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KA records purchases and sales of assets, such as stocks, bonds, and lands
KA surplus (there is net capital inflow) if our receipts from the sale of stocks, bonds, land, bank deposits, and other assets exceed our payments for our own purchases of foreign assets
If a country runs a deficit in its CA (spending more abroad than it receives from sales to the RoW), the deficit needs to be financed by selling assets or by borrowing abroad. This selling or borrowing implies that the country is running a KA surplus. Thus
CA + KA = 0
If a country has no assets to sell, no foreign currency reserves to use up, and if nobody will lend to it, the country has to achieve balance in its CA, however painful and difficult that may be.
KA can be separated into: (i) the transactions of the country’s private sector, and (ii) official reserve transactions which corresponds to the central bank’s activities. So,
A CA deficit can be financed by:
private residents selling off assets abroad or borrowing abroad
the government selling foreign currency in the Forex market (running down its reserves of Forex)
When there is a CA surplus:
private sector may use the Forex revenues it receives to pay off debt or buy assets abroad
the central bank can buy the net foreign currency earned by the private sector and add that currency to its reserves
The increase in official reserves is also called the overall BoP surplus
BoP Surplus = Increase in Official Exch. Reserves
= CA Surplus + Net Priv. Capital Inflow
Exchange rate: the price of one currency in terms of another.
In a fixed exchange rate system, foreign central banks stand ready to buy and sell their currencies at a fixed price in terms of domestic currency (dollars).
Foreign central banks hold reserves (inventories of dollars, other currencies, and gold that they can sell for dollars) to sell when they want to or have to intervene in the Forex market.
Intervention is the buying or selling of Forex by the central banks for defending their currencies.
The amount of intervention? BoP measures the amount of Forex intervention needed from the central bank. E.g. the US is running a deficit in the BoP vis-à-vis Japan the demand for Yen in exchange for USD exceeds the supply of Yen in exchange for USD from Japanese, BoJ would buy the excess USD, paying for them with Yen.
Thus under fixed exchange rate, the central bank has to provide whatever amounts of foreign currency are needed to finance payments imbalances.
If a country persistently runs deficits in the BoP, the central bank eventually will run out of reserves of Forex and will be unable to continue its intervention.
Before reaching that point, the central bank is likely to decide that it can no longer maintain the exchange rate, and will devalue the currency.
In a flexible (floating) exchange rate system, the central banks allow the exchange rate to adjust to equate the supply and demand for foreign currency.
In a system of “clean floating”, central banks stand aside completely and allow exchange rates to be freely determined in the Forex markets.
Under “managed floating” or “dirty floating”, central banks intervene to buy and sell foreign currencies in attempts to influence exchange rates.
Devaluation takes place when the price of foreign currencies under a fixed rate regime is increased by official action. The opposite of devaluation is revaluation.
Under a flexible exchange rate regime, the counterparts are depreciation and appreciation. A currency depreciates when it becomes less expensive in terms of foreign currencies.
Dynamics of IDR per USD
Source: Bank Indonesia (Processed) Dynamics of IDR per USD (Cont’d) Approximately stable around this level
Source: Bordo (2003) based on Reinhart and Rogoff (2002) Chronology of Exchange Rate Regime Period Major Regimes 1880-1914 Specie: Gold Standard (bimetalism, silver); currency unions; currency boards; floats 1919-1945 Gold Exchange Standard; floats; managed floats; currency unions (arrangements); pure floats, managed floats 1946-1971 Bretton Woods adjustable peg; floats (Canada); Dual/Multiple exchange rates 1973-2000s Free floats; managed floats, adjustable pegs, crawling pegs, basket pegs, target zones or bands; fixed exchange rates, currency unions, currency boards
THE EXCHANGE RATE IN THE LONG RUN
In the long run, the exchange rate between a pair of countries is determined by the relative purchasing power of a currency within each country.
If a hot dog costs DKr 25 in Copenhagen and USD 2.50 in Philadelphia, then the exchange rate is USD 0.10 per DKr the theory of purchasing power parity (PPP)
Two currencies are at PPP when a unit of domestic currency can buy the same basket of goods at home or abroad
The relative purchasing power of two currencies is measured by the real exchange rate (R), which is the ratio of foreign to domestic prices, measured in the same currency:
R = e P f / P country’s competitiveness in int’l trade
If R=1, currencies are at PPP.
If R>1, goods abroad are more expensive than goods in the US, implying that people (in both countries) are likely to switch some of their spending to goods produced in the US.
As long as R>1, relative demand for domestically produced goods increases drives up domestic prices and reduces R to be closer to PPP.
Thus market forces prevent the exchange rate from moving too far from PPP or from remaining away from PPP indefinitely. However, pressures to move to PPP work only slowly. Why?
Market baskets differ across countries
Many barriers to the movement of goods b/w countries
Many goods are nontraded and cannot move.
