Balance of

Payments and
Exchange Rates
The Balance of Payments Account

• Meaning of the balance of payments

• The current account
The Balance of Payments Account

• Meaning of the balance of payments

• The current account
– trade in goods
UK balance of payments: 2001 (£ millions)
The Balance of Payments Account

• Meaning of the balance of payments

• The current account
– trade in goods
– trade in services
UK balance of payments: 2001 (£ millions)
The Balance of Payments Account

• Meaning of the balance of payments

• The current account
– trade in goods
– trade in services
– balance of trade in goods and services
UK balance of payments: 2001 (£ millions)
The Balance of Payments Account

• Meaning of the balance of payments

• The current account
– trade in goods
– trade in services
– balance of trade in goods and services
– income flows
UK balance of payments: 2001 (£ millions)
The Balance of Payments Account

• Meaning of the balance of payments

• The current account
– trade in goods
– trade in services
– balance of trade in goods and services
– income flows
– current transfers of money
UK balance of payments: 2001 (£ millions)
The Balance of Payments Account

• Meaning of the balance of payments

• The current account
– trade in goods
– trade in services
– balance of trade in goods and services
– income flows
– current transfers of money
– balance on current account
UK balance of payments: 2001 (£ millions)
 Current account balance as % of
GDP in selected countries: 1970–2003
5

4
Current account balance:% of GDP

-1

-2

-3

-4
 Current account balance as % of
GDP in selected countries: 1970–2003
5

4
Current account balance:% of GDP

1
UK
0

-1

-2

-3

-4
 Current account balance as % of
GDP in selected countries: 1970–2003
5

4
Current account balance:% of GDP

1
UK
0

-1

-2 USA

-3

-4
 Current account balance as % of
GDP in selected countries: 1970–2003
5

4
Current account balance:% of GDP

3
Japan
2

1
UK
0

-1

-2 USA

-3

-4
The Balance of Payments Account

• The capital account

UK balance of payments: 2001 (£ millions)
The Balance of Payments Account

• The capital account

• The financial account
The Balance of Payments Account

• The capital account

• The financial account
– investment
The Balance of Payments Account

• The capital account

• The financial account
– investment
• direct
The Balance of Payments Account

• The capital account

• The financial account
– investment
• direct
• portfolio
UK balance of payments: 2001 (£ millions)
The Balance of Payments Account

• The capital account

• The financial account
– investment
• direct
• portfolio
– other financial flows (mainly short term)
UK balance of payments: 2001 (£ millions)
The Balance of Payments Account

• The capital account

• The financial account
– investment
• direct
• portfolio
– other financial flows (mainly short term)
– flows to and from reserves
UK balance of payments: 2001 (£ millions)
The Balance of Payments Account

• The capital account

• The financial account
– investment
• direct
• portfolio
– other financial flows (mainly short term)
– flows to and from reserves
– financial account balance
UK balance of payments: 2001 (£ millions)
The Balance of Payments Account

• The capital account

• The financial account
– investment
• direct
• portfolio
– other financial flows (mainly short term)
– flows to and from reserves
– financial account balance
• Overall balance of payments
UK balance of payments: 2001 (£ millions)
UK balance of payments: 2001 (£ millions)
The Balance of Payments Account

• The capital account

• The financial account
– investment
• direct
• portfolio
– other financial flows (mainly short term)
– flows to and from reserves
– financial account balance
• Overall balance of payments
• Assessing balance of payments figures
 Exchange Rates
• The rate of exchange
– individual rates of exchange
– exchange rate index
Sterling exchange rates: 1980–2003
Sterling exchange rates: 1980–2003
Sterling exchange rates: 1980–2003
Sterling exchange rates: 1980–2003
 Exchange Rates
• The rate of exchange
– individual rates of exchange
– exchange rate index
The weights of the currencies of various countries
in the sterling exchange rate index
 Exchange Rates
• The rate of exchange
– individual rates of exchange
– exchange rate index
• Determination of exchange rates
 Exchange Rates
• The rate of exchange
– individual rates of exchange
– exchange rate index
• Determination of exchange rates
– the equilibrium exchange rate
 Determination of the rate of exchange

