of Payments Accounting
BOP & Exchange Rates

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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.
Determination of Exchange Rates
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Determination of Exchange Rates
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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.
Parity Conditions Approach
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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.
Balance of Payments Approach
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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.
Asset Market Approach
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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 countrys economic and social infrastructure
Political safety
Corporate governance practices
Contagion (spread of a crisis within a region)
Speculation
Asset Market Approach
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Equilibrium Exchange Rate


Qty
$1.50
S
$/
D
Equilibrium
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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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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.
Forecasting in Practice
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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
Forecasting in Practice
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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.
Forecasting in Practice
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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 countrys trade in goods and
services in the current period.

CA = Exports (X) I mports (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 I nflow (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.
Since the BOP must balance
CA + KA + RFX = 0
CA + KA = RFX
The Balance of
Payments Identity
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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A surplus in the BOP implies that the demand for the
countrys 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
countrys currency on world markets, and the
government should then either devalue the currency
or expend its official reserves to support its value.
BOP in Total
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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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A nations 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
BOP & Macroeconomic Variables
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A countrys 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).
BOP & Exchange Rates
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(X M) + (CI CO) + (FI FO) + FXB = BOP

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

Current Account Balance
Capital Account Balance
Financial Account Balance
BOP & Exchange Rates
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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.
BOP & Exchange Rates
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A countrys 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.
Trade Balances & Exchange Rates
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Trade Balances & Exchange Rates