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DefinitionsThe balance of payments is a form of state

book keeping, where monetary inflows and outflows are recorded

The number of transaction depends heavily on the exchange rate

The exchange rate might be floating (based on S&D) or fixed

Demand for a currency dependents on investment prospects in the home country

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Balance-of-Payments (BoP)It is a record of a country’s all international

monetary transactions over a specific period of time

Includes both private and government transactions

Inflows of money are recorded as credit (+)Outflows of money are recorded as debit (–)Every transaction is recorded twiceBoP should be balanced, but in reality this rarely

happensBoP is calculated quarterly and annually

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BOP ComponentsCurrent Account

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Item Debit Credit

Balance on trade (goods & services)

Imports (–) Exports (+)

Net income flows (wages, investment income e.g. profit, interest, dividends)

Outflows (–)

Inflows (+)

Net current transfers *(government contribution and aid & personal transfers e.g. remittances)

Outflows (–)

Inflows (+)

* Unilateral transfers, where one party benefits economically and provides nothing in return

BOP Components (2)Capital Account

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Item Debit Credit

Net transfers of capital (acquisition or sale of fixed assets e.g. land, funds of migrants, government funds for capital projects (CAP & Cohesion)

Outflows (–)

Inflows (+)

BOP Components (3)Financial Account

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Item Debit Credit

Direct Investment Outflows (–)

Inflows (+)

Portfolio Investment (shares, bonds, government securities)

Outflows (–)

Inflows (+)

Other short-term investment (trade credit, loans, bank deposits & currency)

Outflows (–)

Inflows (+)

Reserves * Adding (–) Drawing (+)

*Buying home currency at the foreign exchange market is considered a (–) from the reserve account, but a (+) in the BoP

Recording transactionsExport of goods from UK

UK granting government aid (goods)

BG government loan ($) from IMF

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Debit Credit

Merchandise exports (current account) £ 125 000

Short term investment (financial account)

£ 125 000

Debit Credit

Unilateral transfer (current account) 10 million

Merchandise exports (current account) 10 million

Debit Credit

Loan (financial account) 50 million

Reserves (financial account) 50 million

Balance of BoPCurrent Account + Capital Account + Financial

Account + Net Errors and Omissions = 0Net Errors and Omissions stem from statistical

mistakes, which are fixed before final calculation

Current Account deficit = M > XTo balance the deficit, governments can:BorrowDraw from reserves Sell assets abroadRaise the interest rate

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Trade deficit

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Trade deficit

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Exchange rate (floating) Exchange rate is the price at

which one currency trades for another

In free exchange rate system, the price of the currency is defined by S & D

When the exchange rate of the £ (vs. X) is high, people will be selling £

Too much £ (c-d) will cause depreciation of the currency

When the exchange rate of the £ (vs. X) is low, people will be buying £

Too few £ (a-b) will cause appreciation of the currency

Eventually there will be an equilibrium

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€

BoP and exchange rate ?When the exchange rate of the pound is high,

imports are cheaper – pounds are going to be in excess on the market:

When the exchange rate is low, exports are cheaper – pounds are going to be in shortage on the market:

The exchange rate should help BoP balance12

Trade deficit Trade deficit Value of poundValue of pound

Trade surplus Trade surplus Value of poundValue of pound

Shift in S & D for a currencyCauses for depreciation:Fall in interest rates Rise of inflation at home, compared to inflation abroadRise in incomes at home, compared to incomes abroadBetter business climate abroad, compared to climate at homeSpeculation

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1.40

1.20

€

Q of £

S1D1

S2D2

Fixed exchange rateSome governments prefer to

stick to a fixed exchange rate, because:

There is more certainty There is less speculation

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Ex. rate

Price Cost Profit

£1=$1.50

$ 1.50 80p 20p

£1=$2 $ 1.50 80p – 5 p

• When the market price falls below the fixed one the difference is financed by:

Borrowing – foreign currency loan to buy out excess pounds

Drawing from reserves – use own currency reserves to buy out excess pounds

Raising interest rates – to raise the demand for the currency

Drawbacks of a fixed exchange rateDo not work during economic recession –

high interests rates reduce aggregate demand and hamper economic activity

Fail in times of economic shock – during an oil crises, oil importing countries face pressure to devaluate their currencies – paying for the difference become too expensive

Cannot resist massive speculation – if demand for the currency is too low for too long, financing becomes impossible

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Intermediate regimesAdjustable peg – fixed in the short term,

adjusted in several yearsCrawling peg – is adjusted frequently by

small amountJoint float – group of currencies, using

adjustable peg among each other and jointly float vis-à-vis other currencies (ERM)

Exchange rate band – fluctuate within limits Managed float – free rate, but governments

intervene to buy and sell in turbulent times

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Currency board In a CB, the exchange rate is completely fixed

to a reserve (anchor) currencyThe country maintains a reserve of 110-115%

equivalent to the whole monetary baseThe government cannot print moneyBG adopted a CB in 1997, after experiencing

hyperinflationInitially the lev was pegged to the DM, later

on the the EuroIMF financed the CB

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The Euro – a panacea?By adopting the euro MS enjoyed following advantages:No more conversion costsNo uncertainty, stemming from floating currenciesLower inflation (strong confidence), guaranteed by ECBIncreased investment coming in the EU

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SourcesLecture is based on:The global financial environment in Sloman, J. and Jones, E. (2011) Economics and

the Business Environment (3rd ed) UK: Pearson

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