An exchange rate can be thought of as the price of one country’s money in terms of another country’s money.
With exchange rates being a price, it should come as little surprise that they are the result of supply and demand. As with traditional supply and demand, we can construct curves which describe how quantities supplied or demanded depend on the price, in this case the price of the currency. We can then determine the equilibrium price, or exchange rate. After the equilibrium is explained we can identify how different factors such as inflation, interest rates, economic growth, foreign debt, political uncertainty, and so on can cause exchange rates to change.
In this chapter we consider the system of flexible exchange rates, which is the predominant exchange rate system in operation today. We also limit ourselves to consideration of ‘‘flow’’ supplies of and demands for currencies – the amount demanded or supplied per period of time– rather than stocks of currencies, which are the amounts that exist at agiven point in time. Later in the book, in Chapters 21, 22, and 23, we deal with fixed exchange rates, and with exchange rate theories involving stocks rather than flows of currencies. These later chapters can be inserted after Chapter 6 in courses that focus on international financial markets and the international financial environment. The two chapters that we do include in Part II contain the essential material on why exchange rates change that is needed in courses that focus on international financial management.
Chapter 5 begins by describing why the balance-of- payments account can be considered as a listing of the reasons for a currency being supplied and demanded.
The chapter explains that all positive or credit items
listed in the account give rise to a demand for the country’s currency, and all negative or debit items give rise to a supply of the currency. After explaining the basic principles of balance-of-payments accounting, each major entry in the account is examined to provide an understanding of what factors can make it increase or decrease, and thereby change the equilibrium exchange rate. The purpose of the chapter is to provide an understanding of the forces behind movements in currency values which is an essential input into the measurement and management of foreign exchange risk later in the book.
Chapter 5 includes a brief account of the different interpretations of the balance of payments with fixed and flexible exchange rates. It is shown that with flexible exchange rates, the balance of payments is achieved without any official buying or selling of currencies by governments, whereas with fixed exchange rates there are changes in official foreign exchange reserves. The chapter also shows how to interpret imbalances in the current- and capital- account components of the balance of payments. This is illustrated by comparing a country’s balance-of- payments account to the income statement of a firm.
The chapter concludes with a discussion of a country’s net indebtedness, and a brief account of recent developments in the balance of payments and indebt- edness of the United States.
Chapter 6 builds the supply-and-demand picture of exchange rates that is suggested by the balance-of- payments account. This involves deriving the supply curve for a country’s currency from that country’s demand curve for imports, and the demand curve for a country’s currency from that country’s supply curve of
ment entries developed in Chapter 5, it is shown how inflation and other factors can shift the currency supply and demand curves, and therefore result in a change in exchange rates. It is also shown, however, that a currency supply curve can slope downward rather than upward as might normally be expected, and that
The chapter explains that the conditions resulting in an unstable foreign exchange market are the same conditions that result in the so-called ‘‘J curve.’’
(A J curve occurs, for example, when a depreciation makes a country’s balance of trade worse, rather than better as would normally be expected.)
The balance of payments
Money is just something to make bookkeeping convenient.
H.L. Hunt
INFLUENCES ON CURRENCY SUPPLY AND DEMAND
The price of a country’s currency depends on the quantity supplied relative to the quantity deman- ded, at least when exchange rates are determined in a free, unregulated market.1It follows that if we know the factors influencing the supply of and demand for a currency, we also know what factors influence exchange rates. Any factor increasing the demand for the currency will, ceteris paribus, increase the foreign exchange value of the currency, that is, cause the currency to appreciate. Simi- larly, any factor increasing the supply of the currency will, ceteris paribus, reduce its foreign exchange value, that is, cause the currency to depreciate.2 Clearly then, there is considerable interest in maintaining a record of the factors affecting the supply of and demand for a country’s currency. That record is maintained in the
balance-of-payments account. Indeed, we can think of the balance-of-payments account as an item- ization of the reasons for demand for and supply of a currency.
