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INTRODUCTION
When studying open economy that trade with other countries, there is a major difference in
the transactions between domestic and foreign residents as compared to those between
residents of the same country. One of the features of international trade is the involvement of
foreign currencies. The subject called International Finance as a part of International
Economics is concerned with monetary and macroeconomics relations among different
countries. International Finance is dynamically evolving discipline and deals with real issues
in business environment related to financing transactions among different nations.
This teaching material, therefore, presents some basic theory and principles of International
Finance that are essential for a better understanding of the subject International Economics.
Such an understanding of the theories and principles would enable students to evaluate and
suggest solutions to improve international economic problems and issues facing the global
economy. Students are expected to appreciate those issues by extending their analysis to
individual countries. The basic knowledge gained from this teaching material will enable
readers to assess the policy implication of the issues and problems.
This teaching material is organized in such a way that, the first two chapters provide basic
knowledge about market for foreign exchange, introduces the major participants in the
foreign exchange market, and types of exchange markets. It also addresses concepts and
issues related to determination of floating exchange rates. It starts by reviewing the basic and
early concepts of purchasing power parity and the law of one price. Version of PPP and
problems associated with PPP in using to determine exchange rate would be explained at the
end of the chapter.
The next three chapters deal broadly with the concept of balance of payment. In these
chapters, the meanings of balance of payment, components of balance of payment and basic
concepts of deficit and surplus of the balance of payment would be explained closely. The
two approaches, the elasticity approach and the absorption approach are dealt is some detail
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in chapter four of the teaching material. The monetary approach to the balance of payment is
analyzed in some detail in one full chapter-chapter five.
Open economy and Macroeconomic policy, particularly the problem of internal and external
balance and the Mundell -Fleming model is revisited in the subsequent chapter –chapter six.
Finally, the international monetary system is presented briefly in the last part of the material -
chapter seven.
For better understanding of the subject, readers are advised to refer additional materials and
revise basic concepts of Macroeconomics, International Trade and other related literatures in
International Economics.
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CHAPTER I
EXCHANGE RATES AND FOREIGN EXCHANGE MARKET
NTRODUCTION
This chapter will attempt to examine different participants in the foreign exchange market
and explains the basic forces that operate in the market. The concept of exchange rate and the
determination of exchange rate would also be examined in some details. The basic
operational differences between fixed exchange rates and floating exchange rates regime will
be explained as well. The basic concepts of spot exchange rates and forward exchange rate
and the relationship between spot and forward exchange rate will finally be presented.
CHAPTER CONTAINT
1.0. Objective
1.1. Exchange Rates and The Foreign Exchange Market
1.2. Characteristics And Participants of The Foreign
Exchange Market
1.3. The spot and Forward Exchange Rates
1.4. Summary
1.5. Review Question
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1.0. OBJECTIVE
At the end of this chapter readers will be able to
• Explain exchange rate
• Understand characteristics of foreign exchange market
• Know major participants of the foreign exchange market.
• Explain the concept of arbitrage in foreign exchange market
• Understand the essence and difference between spot and forward exchange rates
• Explain how exchange rates are determined.
1.1. EXCHANGE RATE AND THE FOREIGN EXCHANGE MARKET
In an open economy that trade with different countries, there is a major difference in the
transaction of goods and services between domestic and foreign residents as compared to
those between residents of the some country. One of the facture of international trade is the
involvement of foreign currencies.
The Ethiopian importer will generally have to pay to the Japanese exporter in yen, to US
exporter in USD and to Germen exporter in Euro. For these reasons, the Ethiopian importers
will have to buy these currencies with birr in foreign exchange market.
The foreign exchange market is not a single physical place rather it is defined as. a market
where the various national currencies are bought and sold.
In this chapter, we will try to look at some of the basic issues like, the participants in the
foreign exchange market and the basic force that operate in the market. We will also try to
examine the basic determinant of exchange behavior. The spot and forward exchange rates
will also be discussion in some brief way.
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What is exchange rate?
People in different countries use different currencies as well as different languages. The
translator between different currencies is the exchange rate, the price of one country money
in unit of another country’s money.
Generally, exchange rate is simply the price of one currency in terms of another. There are
two methods of expressing the price of one country’s currency. These are,.
• Domestic currency unit per unit of foreign exchange. For instance, taking birr as the
domestic currency, on February 15, 2008 there was approximately 9.22 birr required
to purchase one US dollar. Thus, Exchange rate between birr & US dollar (USD) is
9.22 to 1 USD.
• Foreign currency units per unit of the domestic currency. That is, how much USD can
one Ethiopian birr buy? For example, again taking Ethiopian birr as domestic
currency, on February 15, 2008, One Eth. Birr can only buy 0.11 USD.
We can easily observe that the second method is just the reciprocal of the former. It is not as
such important which method of expressing the exchange rate is employed. What important
is to be careful when talking about a rise or fall in the exchange rate. This is because the
meaning will be very different depending up on which definition is used.
A rise in the Eth birr per dollar exchange rate, say from 9.22 to 9.30 means that more birr
have to be given up in order to obtain a dollar. This means that the birr has depreciated in
value or equivalently the dollar has appreciated in value.
Where as if the second definition is employed, a rise in the exchange rate from USD 0.11/ 1
birr to say 0.12 / birr would mean that more dollars are obtained per birr, so that the birr has
appreciated or equivalently the dollar has deprecated.
To avoid unnecessary confusion the rest of this material will refer to exchange rate as the
price of the foreign currency in terms of domestic currency. That is the price paid in the
home currency for a unit of foreign currency.
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1.2. CHARACTERISTICS AND PARTICIPANTS OF THE FOREIGN
EXCHANGE MARKET
The foreign market is the market in which individuals, firms and banks buy and Sell foreign
currency. The foreign exchange market is a world wide market and is made up of primarily
of commercial banks, foreign exchange brokers and other authorized agents trading in most
of the currencies of the world.
These groups are kept in close and continuous contact with one another through the available
means of communications like, telephone, on line computers, telex and fax and video
conference and the like. The current development in Information Communication
Technology has further made easy the communication among different foreign exchange
participant and economic agents
Among the most important foreign exchange centers are London, New York, Tokyo,
Singapore and Frankfurt.
The most widely traded currency is the US dollar which is knows as a vehicle currency-
because it is widely used to denominate international transaction. Oil and many other
important primary products such as tin, coffee and gold all are priced in dollars However,since its existence Euro( European currency unit) is becoming attractive and getting wider
range of acceptability as well.
Partic ipants in the Foreign Exchange Market
The main participants in the foreign exchange market can be categorized as follows.
Retail Clients: - These are made up of business investors, multi-national corporations and so
on. These need foreign exchange for the purpose of operating their business. Commonly they
do not directly purchase or sell foreign currency themselves; rather they operate by placing
buy/sell orders with the commercial banks.
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Commercial Banks: – The commercial banks carry out buy/sell orders from their retail
clients and buy/sell currencies on their own account so as to alter the structure of their assets
and liabilities in different currencies. Banks may deal either directly with other banks or
through foreign exchange brokers.
Foreign exchange brokers: - Commonly banks do not trade directly with one another, rather
they offer to buy and sell currencies via foreign exchange brokers. Brokers intermediate the
exchange currencies between different clients. The benefits of brokers is that, they collect,
buy and sell order for most currencies from different banks around the world thereby the
most favorable quotation can be obtained quickly and at lower cost.
A small brokerage fee is paid when banks are dealing through a broker which can be avoided
in a straight bank to bank deal. Each financial center has just a few authorized brokers
through which commercial banks conduct their exchange.
