Chapter 3

Chapter 3
The Balance of Payments and the

Effective Exchange Rate
Objectives
To study the structure of the balance of payments
To illustrate how the BOP is related to the FX market
To introduce the concept of the effective exchange
rate
Copyright 2010 McGraw-Hill Australia Pty Ltd

PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa
3-2
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.

3-3
Important elements in the definition
Rest of the world

Economic transactions
Resident
Flows versus stocks

3-4
Important elements in the definition (cont.)

The BOP records changes in assets and liabilities
Figures may or may not be seasonably adjusted

3-5
Structure of the BOP

The BOP consists of the current account and the
financial account

3-6
Components of the current account

Merchandise account (trade balance)
Net services
Current transfers

3-7
The financial account

Records official and non-official net financial flows
A balancing item is added to account for errors and
omissions

3-8
The Australian BOP: Current account

(AUD Million)

3-9
The Australian BOP: Financial account

(AUD Million)

3-10
The Australian BOP: Balancing item

(AUD Million)

3-11
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

3-12
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
(cont.)
3-13
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
demand for exports.

3-14
The demand side equations

The following equations are used to derive the demand
curve:
Df P Qm
*
m
Qm a bPm
Pm SPm*
3-15
The supply side equations

The following equations are used to derive the supply
curve:
Sf Px* Qx
Qx c dPx
*
Px
Px

3-16
The demand for and supply of foreign

exchange curves

3-17
Factors affecting the current account

Economic growth: A country with a higher growth
rate than its trading partners will experience
deterioration in the current account.
(cont.)
3-18
Factors affecting the current account (cont.)

The exchange rate: The effect of the exchange rate
depends on the elasticities of demand for exports
and imports.
*
*
Px Qx
*
PmQm
Q m em Pm
*
Q x e x Px
(cont.)
3-19

Inflation: A country that has a higher inflation rate
than its trading partners will experience deterioration
in the current account.
(cont.)
3-20
Improving current account

(zero domestic inflation)
50
40
30
20
10
0
-10
10
11
-20
-30
-40
-50

3-21
Deteriorating current account

(high domestic inflation)
0
1
10
11
-40
-80
-120
-160
-200

3-22

Trade restrictions: One reason for imposing trade
restrictions, such as tariffs and quotas, is the desire
to protect the current account.

3-23
Factors affecting the financial account

Taxes: Taxes that are imposed on capital gains
and/or income from dividends and interest payments
may adversely affect the financial account. This is
because foreign investors no longer find it attractive
to invest in the underlying countrys securities.
(cont.)
3-24
Factors affecting the financial account (cont.)

Capital controls: Capital controls are imposed
typically to deal with a chronic weakness in the
balance of payments.
(cont.)
3-25
Factors affecting the financial account (cont.)

The expected change in the exchange rate: If a
currency is expected to appreciate, the expected rate
of return on investment in securities denominated in
that currency will be higher, attracting capital flows.
Thus, a countrys financial account will improve if
that countrys currency is expected to appreciate.

3-26
The effective exchange rate

The effective exchange rate is an index of a
weighted average of the nominal exchange rates
against the currencies of major trading partners.

3-27
The EER equations

The following equations are used to calculate the EER:
m
Et = wiVi ,t
i =1
m
Et = (Vi ,t ) wi
i =1
Si,t
Vi, t
Si ,0
(cont.)
3-28
The EER equations (cont.)

The following equations are used to calculate the
weights:
wi
Xi
wi
i1
wi
i1
i1
Xi Mi
Mi
Mi
*
i
wi
i 1

3-29
What does the RBA do in practice?

The RBA calculates a nominal effective exchange
rate called the trade-weighted index (TWI).
(cont.)
3-30
What does the RBA do in practice? (cont.)

As the name implies, the index is calculated on the
basis of the (bilateral) trade shares of Australias
major trading partners.
(cont.)
3-31
What does the RBA do in practice? (cont.)

Until October 1988 the TWI was calculated as an
arithmetic weighted average, but since then the RBA
has shifted to using a geometric weighted average.
Major trading partners are those accounting for at
least 90 per cent of Australias trade (exports plus
imports).

3-32
The weights used by the RBA to calculate the

TWI

3-33
The RBAs trade-weighted index, January (1970

= 100)

1-34
The real exchange rate

The real exchange rate is the nominal exchange rate
adjusted for differences in prices or inflation rates:
Py
Q( x / y ) S ( x / y )
Px

3-35
The real effective exchange rate

The real effective exchange rate can be calculated
from the real bilateral exchange rates:
Qi ,t
Qt wi
i 1
Qi ,0
m
Qt
i 1
Qi ,t
Qi ,0
wi

3-36

Chapter 3

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Chapter 3

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Chapter 3

The Balance of Payments and the

Copyright 2010 McGraw-Hill Australia Pty Ltd

Copyright 2010 McGraw-Hill Australia Pty Ltd

Important elements in the definition

Rest of the world

Copyright 2010 McGraw-Hill Australia Pty Ltd

Important elements in the definition (cont.)

Copyright 2010 McGraw-Hill Australia Pty Ltd

Structure of the BOP

Copyright 2010 McGraw-Hill Australia Pty Ltd

Components of the current account

Copyright 2010 McGraw-Hill Australia Pty Ltd

The financial account

Copyright 2010 McGraw-Hill Australia Pty Ltd

The Australian BOP: Current account

Copyright 2010 McGraw-Hill Australia Pty Ltd

The Australian BOP: Financial account

Copyright 2010 McGraw-Hill Australia Pty Ltd

The Australian BOP: Balancing item

Copyright 2010 McGraw-Hill Australia Pty Ltd

The BOP and FX market

Copyright 2010 McGraw-Hill Australia Pty Ltd

Derivation of the demand and supply curves

Derivation of the demand and supply curves

Copyright 2010 McGraw-Hill Australia Pty Ltd

The demand side equations

The supply side equations

Copyright 2010 McGraw-Hill Australia Pty Ltd

The demand for and supply of foreign

Copyright 2010 McGraw-Hill Australia Pty Ltd

Factors affecting the current account

Factors affecting the current account (cont.)

Factors affecting the current account (cont.)

Improving current account

Copyright 2010 McGraw-Hill Australia Pty Ltd

Deteriorating current account

Copyright 2010 McGraw-Hill Australia Pty Ltd

Factors affecting the current account (cont.)

Copyright 2010 McGraw-Hill Australia Pty Ltd

Factors affecting the financial account

Factors affecting the financial account (cont.)

Factors affecting the financial account (cont.)

Copyright 2010 McGraw-Hill Australia Pty Ltd

The effective exchange rate

Copyright 2010 McGraw-Hill Australia Pty Ltd

The EER equations

The EER equations (cont.)

Copyright 2010 McGraw-Hill Australia Pty Ltd

What does the RBA do in practice?

What does the RBA do in practice? (cont.)

What does the RBA do in practice? (cont.)

Copyright 2010 McGraw-Hill Australia Pty Ltd

The weights used by the RBA to calculate the

Copyright 2010 McGraw-Hill Australia Pty Ltd

The RBAs trade-weighted index, January (1970

Copyright 2010 McGraw-Hill Australia Pty Ltd

The real exchange rate

Copyright 2010 McGraw-Hill Australia Pty Ltd

The real effective exchange rate

Copyright 2010 McGraw-Hill Australia Pty Ltd

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