2.20

2.00
$ price of £

1.80

1.60

1.40

1.20
Q of £
 Determination of the rate of exchange

2.20

2.00
$ price of £

1.80

1.60

1.40
D by USA

1.20
Q of £
 Determination of the rate of exchange
S by UK
2.20

2.00
b a
$ price of £

1.80

1.60

1.40
D by USA

1.20 QS
QD Q of £
 Determination of the rate of exchange
S by UK
2.20

2.00
$ price of £

1.80

1.60 d c

1.40
D by USA

1.20
QS QD Q of £
 Exchange Rates
• The rate of exchange
– individual rates of exchange
– exchange rate index
• Determination of exchange rates
– the equilibrium exchange rate
– appreciation and depreciation
 Exchange Rates
• The rate of exchange
– individual rates of exchange
– exchange rate index
• Determination of exchange rates
– the equilibrium exchange rate
– appreciation and depreciation
– shifts in currency demand and supply
 Floating exchange rates: movement to a new equilibrium

S1
1.80

1.60
€/£

1.40

1.20
D1

1.00

0.80
Q of £
 Floating exchange rates: movement to a new equilibrium

S1
1.80

S2
1.60
€/£

1.40

1.20
D1

1.00

0.80
Q of £
 Floating exchange rates: movement to a new equilibrium

1.80
S1

S2
1.60
€/£

1.40

1.20
D1

1.00
D2

0.80
Q of £
 Exchange Rates
• The rate of exchange
– individual rates of exchange
– exchange rate index
• Determination of exchange rates
– the equilibrium exchange rate
– appreciation and depreciation
– shifts in currency demand and supply
• differences in interest rates
 Floating exchange rates: movement to a new equilibrium

1.80
S1

S2
1.60
€/£

1.40

1.20
D1

1.00
D2

0.80
Q of £
 Exchange Rates
• The rate of exchange
– individual rates of exchange
– exchange rate index
• Determination of exchange rates
– the equilibrium exchange rate
– appreciation and depreciation
– shifts in currency demand and supply
• differences in interest rates
• differences in inflation rates
 Floating exchange rates: movement to a new equilibrium

1.80
S1

S2
1.60
€/£

1.40

1.20
D1

1.00
D2

0.80
Q of £
 Exchange Rates
• The rate of exchange
– individual rates of exchange
– exchange rate index
• Determination of exchange rates
– the equilibrium exchange rate
– appreciation and depreciation
– shifts in currency demand and supply
• differences in interest rates
• differences in inflation rates
• relative investment prospects
 Floating exchange rates: movement to a new equilibrium

1.80
S1

S2
1.60
€/£

1.40

1.20
D1

1.00
D2

0.80
Q of £
 Exchange Rates
• The rate of exchange
– individual rates of exchange
– exchange rate index
• Determination of exchange rates
– the equilibrium exchange rate
– appreciation and depreciation
– shifts in currency demand and supply
• differences in interest rates
• differences in inflation rates
• relative investment prospects
• change in aggregate demand
 Floating exchange rates: movement to a new equilibrium

1.80
S1

S2
1.60
€/£

1.40

1.20
D1

1.00
D2

0.80
Q of £
 Exchange Rates
• The rate of exchange
– individual rates of exchange
– exchange rate index
• Determination of exchange rates
– the equilibrium exchange rate
– appreciation and depreciation
– shifts in currency demand and supply
• differences in interest rates
• differences in inflation rates
• relative investment prospects
• change in aggregate demand
• speculation
 Floating exchange rates: movement to a new equilibrium

1.80
S1

S2
1.60
€/£

1.40

1.20
D1

1.00
D2

0.80
Q of £
Exchange Rates and Balance of Payments

• Exchange rates and the balance of

payments: no government intervention

– a floating exchange rate

• how rates are determined by dealers

– automatic balancing of overall balance of

payments

– current, capital and financial accounts may

not separately balance
Exchange Rates and Balance of Payments

• Exchange rates and the balance of

payments: government intervention
– reducing short-term fluctuations
• using reserves
• borrowing from abroad
• changes in interest rates
– maintaining a fixed rate of exchange over
the longer term
• deflation / reflation
• supply-side policies
• import controls
Fixed versus Floating Exchange Rates