Central banks (monetary authority):- The monetary authority of a country can not be
indifferent to change in the external value of its currency, even if exchange rates of the major
industrial nations have been left to fluctuate freely since 1973.
Central banks frequently intervene by buying /selling their currencies to influence the rate at
which their currency is traded. Under a fixed exchange rate system the authorities are obliged
to purchase their currencies when there is excess supply and sell the currency when there is
excess demand.
Bulls, And Bears in the Foreign Exchange Market
Speculators are usually classified as bulls and bears to their views on a particular currency. If
a speculator expects a currency, for example dollar (spot or forward) to appreciate in the
future he is said to be bullish about the currency. Under this condition, it pays the speculator
to take a long-position on the dollar. That is, to buy the dollar spot or forward at cheap price
today in the hope that he can sell it at a higher price in the future.
But if the speculator expects the dollar (spot or forward) to depreciate in the future he is said
to be “bearish” about the currency in which case it would be better for the speculator to take
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short position on the currency. That is, to sell the dollar at what he believed to be a relatively
high price today in the hope of buying it back at a cheap rate sometimes in the future.
Speculation is the opposite of hedging and it is the act of taking a net asset position (long
position) or a net liability position (short – position) in a foreign currency. Speculation means
committing one – self to uncertain future value of one’s net worth in terms of home currency.
Most of these commitments are based on conscious, expectations about the future prices of
the foreign currency.
Arbi trage in the foreign Exchange market
Arbitrage is the exploitation of price differentials for risk less guaranteed profit. There are
two types of arbitrage, financial center and cross – currency arbitrage. To explain these two
forms of arbitrage let us assume that transaction costs are negligible and that there is only a
single exchange rate quotation ignoring the bid – off spread.
Financial center arbitrage:- This type of arbitrage ensure that the birr – dollar exchange
rate quoted in New York will be the some as that quoted in Addis and other financial centers
(assuming that birr is freely traded currency and Addis is one of the finical centers).
This is because if exchange rate is birr 9.22 in Addis but only birr 9.20 in New- York, it
would be profitable for banks to buy birr in New York and simultaneously sell them in Addis
and make a guarantied profit of 2 cents on every dollar sold and bought. Such process of
buying birr in New York and selling it in Addis continues until the rate quoted in the two
centre concedes to equal level . Such action of buying a currency from a financial center
that offers it at lower rate and selling it at higher rate in other financial centers is called
financial center arbitrage.
Cross – Currency arbitrage:- This form of arbitrage can be better explained with the help
of simple and hypothetical example. Suppose the exchange rate of birr is 9.20 birr/1 USD.And the exchange rate of dollar against Euro is 1.5 USD/1Euro. Currency arbitrage implies
that the exchange rate of birr against Euro will be 13.8 birr/ Euro (1.5 x 9.2). If this were not
the case and the actual exchange rate was for example, 14 birr /Euro, then the US dealer
wanting birr would do better to first obtain Euro with 13.8 birr/Euro (1.5x9.2) which will
then buy birr 14, making 0.2 cents per each Euro sold.
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The increase in demand for Euro would quickly appreciate its rate against the Euro to 1.5217
USD/Euro level at which level the advantage to the US dealer in buying Euro first to then
convert into birr disappears.
1.3. THE SPOT AND FORWARD EXCHANGE RATES.
The exchange rate can be of two types depending on the form of delivery takes place. These
are spot and forward exchange rate.
The Spot Exchange Rate
The spot exchange rate is the quotation between two currencies for immediate delivery. In
other words, the spot exchange rate is the current exchange rates of two currencies vis-à-vis
each other. In practice, there is normally a two-day lag between a spot purchase or sale and
the actual exchange of currencies to allow for verification, paper work and clearing of
payments. In the spot transaction, the seller of the currency has to deliver the currency he has
sold” on the spot”, usually with in two days.
The Forward Exchange Rate
Another important market for foreign exchange is the forward market. It is also possible for
economic agents to agree today to exchange currencies at some specified time in the future.
In forward market, the contract is signed and the seller agrees to sell a certain amount of
foreign currency to deliver at future date at a price agreed up on in advance. Analogously, a
buyer agrees to buy a certain amount of a foreign currencies at a future date and at a
predetermine price. The most common forward contracts are 1 month (30 day), 3 months (90
days), and 6 months (180 days). The rate of exchange at which such a purchase or sale can be
made is known as the forward exchange rate.
Why economic agents may engage in forward exchange transaction and how the forward
exchange rate is determined will be discussed below.
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Simple Model of the Determination of the Spot Rate
Since the adoption of floating exchange rate in 1973, there has developed new set of theories
attempting to explain exchange rate behavior, know as the modern asset market approach to
the exchange rate determination
However, in this chapter we will look at a simple model of exchange rate determination
which was widely used prior to the development of these new theories. Despite its short
coming, the model serves as a useful introduction to exchange rate determination and is some
how a prerequisite for understanding of this chapter.
The underlining assumption of the model is that the exchange rate (the price) of a currency
can be analyzed like any other price of commodities with the help of supply and demand
frame work. That is, the exchange rate of the birr will be determined by the intersection of
the supply and demand for birr on the foreign exchange market(if birr was freely traded
currency in major financial markets). Let us briefly look at each of the market forces turn by
turn.
The Demand for Foreign Exchange
The demand for currency in the foreign exchange market is a derived demand. Since we are
not sure that birr is freely traded in foreign exchange market, let us use dollar in stead of birr
for discussion purposes.
Restating the above statement, the demand for dollar is a derived demand It is derived from
the demand for US product. That is, dollar is not demanded because it has intrinsic valve by
itself, but rather because of what it can buy. To derive hypothetical demand for dollar let us
assume that US is exporting country and Ethiopia being importer. Table 1.1 presents the
derivation of a hypothetical demand for dollar schedule with respect to change in the
exchange rate.
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Table 1.1 Demand for dollar
Price of US Export
good in USD (1)
Exchange
rate (2)
Price of Us
export in birr(3)(1x2)
Quantity of
US expert (4)
Demand for
USD(5)=(1) (4)
10 9.20 birr 92 1500 15000
10 9.30 93 1300 13000
10 9.40 94 1100 11000
10 9.50 95 900 9000
10 9.60 96 700 7000
10 9.80 98 500 5000
10 10.00 100 300 3000
As dollar appreciate against birr, that is when it moves from 9.20 to 10 birr, the price of theUS export to Ethiopian importers increase and this leads to a lower quantity of exports and
with it a reduced demand for dollar. Hence, the demand curve for dollar which is shown in
figure 1.1 . slops dawn wards from left to right.
Birr/USD
10
9.5 -
9.20 - D
3000 9000 15000 Quantity US export
Figure 1.1 The demand curve for dollar
In this simple model the demand for dollar depends upon the demand for US export product.
Any factor which results in increase in demand for US exports will result in an increased
demand for dollars and a shift to the right of the demand curve for dollars. Some of the
factors that result in such a shift are
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a change in ETH income
a change in the price of ETH goods (Which can substitute imports from US)
a change in ETH tastes in favor of US goods
All these factors result in an increase or decrease demand for us export and hence dollar anda shift of the demand schedule either to the right or left.
The Supply of Foreign Exchange
The supply of dollars is similar to ETH or other countries demand for dollars. Table 1.2
presents hypothetical supply of dollar schedule.