PPP holds in the long run. If there is a deviation over PPP, it takes about 4 years to reduce deviations from the PPP by half (Frankel and Rose, 1996).
Since P f and P in the formula for R represent baskets of goods specific to each country, PPP does not necessarily imply that the real exchange rate should be equal to 1.
In practice, PPP is taken to mean that in the LR, the real exchange rate will return to its average level called Relative PPP.
So if R is above its LR average level, PPP implies that the exchange rate will fall.
TRADE IN GOODS, MARKET EQUILIBRIUM, AND BoT
In an open economy, the IS curve has to be modified because domestic output is sold to foreigners (X) and part of spending by domestic residents purchases foreign goods (Q).
Spending by domestic residents:
A = C + I + G
Spending on domestic goods:
A + NX = (C + I + G) + (X – Q)
= (C + I + G) + NX
A = A(Y, i)
Balance of Trade, BoT
NX = X(Y f , R) – Q(Y, R) = NX(Y, Y f , R)
A rise in foreign income improves the domestic trade balance and therefore raises the domestic AD
A real depreciation in the home country improves the trade balance and therefore increases the domestic AD
A rise in domestic income raises import spending and hence worsens the trade bal.
Y = A(Y, i) + NX(Y, Y f , R)
IS IS’ LM i E E’ Y Y 0 Y’ Rise in Rise in Real Home Spending Foreign Spd Depreciation Income + + + Net Exports - + + Repercussion Effects: In an interdependent world, policy changes in a country affect may affect the RoW. When G is increased, Y increases and part of it will be spent on imports, so that foreign income will also rise. This increases their imports, adding to the domestic income expansion, etc.
One of the striking facts about the international economy is the high degree of integration (linkage) among financial (capital) markets.
Investors across countries search around the world for the highest return (adjusted for risk) thereby linking together yields in capital markets in different countries.
Perfect capital mobility: investors can purchase assets in any country they choose, quickly, with low transaction costs, and in unlimited amounts.
With perfect capital mobility, any one country’s interest rate cannot get too far out of line without bringing about capital flows that tend to restore yields to the world level.
BoP and Capital Flows (CF)
BP = NX(Y, Y f , R) + CF(i–i f )
An increase in income worsens the trade balance, and an increase in the interest rate above the world level pulls in capital from abroad and thus improves KA.
Thus when income increases, even the tiniest increase in interest rate is enough to maintain an overall BoP equilibrium the trade deficit would be financed by a capital inflow.
Policy Dilemmas: Internal and External Balance
External bal.: BoP is close to balance
Internal bal.: output is at the full employment level (Y*).
Dom. Interest rate Dom income, output 0 Y i i f Y* E BP=0 E 1 : Deficit, Unemployment E 2 : Deficit, Overemployment E 3 : Surplus, Overemployment E 4 : Surplus, Unemployment Key assumption: perfect capital mobility BP=0 line is horizontal.
THE MUNDELL-FLEMING MODEL: PERFECT CAP. MOBILITY UNDER FIXED EXC. RATES
Under perfect capital mobility (PCM), the slightest interest differentials provokes infinite capital flows.
Eg. i rises (monetary contraction) in home country portfolio holders worldwide shift their wealth to take advantage of the new rate in the country huge capital inflow gigantic surplus of BoP foreigners try to buy domestic assets domestic exchange rate appreciation central bank buys foreign money in exchange for domestic money domestic money stock increases the initial monetary contraction is reversed.
Thus the interest differential moves enough money in or out of the country to completely swamp available central bank reserves
So the only way to keep the exc.rate from falling is for the central bank to back off from the int.differ’l.
Monetary expansion: Equilibrium shifts from E to E’ at E’ BoP deficits exc.rate depreciates central bank sells foreign money and receives domestic money money supply declines LM shifts back to initial position. i i=i f BP=0 LM LM’ IS E E’ 0 Fiscal expansion under fixed exc.rates with perfect capital mobility is, in contrast, extremely effective. Fiscal expansion (IS moves to the right) increases in i and Y increased in i sets off a capital inflow that would lead to exc.rate appreciation central bank has to expand the money supply (LM shifts to the right) increases income further. Equilibrium is restored when increased Ms enough to drive back the int.rate so that i=i f .
THE MUNDELL-FLEMING MODEL: PERFECT CAP.MOBILITY UNDER FLEXIBLE EXC. RATES Appr’n Deprec’n i=i f i 0 Y Output IS Effects of Exc.Rate on AD i f i 0 Y Output IS IS’ BP=0 LM E E’ Effects of an Increase in Demand for Exports Under fully flexible exc.rates the absence of intervention implies a zero BoP. Any CA deficit must be financed by private capital inflows; a CA surplus is balanced by capital outflows. Adjustments in the exc.rate ensure that the sum of CA and KA is zero. Effects of fiscal policy is analogue with the effects of increased demand for exports there is complete crowding out real disturbances to demand do not affect equilibrium output.