The motivation for publishing the balance-of- payments account is not simply a desire to maintain a record of the reasons for a currency being supplied or demanded. Rather, the account is primarily to report the country’s international performance in trading with other nations, and to maintain a record of capital flowing into and out of the country.
However, reporting on a country’s international trading performance and capital flows involves measurement of all the reasons why a currency is supplied and demanded. This is what makes the balance-of-payments account such a handy way of thinking about exchange rates. This chapter shows why the balance-of-payments account can be thought of as a list of items behind the supply of and demand for a currency. We begin by examining the principles guiding the structure of the balance-of- payments account and the interpretation of the items that are included. We then consider the dif- ferent ways that balance can be achieved between quantities supplied and quantities demanded. As we shall see, the balance-of-payments account is designed to always balance, but the price at which balance is achieved depends on the magnitudes of items in the account.
1 When exchange rates are fixed, they are still determined by supply and demand, but there is an official supply or demand that is adjusted to keep rates from changing. Fixed exchange rates are discussed briefly later in this chapter, and in greater detail in Chapter 22.
2 When an exchange rate is fixed at a lower value, the currency is said to have beendevalued. When an exchange rate is fixed at a higher value, the currency is said to have been revalued. These terms replace ‘‘depreciate’’ and
‘‘appreciate,’’ which are the terms used with flexible rates.
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PRINCIPLES OF BALANCE-OF-PAYMENTS ACCOUNTING
The guiding principles of balance-of-payments accounting come from the purpose of the account, namely to record the flow of payments between the residents of a country and the rest of the world during a given time period. The fact that the balance of payments records the flow of payments makes the account dimensionally the same as the national- income account – so many dollars per year or per calendar quarter. Indeed, the part of the balance-of- payments account that records the values of exports and imports also appears in the national-income account.
Balance-of-payments accounting uses the system of double-entry bookkeeping, which means that every debit or credit in the account is also represented as a credit or debit somewhere else. To see how this works we can take a couple of examples.
Suppose that an American corporation sells $2 million worth of US-manufactured jeans to Britain, and that the British buyer pays from a US dollar account that is kept in a US bank. We will then have the following double entry in the US balance of payments:
(creditsþ; debits) Millions dollars
Export (of jeans) þ2
Foreign assets in the US: US bank liabilities
2
We can think of the export of the American jeans as resulting in a demand for US dollars, and the payments with dollars at the US bank as resulting in a supply of dollars. The payment reduces the lia- bility of the US bank, which is an asset of the British jeans buyer. We see that the balance-of-payments account shows both the flow of jeans and the flow of payments, and the entries sum to zero.
As a second example, suppose that an American corporation purchases $5 million worth of denim
cloth from a British manufacturer, and that the British company puts the $5 million it receives into a bank account in the United States. We then have the double entry in the US account:
(creditsþ; debits) Millions dollars
Imports (of cloth) 5
Foreign assets in the US: US bank liabilities
þ5
We can think of the US import of cloth as resulting in a supply of US dollars, and the deposit of money by the British company as resulting in a demand for dollars. The deposit of money increases US bank liabilities and the assets of the British company. In a similar way, every entry in the balance of payments appears twice.
The balance-of-payments account records all transactions that affect the supply of or demand for a currency in the foreign exchange markets. There is just as much demand for US dollars when non- Americans buy US jeans as there is when they buy US stocks, bonds, real estate, bank balances, or operating businesses, and all of these transactions must be recorded. Since all sources of potential demand for dollars by foreigners or supply of dollars to foreigners are included, there are many types of balance-of-payments account entries. We need a rule for determining which entries are credits and which entries are debits. The rule is that any international transaction that gives rise to a demand for US dollars in the foreign exchange market is recorded as a credit in the US balance of payments, and the entry takes a positive sign. Any transaction that gives rise to a supply of dollars is recorded as a debit, and the entry takes a negative sign. A more precise way of expressing this rule is with the following definition:
Credit transactions represent demands for US dollars, and result from purchases by foreigners
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of goods, services, goodwill, financial and real assets, gold, or foreign exchange from US resi- dents. Credits are recorded with a plus sign.