As the dollar appreciates the cost of US exports will be higher to Ethiopian importers andcost of ETH exports becomes cheaper for US residents (Ethiopian products will be come
cheaper to US consumers). As such, they demand more Ethiopia’s exports (say Coffee ) and
this results in an increased demand for birr which are purchased by increasing the amount of
dollar supplied in the foreign exchange market. This yields an up ward slopping supply of
dollar curve as shown in figure 1.2.
Table 1.2 The supply of dollar.
Price of
ETH export
goods in
birr(1)
Exchange
rate birr
/USD
(2)
Price of ETH export
in USD
(3)=(1)
(2)
Quantity of
ETH
export
(4)
Demand for
birr (5) (1)x(4)
Supply of
USD (6)
(5)(2)
100 9.20 10.9 300 30000 3260.90
100 9.30 10.75 500 50000 5376.34
100 9.40 10.64 700 70000 7446.80
100 9.50 10.53 947.7 947.70 9000.00
100 9.60 10.42 1200 120000 12500.00
100 9.80 10.21 1350 135000 13775.50
100 10.00 10 1500 150000 15000.00
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The supply curve for dollar is depicted using the supply schedule of demand as shown in
table 1.2.
Exchange rate
9.8
9.6
9.5
9.4
9.3
S
9.2
300 900 9473.7 1500 Quantity of dollar
Figure 1.2 The Supply curve of dollar
The supply of dollar depends up on the US demand for Ethiopian good (in the above
example) .
The supply curve can shift to the right or to the left depending on factors like.
Change in US in come
Change in tastes of US residents
Change in prices of US goods (Which are substitutes or complementary to
Ethiopian export commodities)
All the above factors’ change may increase or decrease demand for Ethiopian goods and birr
which is reflected in an increased supply of dollar.
Since the exchange market brings together those people that whish to buy currency (which
represents the demand) with those that wish to sell their currency (which represent the
supply) then the spot exchange rate can easily be considered as being determined by the
intersection of the supply and demand for the currency. The following figure (Fig..1.3)
presents the determination of the birr-dollar exchange rates. The equilibrium exchange rate is
represented by the intersection of the supply and demand curve and this yields a birr- dollar
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exchange rate of 9.5 USD. When the exchange rate is made to float freely, it is determined by
the intersection of the supply and demand curve as shown below.
Birr/dollar
D
Quantity of dollar
S
9.5
9000
Figure 1.3 Determination of birr-dollar sport exchange rate (spot)
Fixed Vs Floating Exchange Rate
At the Breton Wood conference of 1948 the major nations of the western world agreed to a
pegged exchange rate system. Each country fixes its exchange rate against the US dollar with
a small margin of fluctuation around the par value. In 1973 the Breton Woods system broke
down and the major currencies were left to be determined by market forces in a floating
exchange rate world. The basic difference between the two systems can be explained using
the supply and demand frame –work.
Floating Exchange- Rate Regime
Under the floating exchange rate regime the authority do not intervene to buy or sell their
currency in the foreign exchange, market rather, they allow the value of their currency to
change due to fluctuations in the supply and demand of the currency, and this is illustrated in
figure below.
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In figure 1.4 ( a) shows how the exchange rate is initially determined by the equality of
demand (D1) and supply (S1) of dollar at the exchange rate of 9.50 birr per dollar.
Q1 Q2 QUSD Q1 Q2 Q USD
Birr/ $ S birr /$ S1
S29.70
. 9.5D2
D1
(a) (b)
Figure 1.4 floating exchange rate regimes (a) in crease in demand and (b) increase in
supply
If there is an increase in the demand for US exports, there will be a shift in the demand curve
for dollar from D1 to D2 , this increase in demand for dollar will lead to an appreciation of
the dollar from 9.5 say, to 9.70 or depreciation of birr Figure 1.4 (b) shows the impact of
increase in supply of dollar due to an increase demand for Ethiopian export and thus for birr.
The increased supply of dollar shifts the supply curve S1 to the right to S2 , resulting in a
depreciation of dollar from 9.50 to 9.40 .or appreciation of birr In general, the essence of a
floating exchange rate is that the exchange rate adjusts in response to any changes in the
supply and demand for currency.
Fixed Exchange Rate Regime
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In fixed exchange rate regime, exchange rate is fixed by the authorities and can not adjust in
response to the change in supply and demand for currency. Figure 1.5 illustrates the
mechanism of fixing exchange rate.
In figure 1.5 (a) the exchange rate is assumed to be fixed by monetary authorities at the point
where demand intersect the supply curve at birr 9.50. If there is an increased demand for
dollar which shifts the demand curve from D1 to D2, there is a resulting pressure for the
dollar to be revaluated. To control the appreciation of dollar, the National Bank of Ethiopia
will sell Q1 Q2 amount of dollar to purchase birr with dollars in the foreign exchange market.
This save of dollar by National Bank of Ethiopia shifts the supply curve of dollar from S1 to
S2. Such intervention eliminate the excess demand for dollar so that exchange rate will
remain fixed at birr 9.5. This intervention will decrease the amount of birr in circulation anddecreases the National Bank’s dollar reserve.
Similarly figure 1.5 (b) presents a situation where the exchange rate is pegged by the
National Bank at the point where S1 intersects D1 at birr 9.50 per dollar.
Birr/USD Birr/ USD
S1
S1 S2
S2
9.5 9.5D2
D1D2 D1
Q1 Q2 QUSD Q1 Q2 QUSD (a) (b)
Figure 1.5 Fixed exchange rate regime (a) increase in demand (b) increase in supply
If there is an increase in demand for Ethiopian export, there will be an increased demand for
birr and increased supply of dollar which shifts the supply curve to S2. That is excess supply
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of dollar at the prevailing exchange rates and there will be a pressure on the dollar to be
devaluated or domestic currency to be revalued . To avoid this the National (Central) Bank
of Ethiopia has to intervene in the foreign exchange market by purchasing Q1 Q2 amount of
dollar to keep the exchange rate fixed at birr 9.50 per dollar. This intervention is shown by a
right ward shit of the demand curve from D1 to D2 . Such intervention removes the excess
supply of dollar so that the exchange rate remain pegged at birr 9.50 per pound and it leads to
an increase in the Ethiopian National Bank’s reserves of dollar and in the amount of birr in
circulation.
Forward Exchange Rate and its Determination
The forward exchange-market is a market where buyers and sellers agree to exchangecurrencies at some specified date in the future. For example, Ethiopian importer who has to
pay $10,000 to his US supplier at the end of August, may decide on June 1 to buy $ 10,000
for delivery on August 31 of the same year at a forward exchange rate of say birr 9.40 per
dollar. The question that commonly arises is that, why should any one wish to agree today to
exchange currencies at some future date?
To answer this question we need to look at different participants in the forward exchange
market. Traditionally, economic agents involved in the forward exchange market are divided
into three groups based on their motives for participation in the foreign exchange market.
These are
• Hedgers
• Speculators
• Arbitrageurs
Hedger: These are agents (usually firms) that enter the forward exchange market to protectthemselves against exchange rate fluctuation, which entail exchange rate risk.
Exchange risk is the risk of loss due to adverse exchange rate movements. We will explain
why a firm may engage in a forward exchange rate transaction using the following
illustrative example.
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Consider the Ethiopian importer who is going to pay for goods imported from the US to the
value of US $ 10,000 in one year time. Suppose the spot exchange rate is 9.5 birr while the
one year forward exchange rate is birr 9.4. By buying dollars forward at this rate the importer
can be sure that he only has to pay birr 94000. If he does not buy forward today, he might run
the risk that in one year’s time the spot exchange rate may be higher that birr 9.4 such as birr
9.50 which would mean he has to pay birr 95000. Of course, the spot exchange rate in one
year’s time may be changed in favor of the importer and may be birr 9.20 in which case he
would only has to pay birr 92000. But by engaging in a forward exchange contract the
importer can be sure of the amount of birr he have to pay for the imports, and therefore can
protect himself against the risk of exchange rate fluctuation.
