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Lecture International finance: An analytical approach (2/e) – Chapter 3: The balance of payments and the effective exchange rate

Lecture International finance: An analytical approach (2/e) – Chapter 3: The balance of payments and the effective exchange rate. The goals of this chapter are: To study the structure of the balance of payments, to illustrate the relationship with the FX market, to introduce the concept of the effective exchange rate. | Chapter 3 The Balance of Payments and the Effective Exchange Rate Objectives To study the structure of the balance of payments. To illustrate the relationship with the FX market. To introduce the concept of the effective exchange rate. Definition The balance of payments (BOP) is a systematic record of all economic transactions between the residents of the reporting country and the rest of the world over a specified period of time. Important Elements in the Definition Rest of the world Economic transactions Resident Flows versus stocks Important Elements in the Definition (cont.) The BOP records changes in assets and liabilities. Figures may or may not be seasonably adjusted. Structure of the BOP The BOP consists of the current account and the financial account. Components of the Current Account Merchandise account (trade balance) Net services Current transfers The Financial Account Records official and non-official net financial flows. A balancing item is added to account for errors and omissions. The Australian Balance of Payments (AUD Million) The Australian Balance of Payments (AUD Million) (cont.) The Australian Balance of Payments (AUD Million) (cont.) The BOP and FX Market The BOP is related to the FX market because transactions involving trade and capital flows give rise to the demand for and supply of currencies. The demand for foreign currency is the supply of domestic currency, and vice versa. Derivation of the Demand and Supply Curves The demand for foreign exchange is equivalent to import expenditure. The demand curve is derived from the supply and demand for imports. Derivation of the Demand and Supply Curves (cont.) The supply of foreign exchange is equivalent to export revenue. The supply curve is derived from the supply of and the demand for exports. The Demand for and Supply of Foreign Exchange Curves Factors Affecting the Current Account Economic growth The exchange rate Inflation Trade restrictions Improving Current Account (Zero Domestic . | Chapter 3 The Balance of Payments and the Effective Exchange Rate Objectives To study the structure of the balance of payments. To illustrate the relationship with the FX market. To introduce the concept of the effective exchange rate. Definition The balance of payments (BOP) is a systematic record of all economic transactions between the residents of the reporting country and the rest of the world over a specified period of time. Important Elements in the Definition Rest of the world Economic transactions Resident Flows versus stocks Important Elements in the Definition (cont.) The BOP records changes in assets and liabilities. Figures may or may not be seasonably adjusted. Structure of the BOP The BOP consists of the current account and the financial account. Components of the Current Account Merchandise account (trade balance) Net services Current transfers The Financial Account Records official and non-official net financial flows. A balancing item is added to account for errors .