Debit transactions represent supplies of US dollars, and result from purchases by US resi- dents of goods, services, goodwill, financial, and real assets, gold, or foreign exchange from for- eigners. Debits are recorded with a minus sign.3 The full meaning of our definition will become clear as we study the US balance of payments in Table 5.1. Let us consider each item and the factors that influence them.
BALANCE-OF-PAYMENTS ENTRIES AND THE FACTORS THAT INFLUENCE THEM Exports of goods, services, and
income receipts
In order for overseas buyers to pay for US goods and services which are invoiced in dollars, the overseas buyers must purchase dollars. In the rarer event that US exports of goods and services are invoiced in foreign currency, it is the American exporter that will purchase dollars when selling the foreign cur- rency it receives. In either case US exports give rise to a demand for US dollars in the foreign exchange market, and are recorded with a plus sign. (If the foreign buyer of a US good or service pays with foreign currency which the US exporter chooses to hold rather than sell for US dollars, the balance-of- payments account records the value of the export, and an increase in US assets abroad. In this case the US export is considered, as always, to give rise to a demand for US dollars, and the increase in US assets abroad is considered to give rise to an equal increase in the supply of US dollars.)
US exports of goods, which are sometimes referred to as merchandise exports, include wheat and other agricultural commodities, aircraft, computers, automobiles, and so on. The factors affecting these exports, and hence the demand for US dollars, include:
1 The foreign exchange value of the US dollar For a particular level of domestic and foreign prices of internationally traded goods, the higher the foreign exchange value of the dollar, the higher are US export prices facing foreigners, and the lower is the quantity of US exports.
Normally, we single out the exchange rate as the principal factor of interest and put this on the vertical axis of a supply and demand figure.
Then, all other factors listed below shift the currency demand curve. Changes in the exchange rate cause movements along the demand curve.
2 US prices versus the prices of foreign competitors If inflation in the United States exceeds inflation elsewhere then, ceteris paribus, US goods become less competitive, and the quantity of US exports will decline. US inflation therefore tends to reduce the demand for US dollars at each given exchange rate.4This is a leftward shift in the demand curve for dollars.
3 Worldwide prices of products that the US exports Changes in the worldwide prices of what the US exports shift the demand curve for dollars.
Higher world prices shift the demand curve to the right, and vice versa. This is a different effect to that in point 2 mentioned earlier.
Here, we refer toterms of tradeeffects; an increase in US export prices versus US import prices – where imports aredifferentgoods than exports – is an improvement in the US terms
3 The item with the least obvious meaning in this definition is
‘‘goodwill.’’ As we shall explain later, goodwill consists of gifts and foreign aid. In keeping with the double-entry bookkeeping system, the balance-of-payments account assumes gifts and aid buy goodwill for the donor.
4 Thevalueof exports could increase if the reducedquantity of exports comes as a result of higher prices. As we shall show in chapter 6, values increase from higher prices when demand is inelastic so that the quantity of exports falls less than export prices increase. However, profit maximizing exporters do not choose an inelastic part of the demand curve.
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&Table 5.1 Summary format of the US balance of payments, 3rd quarter, 2002
Line# (credits,þ; debits,) Billions of US dollars
1 Exports of goods, services, and income receipts þ313
2 Goods þ176
3 Services, including travel, royalties, and license fees
þ74
4 Income receipts on US assets abroad þ63
5 Imports of goods, services, and income payments 427
6 Goods 299
7 Services, including travel, royalties, and license fees
61
8 Income payments on foreign assets in United Status 67
9 Unilateral transfers, net, increase/financial outflow ()
13
10 US-owned assets abroad, net þ24
11 US official reserve assets, incl. gold reserves at IMF, net
1
12 US Govt. assets other than official reserves, net 0
13 US private assets, net þ25
14 Direct investment 27
15 Foreign securities þ18
16 US claims on foreigners reported by non-banks 12
17 US claims reported by US banks þ46
18 Foreign owned assets in the US net, increase/financial inflow (þ)
þ149
19 Foreign official assets in US þ9
20 Other foreign assets in US þ139
21 Direct investment þ11
22 US Treasury securities þ55
23 US securities other than Treasury securities þ47
24 US currency þ2
25 US liabilities reported by non-banks þ16
26 US liabilities reported by US banks þ8
27 Statistical discrepancy (sum of above, sign reversed) 46
Memoranda:
28 Balance on goods (lines 2þ6) 123
29 Balance on services (lines 3þ7) þ12
30 Balance on goods and services (lines 28þ29) 111
31 Balance on investment income (lines 4þ8) 3
32 Unilateral current transfers (net) (line 9) 13
33 Balance on current account (lines 1þ5þ9, or lines 30, 31, and 32)
127 Source:US Department of Commerce,Survey of Current Business, December 2002.
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of trade. On the other hand, in point 2 we refer to prices of US goods versuscompetitors’
goods abroad, that is, prices of the same goods supplied by Americans or by foreigners.
4 Foreign incomes When foreign buyers experi- ence an increase in their real incomes, the result is an improvement in the export market for American raw materials and manufactured goods. Ceteris paribus, this increases US ex- ports, and therefore also increases the demand for dollars.
5 Foreign import duties and quotas Higher foreign import tariffs – taxes on imported goods – and lower foreign importquotas– the quantity of imports permitted into a country during a period of time – as well as higher foreign nontariff trade barriers such as quality requirements and red tape, reduce US exports.
Alongside exports of goods are exports of ser- vices. These service exports are sometimes called invisibles. US service exports include spending by foreign tourists in the United States. Service exports also include overseas earnings of US banks and insurance companies, engineering, consulting, and accounting firms; overseas earnings of US holders of patents; overseas earnings of royalties on books, music, and movies; overseas earnings of US airlines and shipping, courier, and freight services;
and similar items. These service exports give rise to a demand for US dollars when the foreign tourists buy US currency, when the US banks repatriate their earnings, and so on. US earnings on these
‘‘performed service’’ exports respond to the same factors as affect exports of goods – exchange rates, US prices versus foreign competitors’ prices, world- wide prices of US exports, incomes abroad, foreign import tariffs and quotas, and so on.
The final category covered by ‘‘exports of goods, services, and income receipts,’’ namely ‘‘income receipts,’’ is the earnings US residents receive from past investments made abroad. These earnings can come in the form of interest on bills and bonds, dividends on stocks, rent on property, and profits of businesses. Sometimes these various sources of
investment income are, for convenience, simply referred to as debt-service exports. These export earnings are derived from past foreign investments and therefore depend principally on the amount Americans have invested abroad in the past.
Debt-service exports also depend on the rates of interest and sizes of dividends, rents, and profits earned on these past foreign investments. Unlike the situation with goods and services exports, the exchange rate plays only a minor role in the income received from abroad. Exchange rate changes affect only the translated value of foreign currency denominated income.
Imports of goods, services, and income payments
US imports of goods include such items as oil, automobiles, consumer electronics, computers, clothing, wine, coffee, and so on. US imports respond to the same factors that affect exports, the direction of response being reversed.Ceteris paribus, the quantity of US imports of goods increases when the US dollar is worth more in the foreign exchange markets: a more valuable dollar makes imports cheaper. US imports are also higher when US prices are higher relative to competitors’ prices of the same goods, when world prices of US imports increase, when US tariffs are reduced, and when US import quotas are increased.5US imports of per- formed services (such as American tourists’
spending abroad, Americans’ use of the services of foreign banks and consulting firms, Americans’
use of foreign patents, airlines, and shipping, and purchases of foreign movies and books) also depend on exchange rates, relative prices, US incomes, and US import restrictions. In the case of income payments, which are payments by Americans of
5 As with the effects of exchange rates and inflation on exports, we should really distinguish between thequantity andvalueof imports. For example, an appreciation of the US dollar could reduce thevalueof US imports even if it increases the quantity of US imports. This occurs if the demand for imports is inelastic. We discuss this possibility in Chapter 6.
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