One may ask why the importer does not immediately by US$
10,000 at spot at birr 9.40 andhold for 1 year. One reason is that he may not at present have the necessary funds for such a
spot purchase and is reluctant to borrow the money, knowing that he will have the funds in
one year’s time from sales of goods. By engaging in a forward contract he can be sure of
getting the dollars he requires at known exchange – rate even though he does not yet have the
necessary birr.
In effect, hedgers avoid exchange risk by matching their asset and liability in the foreign
currency. In the above example, the Ethiopian importer buys 10,000 USD forward (his asset)
and will have to pay 10,000 for imported goods (his liability).
Arbitrageurs:- These are agents (usually banks) that aim to make a risk less profit out of
discrepancies between exchange rates differences and what is know as the forward discount
or forward premium.
A currency is said to be at a forward premium if its forward exchange rates represents an
appreciation as compared to the spot rate quotation. On the other hand a currency is said to
be at forward discount if its forward exchange rate quotation shows depreciations as
compared to its spot- rate quotation.
The forward discount or premium is usually expressed as a percentage of the spot exchange
rate. That is,
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Forward discount/Premium = 100S F
S X −
Where F is the forward exchange rate quotation and S is the spot exchange rate quotation.
The presence of arbitrageurs ensures that the covered interest parity (CIP) condition holds
continuously.
CIP is the formula used by banks to calculate their exchange quotation and is given by the
following
F =( * )
(1 )
r r s
r s−+ +
Where,
• F is the one - year forward exchange rate quotation in domestic currency per unit of
foreign currency,
• S is the spot exchange rate quotation in domestic currency, per unit of foreign
currency, r is the one year foreign interest rate and
• r* is the one – year domestic interest rate
The above formula has to be amended by dividing the three months interest rate by 4 to
determine the three – month forward exchange rate quotation and dividing by 2 to calculate
the six moth forward exchange rate.
As an illustrative example of the determination of the forward exchange rate, suppose that
the Euro interest rate is 5%, and the birr interest rate is 3%, and the spot rate birr against Euro
is birr 10 per euro. The one year forward exchange rate can be calculate as follows.
F =(0.03 0.05)10 0.2
(1 0.05 1.0510 10 9.81F
− −+
+ => = + =
Forward discount/premium =9.8110
10100 0.019 100 x− X =− which is nearly – 0.02. The one
year forward rate of euro is at an annual forward discount of 2%.
To understand why covered interest parity (CIP) must be used to determine the forward
exchange rate, consider what would happen if the forward rate was different from that of
calculated in the above example, for example birr 10.1/Euro. In this instance an Ethiopian
investor with birr 1000 could earn 1050 birr at the end of the year, but by buying Euro spot at
birr 10 per euro, and simultaneously selling pounds forward at birr 10.10 at spot exchange
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rate he would buy 100 Euro (1000/10) and will earn 105 at the end of the year at 5% Euro
interest rate (1.05x100=105). Selling 105 at forward rate of 10.1 giving him birr 1060.5
(105x10.1).
Clearly, it pays Ethiopian investor to buy Euro at spot and sell Euro forward. With sufficient
numbers of investors doing this, the forward rate would gradually depreciate until such
arbitrage possibilities were eliminated. With a spot rate of investors doing this, the forward
rate would gradually depreciate until such arbitrage possibilities were eliminated. With a spot
rate of birr 10/Euro, only the forward rate is at 9.81 birr will yield in Ethiopia and in
European Union time deposit be identical (since 105x9.81=1030). Only at this forward rate
there is no risk-less arbitrage profits to be made.
Since the denominator in the above equation is very close to one (unity), the equation can be
modified to yield an approximate expression for forward premium /discount
( * ) ( * ) 5
( 1 )
*
5,
r r s r r S S
r S
F S
F s
T h u s r r
− −
+
−
= + ⇒
= −
+ −
This approximate version of CLP says that, if the country interest rate is higher than the
foreign interest rate, then its currency be at forward premium by equivalent percentage ;
while if the domestic interest rate is lower than the foreign interest rate, the currency will be
at forward discount by an equivalent parentage. In our example, the Ethiopian, interest rate of
3% less than Euro interest rate of 5% indicate an annual forward discount on Euro of 2%,
which is an approximation to the actual 1.9 percent discount obtained using the full CLP
formula.
Speculators: - speculators are agents that hope to make a profit by accepting exchange raterisk. They engage in the forward exchange market because they believe that the future spot
rate corresponding to the date of the quoted forward exchange rate will be different from the
quoted forward rate
Consider the situation where the one year forward rate is quoted at birr 9.40/ USD and a
speculator fells that the dollar will be rather birr 9.20 /USD in one years time. In this case he
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may sell $1000 forward at birr 9.40 so as to obtain birr 9400 one year and hope to change
them back into dollar in one year’s time at birr 9.20 /USD, and so obtain US $1021.74
making $21.74 profit.
In fact the speculators may be wrong in his expectation and find that in one year’s time spot
exchange rate is rather above 9.40, say birr 9.50 /USD, in which case his 9400 birr are worth
only 989.47 USD implying a loss of USD 10.53
Generally, speculator hops to make money by taking and open position in the foreign
currency. In our example, he has a forward asset in Birr which is not matched by a
corresponding liability of equivalent value.
The Relation Between Spot and Future Exchange Rate
Why spot and forward exchange rate are different in most cases?
The answer is that, the spot and forward exchange rate should differ by about as much as
interest rate differs in the two countries currencies as explained earlier.
Here is an explanation for difference between spot and forward rates. A country with one
percent higher interest rate will tend to have a one percent forward discount (short fall of the
forward rate below the spot rate) on its currency. In fact, Euro did have a forward discount in
our previous example (and this is a forward premium to birr).
The relationship between spot and forward rate is thus, dictated by the international interest
rate gap. As long as this gap stays the same, the spot and forward rates will keep differing by
the same percentage, and whatever moves the spot rate up and down will do the same to the
forward rate.
Interest rate parity :- The forward exchange value of a currency will tend to exceed its spot
value by as much (in percent) as its interest rate are lower than the foreign interest rate.
For our better understanding how interest rate parity condition works let us have one moreexample.
i. We can convert present dollar into future birr by selling them at the spot
exchange rate (r s, measures birr per dollar) and investing those birr at the
Ethiopian interest rate. In the case future birr per present dollar Or.(1 )sr ia= +
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ii. We can convert present dollar into future birr by investing the dollar in US at
the interest rate i b and selling the later earnings right now at the forward
exchange rate f r again measured in birr per dollar.
In this case future birr value per present dollar (1 ). f ib r = +
If you can get from present dollar to future birr in either of the two ways, you will take the
more profitable way. But every body thinks the same way. Since investor have choices, the
exchange rates and interest rates will adjust so that the two future dollar values are equal.
That is.
.(1 ) (1 ). (1 ) /(1 ) f s f as
r r ia ib r or i i
r + = + = + + b
This is called the interest rate parity condition.
1.4. SUMMARY
As trade among counties (international trade) increases the need the need for foreign
exchange market becomes very important activity of economic agents. Trade with financial
assets always involves the exchange of different national currencies. If the world economy
had a single currency then a foreign exchange market would not exist. The modern foreign
exchange market is truly a global market and is characterized by a large volume of dailytransactions.
