CHAPTER 24

Exchange rates and the balance of

payments

©McGraw-Hill Education, 2014

Exchange rates and international
trade
• The domestic price of foreign
exchange is the quantity of domestic
currency per unit of the foreign
currency.
• The foreign exchange market (forex)
exchanges one national currency for
another at a price called the
exchange rate.

©McGraw-Hill Education, 2014

 The foreign exchange market
The foreign exchange market is the international market in which one
national currency can be exchanged for another.
The exchange rate is the price at which two currencies exchange.
Suppose 2 countries: UK & USA DD shows the demand for
pounds by Americans wanting
to buy British goods/ assets.
Exchange rate ($/£)

SS SS1 SS shows the supply of pounds

by UK residents wishing to buy
e0 American goods/assets.

e1 Equilibrium exchange rate is

e0
If UK residents want more $
DD at each exchange rate, the
supply of £ moves to SS1
Quantity
of pounds
New equilibrium at e1.
©McGraw-Hill Education, 2014
 Exchange rate regimes
• In a fixed exchange rate regime
– the national governments agree to
maintain the convertibility of their
currency at a fixed exchange rate.
• In a flexible exchange rate regime
– the exchange rate is allowed to attain
its free market equilibrium level without
any government intervention using
exchange reserves.

©McGraw-Hill Education, 2014

 Intervention in the forex market
Suppose the government is
committed to maintaining the
SS exchange rate at e1 ...
If the demand for pounds is DD1
there is excess demand AC.
E A C
e1 The Bank of England must
supply AC £s in return for $,
which are added to reserves.
DD1
DD The reverse occurs if
demand is at DD2.
DD2
When demand is DD, no
Quantity of £s intervention is needed ...
there is a balance in
transactions between the
countries.
©McGraw-Hill Education, 2014
QUESTIONS?

©McGraw-Hill Education, 2014

International competitiveness
• The competitiveness of UK goods in international
markets depends upon:
– the nominal exchange rate
– relative inflation rates.
• The real exchange rate
– measures the relative price of goods from
different countries when measured in a
common currency.
– Changes in the real effective exchange rate
are a good indication of what is happening to
competitiveness.

©McGraw-Hill Education, 2014

UK effective exchange rate
The effective exchange
rate (eer) is a weighted
average of individual
bilateral exchange rates.

Sterling has fluctuated

against both the dollar and
the euro, but its average or
effective rate is a little
smoother than the
individual exchange rates.
The eer is more similar to
the bilateral rate against
the euro than the dollar,
as the UK mainly trades
with other European
countries.

©McGraw-Hill Education, 2014

Real exchange rate &
competitiveness

©McGraw-Hill Education, 2014

QUESTIONS?

©McGraw-Hill Education, 2014

Gross international capital flows,
1983-2008
• International capital flows are increasingly volatile
and this leads to two important questions.
• When countries borrow from foreigners can they
rely on this inflow being stable?
• Would it be feasible and desirable to regulate to
reduce the mobility of international capital?

©McGraw-Hill Education, 2014

Gross international capital flows,
1983-2008

©McGraw-Hill Education, 2014

 Interest rate parity
• Expected exchange rate changes offset
the interest differential between domestic
and foreign currency assets:

Return on return on foreign % depreciation of

domestic = foreign = interest + exchange rate
asset asset rate while funds abroad

©McGraw-Hill Education, 2014

 Balassa Samuelson effect
• Countries with higher per capita real incomes have
a higher real exchange rate.
• Typically, there is more technical progress in
industries making goods for trade (computers, cars,
telecommunications) than in industries making
services for the home economy (haircuts, laundry,
crèches).
• Countries with high per capita incomes therefore
have high real exchange rates because their traded
goods sector is more productive.
• Without real exchange rate appreciation such
countries would be too competitive.

©McGraw-Hill Education, 2014

 Balassa Samuelson effect & China
• China has fixed its exchange rate to the US dollar at a
level that keeps the Chinese economy super-
competitive. This is why China has massive current
account surpluses (and other countries deficits).
• Apart from an upward adjustment of China’s nominal
exchange rate, it is possible that Chinese prices will rise
sufficiently more quickly that those in the west that the
real exchange rate increases substantially.
• However, the Balassa Samuelson effect suggests that as
Chinese economic development continues, rapid
productivity growth in its traded goods sector will allow it
to cope with some degree of real appreciation without
losing competitiveness.
©McGraw-Hill Education, 2014
QUESTIONS?

©McGraw-Hill Education, 2014

 Concluding comments (1)
• The demand for domestic currency in the forex
market arises from exports and purchases of domestic
assets.
• The supply of domestic currency in the forex market
arises from imports and purchases of foreign assets.
• Under a floating exchange rate regime demand and
supply determine the exchange rate.
• Under a fixed rate regime, the government intervenes
to maintain the exchange rate.

©McGraw-Hill Education, 2014

 Concluding comments (2)
• The real exchange rate adjusts the nominal exchange
rate for prices at home and abroad.
• An increase in the real exchange rate will lead to a
reduction in reduces competitiveness in international
markets.
• Purchasing power parity refers to the change in nominal
exchange rates required to keep the real exchange rate
constant.
• The interest parity condition says that, when capital
mobility is perfect, interest rate differentials across
countries should be off set by expected exchange
rate changes, so that the total expected return is
equated across currencies.
©McGraw-Hill Education, 2014
QUESTIONS?

©McGraw-Hill Education, 2014