• Advantages of fixed exchange rates

– certainty
– no speculation (if rate is absolutely fixed)
– prevents 'irresponsible' government policies
• Disadvantages of fixed exchange rates
– conflicts with other macro objectives
– danger of competitive deflations
– problems of international liquidity
– difficulties in adjusting to shocks
– speculation
Fixed versus Floating Exchange Rates

• Advantages of free-floating rates

– automatic correction
– no problem of international liquidity
– insulation from external events
– less constraint on domestic macro policy
• Disadvantages of free-floating rates
– possibly unstable exchange rates
– speculation
– uncertainty for business
• but use of forward markets
– lack of discipline on economy
 $ / £ exchange rate and £ exchange rate index: 1976-2003
$/£
$2.40

$2.20

$2.00

$1.80

$1.60

$1.40

$1.20
 $ / £ exchange rate and £ exchange rate index: 1976-2003
$/£
$2.40

$2.20

$2.00

$1.80

$1.60

$1.40

$1.20
 $ / £ exchange rate and £ exchange rate index: 1976-2003
Index
$/£ 1990=100
$2.40

$2.20

$2.00

$1.80

$1.60

$1.40

$1.20
 $ / £ exchange rate and £ exchange rate index: 1976-2003
Index
$/£ 1990=100
$2.40

$2.20

$2.00

$1.80

$1.60

$1.40

$1.20
 The Origins of the Euro

• Post-war regulation of exchange rates

– the Bretton Woods system
– its collapse in the early 1970s
– dirty floating
• The ERM
– features of the ERM
– the 1980s
– crisis in the ERM
• events of 1992
• events of 1993
– a return of calm
 The Origins of the Euro

• The Maastricht Treaty

– the timetable for EMU
– the convergence criteria
• inflation
• interest rates
• budget deficits
• general government debt
• exchange rates
• Birth of the euro
– meeting the convergence criteria
– role of the European Central Bank (ECB)
European Economic and Monetary Union

• How desirable is EMU?

– Advantages of a single currency
• eliminating conversion costs
• increased competition and efficiency
• elimination of exchange-rate uncertainty
• increased inward investment
• lower inflation and interest rates
– Disadvantages of EMU
• political arguments
• adjustment to shocks
– problem of asymmetric shocks
• EU12 may not be an optimal currency area
• regional problems
Fluctuations between the euro and the dollar
Fluctuations between the euro and the dollar

US interest
rate
Fluctuations between the euro and the dollar

US interest
rate

ECB
interest rate
Fluctuations between the euro and the dollar

US interest
$/€ rate

ECB
interest rate

$/€
Globalisation and the Problem of Instability

• Interdependence through trade

– international effects of changes in
aggregate demand

– vulnerability of open economies

• Financial interdependence
– size of international financial flows

– international effects of changes in interest

rates
Globalisation and the Problem of Instability

• The need for policy co-ordination

– the search for policy co-ordination
• G7/G8 meetings: attempts at harmonisation
• but lack of convergence

• Difficulties in achieving harmonisation

– differences in budget deficits and debt
– interest rate divergence
– different internal structures of economies
– politicians more concerned with domestic
issues
 Debt and Developing Countries

• The debt problem

Debt ratios: average of all developing countries
Debt ratios: average of all developing countries
Debt ratios: average of all developing countries
 Debt and Developing Countries

• Origins of the debt problem

– borrowing to finance development
– the 1973/4 oil shock
– the 1979/80 oil shock
• world recession → fall in export earnings
• fall in commodity prices (exports)
• high interest rates → cost↑ of servicing debt

• Rescheduling debt
– rescheduling official loans
– rescheduling commercial bank loans
 Debt and Developing Countries

• Dealing with debt

– structural reforms
– IMF structural adjustment programmes
• tight fiscal policies to reduce budget deficits
• privatisation and market liberalisation
• open trade policy
• hardship from IMF programmes
– debt forgiveness
• HIPC initiative
– successes / failures to date
• pressure to cancel debts