Most topics in international finance focuses on the forces that determine exchange – rate
movement, and the implication of these movement for trade and economic growth and the
development of the world economy. Conducting Economic analysis of the effect of
exchange- rate changes, require making distinction between the real and nominal exchange
rate and between bilateral and effective exchange rates depending on the purpose of the
particular analysis being undertaken.
Even if exchange rate may change significantly at time, this is not necessary disruptive to the
international trade as traders can protect themselves against exchange risk by hedging in the
forward exchange market. For many countries the depreciation / devaluation of their
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currencies is an important mechanism for maintaining their international competitiveness and
trade volume.
1.5. REVIEW QUESTIONS
1. How do you understand Exchange- rates?
2. What are the major participants of foreign Exchange market and explain their
characteristics?
3. What do you understand by Bulls and Bears in the foreign exchange market ?
4. Explain the difference between the act of speculation and Hedging in the foreign
exchange market ?
5. Explain the difference between financial center and cross-currency arbitrage.
6. What do you understand by spot exchange rate?
7. Explain the essence of determination 7 spot exchange- rate.
8. What is for-ward exchange Rate?
9. What are factors affecting demand for foreign exchange ?
10. What are factors affecting supply of foreign exchange?
11. What are the economic agents participating in the foreign exchange market?
12. Explain the relationship between spot and future exchange rate.
13. Suppose you are a speculator in the foreign exchange market and suppose that Euro can
be purchased sold to day at a for ward rate of 15 birr/ Euro in one Years time and you
expect the spot rate to be 14.5 birr/Euro after one year. If you have 10,000 Euro at hand
today, how can you earn benefit from it?
How would your answer change if the expected spot rate after one year were birr
16/Euro?
CHAPTER II
DETERMINATION OF FLOATING EXCHANGE RATE
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INTRODUCTION
This chapter presents one of the earliest and simplest models of exchange rate determination
know as purchasing power party (PPP) theory. Common understanding of PPP is essential to
the study of international finance.
In fact this theory has been advocated as an appreciate model of exchange rate determination
for the long-run exchange rate theories. The concept of Purchasing power parity (PPP) is
linked to what we call it the law of one price The purchasing power parity, has its original
date back to nine teeth – century – by David Ricardo. The basic concept underlying PPP
theory is that arbitrary forces will lead to the equalization of goods prices internationally
once the price of goods are measured in the same currency. As such this chapter presents the
theory of PPP and the application of the “law of one price “. It also summarizes some of the
problems associated with the concept and with the measurements of PPP.
CHAPTER CONTENT
2.0. Objective
2.1. The law of one price and purchasing power parity
2.1.1. Absolute purchasing power parity
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2.1.2. Relative purchasing power parity
2.2. The Generalized version of purchasing power parity
2.3. Measurement problems and poor performance of the
theory of PPP.
2.4. Summary
2.5. Review Question
2.0. OBJECTIVE
At the end of this chapter the reader will be able to.
• Explain the law of one price and the concept of purchasing power parity. • Explain the difference between the absolute and relative purchasing power
parities.
• Understand generalized version of the purchasing power parity.
• Explain the reason why the theory of purchasing power parities perform poorly in
the real world condition
• Explain the problem of measuring purchasing power parity
2.1 THE LAW OF ONE PRICE
The law of one price state that in the presence of a competitive market structure and the
absence of transport costs and other barriers to trade, identical products which are sold in
different markets will be sold at the same price when expressed in terms of a common
currency . The law of one price is based up on the idea of perfect goods arbitrage.
Arbitrage occurs when economic agents exploit price differences to provide a risk less profit.
Examples
If a car costs $20,000 in US and the identical model costs birr 180,000 in Ethiopia, then
according to the law of one price the exchange rat should be 180,000/ 20,000, which is birr
9/USD.
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Suppose the actual exchange rate were higher than this at birr 9.20 /USD, then it would pay
US citizens to buy a car in Ethiopia, because with 19565 USD he can buy a car
(1800,000/9.20) by doing so he will save 435 USD compared to purchasing the car in the US
market.
According to the law of one price, US residents will exploit this arbitrage possibility and start
purchasing birr and selling dollars. Such a process will continue until the birr appreciates to
birr 9/USD at which point arbitrage profit opportunities are eliminated.
Conversely, if the exchange rate is birr 8.50/USD then US car cost the Ethiopian residents
21176 USD if he purchases the car in Ethiopia. But if he purchases in US the Ethiopian
resident may save 1176 USD. Thus, Ethiopian residents will purchase dollar and sell birr
until the dollar appreciates and exchange rate becomes 9 birr/USD.
The proponents of PPP argue that the exchange rate must adjust to ensure that the law of one
price which applies, to individual good, also holds internationally for identical bundles of
goods.
Purchasing power parity (PPP) theory comes in two forms on the basis of strict interpretation
of the law of one price
Absolute purchasing parity
Relative purchasing power parity
2.1.1. ABSOLUTE PURCHASING POWER PARITY (PPP)
This is a strict form of interpretation of the law of one price. In this approach, if one takes a
bundle of goods in one country and compares the price of that bundle with an identical
bundle of goods sold in a foreign country converted by the exchange into a common currency
measurement, then the price will be equal.
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For example, if a bundle of goods costs birr 20 in Ethiopian and the same bundle costs $2 in
the US, then the exchange rate defined as birr per dollar will be 20 birr/2 USD = birr
10/USD . Algebraically, the absolute version of PPP can expressed as
* pS
p=
Where,
• S represents the exchange rate defined by domestic currency units (birr) per unit of
foreign Currency (USD)
• P – is the price of bundles of goods expressed in the domestic currency ( price in
birr)
• P*- is the price of identical bundle of goods expressed in the foreign currency (USD).
According to the absolute PPP a rise in the home price level relative to the foreign price
level will lead to a proportional depreciation of the home currency against the foreign
currency.
In the above example, if the price of Ethiopian bundle of goods rise say to 21 birr while the
price of the same bundle remain unchanged , that is $ 2 then the birr will depreciate to birr
10.5 / USD ( 21/2).
2.1.2. RELATIVE PURCHASING POWER PARITY (PPP)
Many economist are some how skeptical as to the application of the absolute version of PPP,
According to them the absolute version of PPP is unlikely to hold precisely because of the
existence of transportation cost, imperfect information and the distorting effect of tariffs and
other forms of protectionism.
However, it is argued that a weaker form of PPP known as relative PPP can hold even in the
presents of such distortions
In other words, the relative version of the theory of PPP argues that the exchange rate will
adjust by the amount of the inflation differentials between two economies. This can be
expressed as follows
% %S p∆ = ∆ − ∆ * p
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Where,
% s∆ − The percentage change in the exchange rate
% p∆ − The percentage change in the domestic inflation rates
% ∆ P* The percentage change in the foreign inflation rate
According to the relative version of PPP, if the inflation rate in the US is 10 percent that of
Ethiopia is 5 percent, the birr per dollar exchange rate should be expected to appreciate by
the approximately 5 percent .
The absolute version of PPP does not have to hold for this to be the case. For example, the
exchange rate may be birr 10/ USD while the Ethiopia bundle of goods costs birr 120 and the
US bundle of identical goods cost, USC 10 so that absolute PPP to hold it would require
(120
12 / )10
US = . But if Eth price goes up 10 percent to birr 132 and the US bundle of goods
goes up 5 Percent to 10.5 USD, the relative version of PPP predicts the birr will deprecate by
5% to birr 10.5 /USD.
