3. 1-3
What will we covertoday?
LearningObjectives
• Describe a country’s balance of trade and balance of payments.
• Explain what determines the amount of international borrowing
and lending.
• Explain the exchange rate, how it is determined and why it
fluctuates.
4. 1-4
International Flows of Funds
Australians participate in the Australian (domestic) economy, and in
economies around the world.
We may buy goods made overseas, services provided overseas, or invest
overseas directly in indirectly.
An open economy interacts with other countries in three ways:
1. It buys and sells goods and services in world product markets.
2. It buys and sells assets in world asset markets.
3. It makes and receives transfer payments to and from other
countries.
5. 1-5
International Flows of Goods and Services
The balance of trade (BoT) is the difference between the value of a
country's exports and imports of goods and services for a given period.
A country that imports more goods and services than it exports in terms
of value has a trade deficit or a negative BoT.
A country that exports more goods and services than it imports in terms
of value has a trade surplus or a positive BoT.
Balance of trade is the largest component of a country's balance of
payments (BoP).
6. 1-6
International Flows of Goods and Services
The balance of trade (BOT) is calculated as
Value of exports – Value of imports = X - M = NX
Factors that influence a country’s net exports (NX) include:
• consumer preferences for domestic and foreign goods.
• relative prices of goods at home and abroad.
• the rates at which people can exchange domestic currency for foreign
currencies, i.e. exchange rate.
• government trade policy.
• the cost of transporting goods from one country to another.
7. 1-7
International Flows of Goods and Services
The increase in international trade is due to improvements in
transportation, advances in telecommunications, technological progress,
and changes in government policies that favour free trade.
8. 1-8
International Flows of Assets
International asset flows are typically financial assets (e.g. equities,
bonds) and can also be investments in physical assets that remain in the
domestic country (e.g. property)
Foreign portfolio investment (FPI) is investment made in securities and
other financial assets issued and located in another country.
Foreign direct investment (FDI) is investment made by, typically by a firm,
in one country into business interests located in another country.
FDI by overseas investors in Australia is subject to approval by the Foreign
Investment Review Board (FIRB).
9. 1-9
International Flows of Assets
Factors that influence the international flow of assets include:
• interest rates being paid on domestic versus foreign financial
assets.
• relative rates of return and/or dividend yields on domestic versus
foreign equites.
• exchange rates.
• perceived economic and political risks of holding assets abroad.
• government policies affecting foreign ownership of domestic
assets.
10. 1-10
Balance of Payments (BoP)
The balance of payments (BoP) summarises the economic transactions of
a domestic economy with the rest of the world, including payments for
exports and imports of goods, services and financial assets, and transfer
payment inflows and outflows.
The BoP divides transactions into two broad accounts:
1. current account (CA).
2. capital and financial account (KA).
The third key (balancing) account is the reserve assets account.
11. 1-11
Balance of Payments (BoP)
The current account records the value of the flow of goods, services and
income (net interest earned and transfers) between Australian residents and
the rest of the world. The balance of trade (BOT) is a component of the current
account.
The capital and financial account records the difference between foreign
investment in Australia and Australian investment overseas.
The reserve assets account records changes in the government’s holdings of
foreign currency that the government uses to balance international payments.
The sum of the current account and capital account is always zero.
13. 1-13
Exchange Rates
The nominal exchange rate is the rate of exchange between two
national currencies, i.e. the price of one national currency in terms of
another national currency.
1 AUD = USD 0.7000
One Australian dollar will exchange for 70 cents US, i.e. the price for
me to buy one Australian dollar is 70 cents US.
14. 1-14
Exchange Rates
The nominal exchange rate is the rate of exchange between two
national currencies, i.e. the price of one national currency in terms of
another national currency.
1 USD = AUD 1.4286
One US dollar will exchange for 1.4286 Australian dollars, i.e. the
price for me to buy one US dollar is 1.4286 Australian dollars.
15. 1-15
Exchange Rates
The nominal exchange rate is the rate of exchange between two national
currencies, i.e. the price of one national currency in terms of another
national currency.
1 AUD = USD 0.7000
1 USD = AUD 1.4286
Saying the price for me to buy one Australian dollar is 70 cents US is the
same as saying the price for me to buy one US dollar is 1.4286 Australian
dollars.
17. 1-17
Exchange Rates
Australia has a floating exchange rate, which means that movements
in the Australian dollar (AUD) exchange rate are determined by the
supply of, and demand for, AUD in the foreign exchange market.
Depreciation is when value of a currency falls in terms of its
exchange rate versus another currency, e.g. when the AUD
depreciates vs. the USD, it costs fewer USD to buy 1 AUD.
Depreciation can increase a country’s export activity as its goods and
services become relatively cheaper to buy overseas.
18. 1-18
Exchange Rates
Australia has a floating exchange rate, which means that movements
in the Australian dollar (AUD) exchange rate are determined by the
supply of, and demand for, AUD in the foreign exchange market.
Appreciation is when value of a currency rises in terms of its
exchange rate versus another currency, e.g. when the AUD
appreciates vs. the USD, it costs more USD to buy 1 AUD.
Appreciation can increase a country’s import activity as foreign
goods and services become relatively cheaper to buy domestically.
19. 1-19
Balance of Payments and Exchange Rates
The BOP is related to the foreign exchange market because transactions
involving trade and capital flows give rise to supply and demand for
currencies.
The demand for AUD is equivalent to export revenue from foreign
countries.
The demand curve is derived from:
• the demand for Australian exports overseas.
• income payments and other financial capital inflows from overseas.
• central bank purchases of AUD in the foreign exchange market.
20. 1-20
Balance of Payments and Exchange Rates
The BOP is related to the foreign exchange market because transactions
involving trade and capital flows give rise to supply and demand for
currencies.
The supply of AUD is equivalent to import expenditure to foreign
countries.
The supply curve is derived from:
• the demand for foreign imports from overseas.
• income payments and other financial capital outflows overseas.
• central bank sales of AUD in the foreign exchange market.
21. 1-21
Exchange Rates
Ceteris paribus, when demand for AUD increases / supply of AUD
decreases, the AUD appreciates.
Ceteris paribus, when demand for AUD decreases / supply of AUD
increases, the AUD depreciates.
The demand for domestic currency is the same as the supply of foreign
currency and vice versa.
Other than international trade effects, supply and demand for currency is
also driven by relative prices, inflation, interest rates, and speculative
demand.
22. 1-22
Balance of Payments and Exchange Rates
Since floating exchange rates are determined by the market forces of
supply and demand, they can be extremely volatile with large
fluctuations.
Large and frequent changes in the value of the AUD are a disadvantage for
international trade and impact NX and therefore GDP.
Most real world floating exchange rate systems are ‘dirty floats’, meaning
that nation’s central banks will buy and sell their own currency to smooth
out large changes.