2.2. THE GENERALIZED VERSION OF PPP
One of the major problems with PPP is that it is supposed to hold for all types of goods.
However, a more generalized version of PPP provides some useful insights and makes
distinction among goods traded. According to general version of PPP goods can be
categorized into traded goods and non-traded goods.
Traded goods:- These are goods which are susceptible to international competition. Here
belongs most manufacturing goods like.
• Automobile
• Electronics products and fuels and the like
Non traded goods:- are those that can not be traded internationally at a profit. Their price
will not be affected by the international competition. These includes different goods and
services like
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Hair cut (hair dressing)
Restaurant food service
Houses
Etc
The distinction between them is due to the fact that the price of traded goods will tend to be
kept in line with the international competition, while the price of non-traded goods will be
determined predominantly by domestic supply and demand considerations.
For instant, if a car costs 15,000 Pound in the UK and $ 30,000 in US arbitrage will tend to
keep the pound-dollar rates at 2 USD/Pound.
However, arbitrage forces do not play a role in the case of house trade. Similarly, if a hair-cut
cost birr 10 in Ethiopia but $10 in US and the exchange rate is birr 10/USD,
No one in the US will travel to the Ethiopia for a haircut knowing that they can save $9
because of the time and transport costs involved.
When aggregate price-indices is determined both tradable and non-tradable are considered.
Assuming that PPP holds for tradable we have the following locations.
*T T p sp=
Where,
• T p − price of traded goods in the domestic country measured in terms of the domesticcurrency
• the price of traded goods in the foreign country measured in-terms of the foreign
currency.
*
T p −
• S - The exchange rate defined as domestic currency units per unit of foreigncurrency.
The aggregate price index ( ) I p for the domestic economy is made up of a weighted average
of the price of both tradable ( )T p and non-tradable goods ( priced in the domestic
currency. Likewise, the foreign aggregate price index ( is made up of a weighted
average of the prices on tradable ( priced in the foreign currency. This is shown as
), N P
( *), I p*) N P
...............(1 ) (1) I T p N pPα α = + −
Where, α is the proportion of non-traded goods in the domestic price index
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* *
* (1 ) .........(2) I T
p PN P β β = + −
Where, β is the proportion of non-traded goods in the foreign price index.
Dividing equation (1) and (2) we obtain
* *
*
(1 )
(1 ) I T
I T
P PN P
P PN P
α α
β β
+ −=
+ −
If we divide the numerator by and the denominator by which because of the
assumption of PPP for tradable goods are equivalent expression, we obtain
T p *T SP
* * *
( / ) (1 )......(3)
( / ) (1 ) N T I
I N T
P PPS
P P P
α α
β β
⎡ ⎤+ −= ⎢ ⎥
+ −⎢ ⎥⎣ ⎦
This can be rearranged, to give the solution for the exchange rate as
* *
*
( / ) (1 )........(4)
( / ) (1 N I I
I N T
P PPS
P P P
β β
α α
+ −⎡ ⎤= ⎢ ⎥
+ −⎣ ⎦
The above equation is an important modification to the initial PPP equation. This is because
PPP no longer necessary holds in terms of aggregate price indices due to the terms on the
right hand side. Further more, the equation suggests that the relative price of non –tradable
relative to tradable will influence the exchange-rate.
Testing for PPP using price indices based on tradable goods prices is likely to lead to better
results than when using aggregate price indices made up of both types of goods.
2.3. MEASUREMENT PROBLEMS AND POOR PERFORMANCE OF
THE THEORY OF PPP
Many of the proponents of PPP argued prior the adoption of floating exchange rate changes
would be in line with those predicted by the theory of PPP.
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However, there are problems faced when it is applied practically. One of such problems is
that, whether the theory is applicable to both traded and non-traded goods.
At the beginning PPP seems readily applicable to traded goods. However, some people
argued that the distinction between tradable and non tradable is fuzzy, because in most cases
they are linked to each other. Moreover tradable goods are used as input into the production
of non-tradable goods.
Money researchers have tried to test whether PPP can be used to predict exchange rate or not.
They used graphical evidence, simplistic data analysis and more sophisticated econometric
evidences and the results are summarized as follows.
• PPP performs better for countries that are geographically close to one another
and where trade linkages are high• Exchange rates have been much volatile than the corresponding national prices
level. This is against the PPP hypothesis in which exchange rates are only
expected to be as volatile as relative price.
• PPP holds better in the long-run than in the short-run.
• The currencies of countries with very high inflation rates relative to their trading
partners, mostly likely would experience depreciation reflecting their high
inflation rate. This suggests that PPP is the dominant force in determining their
exchange rate.
• Overall , PPP holds better for traded goods than non-traded goods
• Strikingly, it was observed that the price of non-traded goods tends to be more
expensive in rich countries than in poor countries once they are converted into a
common currency.
There have been many explanation put forward to explain the reasons for poor performance
of the theory of purchasing power parity. Some of these reasons are,
• Statistical Problem,
• Transport Costs and Trade Impediment
• Imperfect competition
• Difference Between capital and goods markets.
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• Productivity Differentials.
Statistical Problems
The theory PPP is based on the concept of comparing identical baskets of goods in two
economies. The problem facing researchers is that different countries usually attach different
weight to various categories of goods and services when constructing their price indices. This
factor is very significant when testing for PPP between developing and developed nations.
People in developing countries usually spend a high proportion of their income on basic
goods like food and clothing, while these take up a much smaller proportion of people’s
expenditure in developed economies.
Transportation Cost and Trade Impediments
Studies by Frenkel (1981) showed that PPP holds better when the countries are
geographically close and trade linkage are high, can partly be explained by transport costs
and the existence of other trade barrier such as tariff.
For example, if a bundle of good costs birr 100 in Ethiopia and $ 10 in US then the PPP
suggests that the exchange rate would be birr 10/USD. If transport costs are birr 20 then theexchange rate would be between birr 12/USD and birr 8/USD. Without bringing arbitrage
forces in to play. However, since transportation costs and trade barriers do not change
dramatically over time they are not sufficient reason for the failure of the relative version of
PPP .
Imperfect Competition
The main idea behind PPP is that there is sufficient international competition to prevent
major departure of the prices of goods among countries. However, it is know that there areconsiderable variations in the degree of competition internationally. In fact these conditions
are necessary for successful price determination.
Difference between Capital and Goods Market
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Purchasing power parity is based on the concept of goods arbitrage and has nothing to say
about the role of capital movement. Rudiger D. (1976) hypothesized that in a world where
capital market are highly integrated and goods markets exhibit slow price adjustment., there
can be substantial prolonged deviation of the exchange rate from PPP.
The basic idea is that in the short-run good price in both home and foreign country can be
considered as fixed , while the exchange rate adjusts quickly to new information and change
in economic policy , This is the case being exchange rate changes represent deviation from
PPP which can be quite substantial and prolonged .
Productivity Differentials
The other striking result obtained is that when prices of similar basket of both traded and
non-traded goods are converted in to a common currency, the aggregate price indices tend to
be higher in rich countries than in poor countries. In other words, a dollar buys more goods in
say, Ethiopia than in US. The over all higher prices in rich countries is mainly due to the fact
that non-tradable goods prices are higher in developed than in developing countries.
An explanation for the lower relative price of non-tradable in poor countries is due to their
lower labor productivity between developing and developed countries. In other words higher price of non-traded goods in developed countries is mainly due to their higher labor
productivity in the traded sector as compared to developing countries.
2.4. SUMMARY
When major country abandon fixed exchange rate regime and adopt floating exchange rate, it
was widely believed that the exchange rate would adjust in line with change in national price
levels as provided by PPP theory.
The basic concept underlying PPP theory is that arbitrage forces will lead to the equalization
of goods prices internationally once the price of goods are measured in the same currency.
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As such the theory represents the application of the law of one price. According to this law in
the presence of a competitive market structure and the absence of transport costs and other
barrier to trade, identical products which are sold in different market will be sold at the same
price when expressed in terms of a common currency.
Purchasing Power Parity theory comes in two forms, relative and absolute PPP. Absolute
purchasing power parity holds that if one takes a bundle of goods in one country and
compare the price of that bundle with an identical bundle of goods sold in a foreign country
and converted into common currency, then the price will be the same (equal) Relative PPP
which is a weaker form of PPP state that the exchange rate will adjust by the amount of the
inflation differential between two counties.
One of the major problems with PPP theory is that it is suggested to hold for all types of
goods. However, the more general version of PPP makes distinction between traded and non-
tradable goods. By considering these two types of goods the generalized version. suggests to
use the aggregate price index to estimate the exchange rate, tend to be higher in rich
countries than in poor countries. In other words, a dollar buys more goods say, in Ethiopia
than in US. The over all higher prices index in rich countries is mainly due to the fact that
non-tradable goods prices are higher in developed than in developing countries. An
explanation for the lower relative price of non-tradable goods in poor countries is due to their
labor productivity between developing and developed countries.
In other words higher price of non-traded goods in developed countries is mainly due to their
higher labor productivity in the traded sector compared to developing countries
2.5. REVIEW QUESTIONS
1. Explain the concept of the law of one price.
2. Explain the essence of Absolute purchasing power parity using appropriate example.
3. Suppose one kilogram of coffee costs birr 10 in Ethiopia, 40 shillings in Kenya,
determine the exchange rate defined as birr per Kenyan shelling using Absolute
purchasing power approach .
4. Explain how Relative purchasing power parity differs from Absolute purchasing power
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Parity!
5. What are traded goods?
6. Explain the importance of traded goods in determining exchange rate.
7. What are problems faced when purchasing power party theory is applied practically.
8. List some of the empirical test results concerning the applicability of PPP to predict
exchange rates.
9. The poor performance of purchasing power parity in predicting exchange rate has been
explained by many factors. Explain them.
CHAPTER III
BALANCE OF PAYMENT AND NATIONAL INCOME
ACCOUNT
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INTRODUCTION
The Balance of payment accounts are an integral part of the national income account for an
open economy. Balance of payment is one of the most important economic indicators for
policy-makers in the open economy. The balance of payment (BP) records all transactions
among residents of different counties are broadly interpreted as all individuals, business, and
governments and their agencies, international organizations are also included as well.
What is happening to a country’s balance of payment often captures the news headlines and
can become the focus of attention particularly in most industrialized countries. A good or a
best set of figures can have an effect on the exchange rate and can lead policy-makers tochange their economic policy. BP deficit may lead to the government raising interest rater or
reducing public expenditure to reduce expenditure on imports. Deficit may also lead to
protectionism against foreign imports or capital controls to defend the exchange rate.
Before, considering various policy options to deal with the perceived problems in the balance
of payments, we need to consider what the balance of payment figure are and what is meant
by the notion of a surplus or deficit. This chapter will try to look at the components of
balance of payment, how they are compiled and interpretation of different statistical figures.
CHAPTER CONTENT
3.0. Objective
3.1. What is Balance of Payment?
3.2. Balance of payment Account
3.2.1. The Current Account Balance
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The balance of payment is one of the most important statistical statements for any country. It
reveals how many goods and services the country has been exporting and importing and
whether the country has been borrowing or lending money to the rest of the world. In
addition, whether or not, the monetary authority ( National Bank ) has added to or reduced
its reserves of foreign currency is reported in the statistics. It is important to note that
citizenship and residency are not necessarily the same from the view point of the balance of
payments statistics.
Thus, a key definition that needs to be resolved at the outset is that a domestic and foreign
residents.
The term residents refers to individuals, house holds, firms and the public authorities. The
problem arising from the definition of residents is those multinational corporations are by
definition resident in more than one country.
For the purpose of balance of payment reporting, the subsidiaries of a multinationals are
treated as being residents in the country in which they are located even if their share are
actually owned by foreign residents. Another distinction regarding the treatment of
international organizations such us, the International Monetary Fund, the World Bank,
United Nations and the like, these institutions are treated as being foreign residents even
though they may actually be located in the reporting country. Tourists are regarded as being
foreign residents if they are in the reporting country for at less than a year.
Collection, Reporting of the Balance of Payment
The balance of payments statistics record all of the transaction between domestic and foreign
residents, be they purchases or sales of goods, services or of financial assets such as bonds,
equities and banking transactions.
Reporting figures are usually in terms of the domestic currency of the reporting country. The
authorities collect their information from the custom authorities, survey of tourist numbers
and expenditure, and data on capital in-flow outflow is obtained from banks, pension funds,
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multinationals and investments houses. The responses from different sources are compiled by
government statistical agencies.
3.2. BALANCE OF PAYMENT ACCOUNTING
An important point about balance of payment statistics is that in an accounting sense they
always balance. This is because they are based up on the principle of double-entry book-
keeping. Each transaction between domestic and foreign residents has two sides to it, a
receipt and payment, and both these sides are recorded in the balance of payment statistics.
Each receipt of currency from residents of the rest of the world is recorded as a credit item
(carries a plus in the account) while each payment to residents of the rest of the world is
recorded as a debt item (carries a minus in the accounts).
Components of Balance of Payment
Before considering some examples of how different types of economic translations between
domestic and foreign residents get recorded in the balance of payment, we need to consider
the various sub-accounts (components) that make up the balance of payment.
Traditionally, the statistics are divided into two main sections, the current account and the
capital account. Each of them can be further subdivided. The explanation for division into
these two main parts is that the current account refers to income flows, while the capital
account records change in the assets and liabilities.
Example of a simplified annual balance of payment for Europe as a whole is presented in
table 3.1
Table 3.1. Balance of payment of Euro land
Current Account
1. Export of goods +150
2. Import of goods - 200
3. Trade balance - 50 (1+2)
4. Export of services + 120
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5. Import of services - 160
6. Interest, profit and Dividend received + 10
7. Interest, profit and dividend paid -10
8. Unilateral receipts +30
9. Unilateral payment -20
10. Current Account balance -70 (sum 3-9)
Capital Account
11. Investment abroad -30
12. Short –term lending -60
13. Medium and long –term lending -80
14. Repayment of borrowing than Row -70
15. Inward foreign investment +170
16. Short-term borrowing +40
17. Medium and long-term borrowing +30
18. Repayment on loans received from Rest of the world +50
19. Capital Account Balance +50 (sum (11-18)
20. Statistical Error +5 (zero minus (10+19+24)21. Official settlement balance -15 (10 + 19+ 20)
22. Change in reserves rise (-) fall (+) -10
23. IMF borrowing from (+) repayment to (-) -5
24. Official financial balance +15 (22+23)
The Trade balance
The trade balance some time referred to as the visible balance because it represents the
difference between receipts from export of goods and expenditure on imports of goods which
can be visibly seen crossing frontiers.
The receipts for exports are recorded as a credit in the balance of payment, while the
payment for import is recorded as a debit. When the trade balance is in surplus this meant
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that a country has earned more from its exports of goods than in has paid for its imports of
goods.
3.2.1 THE CURRENT ACCOUNT BALANCE
The current account balance is the sum of visible trade balance and the invisible balance. The
invisible balance shows the difference between revenue received from export of services and
payment made for imports of services such as
• Shopping,
• Tourism
• Insurance and Banking
• Transport
In addition receipts and payments of interest, dividends and profits are recorded in the
invisible balance as they represent the rewards for investment in overseas companies, bonds
and equities. Payment represents the reward to foreign residents for their investment in the
domestic economy.
From table 3.1 we can observe an item called unilateral transfers included in the invisible
balance. These are payment or receipts for which there is no corresponding transaction or
activity. Examples of such transactions are migrant workers’ remittances to their family back
home, the payment of pensions to foreign residents, and foreign aid. Such receipts and
payments represent a redistribution of income between domestic and foreign residents. A
unilateral payment can be considered as a fall in domestic income due to payment to
foreigners and so are recorded as a debit, while unilateral receipts can be viewed as an
increase in income due to receipts from foreigner and consequently are recorded as credit .
3.2.2. THE CAPITAL ACCOUNT BALANCE
The capital account records transactions concerning the movement of financial capital into
and out of the country. Capital comes into the country by borrowing, sales of foreign assets
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and investment in the country by foreigners. These items are referred to as capital in flows
and are recorded as credit items in the balance of payment.
Capital inflows are a decrease in the country’s holding of foreign assets or increase in
liabilities of to foreigners. Usually capital inflows are recorded as credit in the balance of
payment - it presents some confusion to many readers.
The easiest way to minimize this problem is that to think of investment by foreigners as
export of equity or bonds and sales of foreign investment as an export of those investments to
foreigners.
Capital leaves the country due to lending, buying of overseas asset, and purchase of domestic
assets owned by foreign residents. These items are recorded as debits as they are represent
the purchase of foreign bonds or equities, and the purchase of investment in the foreign
country.
Items in the capital account are normally classified on the basis of their origin as private or
public sector. On the basis of the time period the capital account items are classified as
short-term or long-term capital items. The summation of the capital inflows and outflows are
recorded in the capital account gives the capital account balance.
3.2.3 OFFICIAL SETTLEMENTS BALANCE
Due to huge statistical problems involved in compiling the balance –of – payment statistics,
there will be a discrepancy between the sums of all the items recorded in the account. To
ensure that the credits and debits are equal, it is necessary to incorporate a statistical
discrepancy for any difference between the sum of credit and debits.
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There are different sources of such error. One of the most important is that it is impossible to
keep record of all the transactions between domestic and foreign residents, many of the
reported statistics are based on sample estimate derived from separate sources; as a result
some errors are unavoidable. Another problem is that due to the desire to avoid taxes some of
the transactions in the capital account are under reported. Moreover, some dishonest firms
may deliberately under invoice their exports and over invoice their imports to artificially
deflate their profit.
The balance of payments records receipts and payments for a transaction between domestic
and foreign countries, but most of the time goods are imported but the payment delayed.
Since the import is recorded by the customs authority and the payment by banks, the time
discrepancy may mean that the two sides of the transaction are not recorded in the same setof figure.
The summation of the current balance, capital account balance, and the statistical discrepancy
gives the official settlements balance. The balance on this account is important because it
shows the money available for adding to the country’s official reserves or paying off the
country’s official borrowing. The central bank normally holds a stock of reserves made up of
foreign currency assets like different government Treasury-Bills (T-bills).
Such reserves are held primarily to enable the central bank to purchase its currency in order
to prevent the depreciation of its currency.
Any official settlements deficit has to be covered by the authorities drawing on their reserves,
or borrowing money from foreign central banks or from the IMF (recorded as plus in the
account).
If, on the other hand, there is an official settlement surplus then this can be reflected by the
government increasing official reserves or repaying debts to the IMF or other sources (a
minus since money leaves the country).
Reserve increases are recorded as a minus, while reserve fall are recorded as a plus in the
balance of payment statistics. Such recording is a source of confusion for many students. For
better understanding we can think that reserves increase when the authorities purchase
foreign currency.
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3.3. RECORD OF TRANSACTIONS IN THE BALANCE OF PAYMENT
To understand exactly why the sum of credits and debits in the balance of payment should
sum to zero we consider some examples of economic trisections between domestic and
foreign countries
There are basically five types of such transactions that can take place. These are
i. Exchange of goods/services in reform for a financial asset.
ii. An exchange of goods/services in return for other goods/ services
iii. An exchange of a financial item in reform for a financial item
iv. A Transfer of goods or services with no corresponding transaction (aid (frod or
military) )
v. A unilateral transfer of financial asset with no corresponding transaction.
Let us look at how each transaction is recorded twice once as a credit and once as a debit.
Consider the case of different types of trisections between two countries, USA and UK
residents and table 3.2 shows how each transaction is recorded in each of the two countries
balance of payment. The exchange rate between these two countries at the time of transaction
was $ 1.60 /pound. Since each credit in the accounts has a corresponding debit elsewhere, the
sum of all items should be equal to zero.
This by itself raises the question as to what is means by a balance of payments deficit or
surplus.
Table 3.2 Example of balance of payment account as provided by Pilbeam (1998)
US balance of payment UK balance of payment
Current Account Current Account
Export of goods + 80 m Import of goods -50m
Capital Account
Reduced US bank liability – 80 m
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Example 2 :- The US exports $ 1000 of goods to the UK in exchange for $1000 of services
US Balance of payment UK Balance of payment
Current account Current Account
Export of goods +$ 1000 Import of goods -£ 625
Import of services -$ 1000 Export of services +£ 625
Example 3:- A US investor decides to buy £ 500 of UK T- bills and to pay for them by
debiting his US bank account and crediting the account of the UK T-bill held
in New York
US balance of payment UK balance of payment
Capital Account Capital Account
Increase in UK T-bills holding - $ 800 - Increase UK liability + £ 500 US
Increase in US liability +$ 800 resident
- Increase in US T-bill holdings - £ 500
Example 4- The US makes gift of $ 1.6 million of goods to a UK charitable organization
US balance of payment UK balance of paymentUS Current Account UK Current Account
Export + $ 1.6 million Import -£ 1 million
Unilateral Transfer -$1.6 million Unilateral receipt + £1 million
Example 5:- The US pays interest, profit and dividend to UK investor of $ 80 million by
debiting US bank account which are then credited to UK resident bank
account held in US
US balance of payment UK current account
Current Account Current Account
Interest, profit, dividend Interest, profit, dividend
Paid -$ 80 m receipts + £ 50m
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US Capital account UK Capital account
Increased US bank liability + 80 m Increased US bank deposit -£ 50m
3.4. WHAT IS A BALANCE OF PAYMENT SURPLUS OR DEFICIT?
As we have seen in table 3.2, the balance of payment always balances, since each credit in
the account has a corresponding debit. However, this does not mean that each of the
individual accounts that make-up the balance of payment is necessarily in balance. For
instance the current account can be in surplus while the capital account is in deficit.
Economist make a distinction between autonomous (above line item) and accommodating
(below the line) items. The autonomous items are transactions that take place independently
of the balance of payments. While accommodating items are those transactions which
finance any difference between autonomous receipts or payment.
Surplus in the balance of payment is defined as excess of autonomous receipts over
autonomous payment. The deficit is an excess of autonomous payment over autonomous
receipts. That is,
• Autonomous receipts > Autonomous payment = Surplus
• Autonomous receipts < autonomous payment = Deficit
The major issues raised here is that which items are categorized in autonomous and which
one in a commendation items. There is no agreement among economists as to the
c