Unit –IV Foreign Exchange Market

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Foreign Exchange Market

In today's global economy world, the phenomenon of the "closed economy" —one that is unaffected by international trade and capital flows— is little more than an abstract textbook concept. The notion of a closed economy is nevertheless quite useful in intermediate macroeconomics, as it allows for the analysis of the fundamental aspects of the economy (e.g.

the impact of monetary and fiscal policy) without considering the complicating effects of globalization. With the fundamentals well understood, however, we can now provide more realism by looking at the ‘open economy” that is directly affected by global marketplace.

Considering an economy as part of the global marketplace adds complexity to our model. The first bit of complexity comes in form of new terminology and concepts. We shall start by introducing the two fundamental concepts of the open economy: the balance of payments (BoP) and the exchange rate. These two notions are both elementary and extraordinarily powerful in providing rich insights into the workings of an international economy. The balance of payments usually is compiled by each country’s central bank or finance ministry.

International Transactions Accounts

The balance of payments (BoP) is the international balance sheet of a nation that records all international transactions in goods, services, and assets over a year. That is why this BoP is usually under the International Transactions Accounts in national statistical data. The BoP is that of a simple accounting tool, similar to balance sheets of companies that report transactions such as goods bought and sold, or assets borrowed and acquired. After we have studied all components of the BoP, we will find that it serves as the most important statistics in the open economy since it summarizes exactly how the domestic economy interacts with the rest of the world.

Key Components of the Balance of Payments

The BoP is broken down into three important sub-components: the current account balance (CA), the capital account balance (KA), and the financial account balance (FA):

BoP = CA + KA + FA

We will discuss each major sub-component in detail below, but for now we want to keep in mind that the current account represents basically trade in goods and services and the financial account collects information on financial transactions such as international stock and bond purchases. Finally, the capital account keeps track of all the flow of non-financial assets, such as the transfer of intellectual property rights. Changes in each sub-component will have a different impact on the domestic economy.

Recall that we labelled the BoP an “international balance sheet,” and just like the accounting in any other balance sheet, the BoP is tracked using double-entry accounting. Double-entry accounting means that every transaction enters the BoP twice, once as a credit (+), for example the export of a car to foreigners, and once as a debit (-), which is how you would record the payments for the car.

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[email protected] 2 The balance of payments records each transaction as either a plus (credit) or a minus (debit).

The general rule in BOP accounting is specified as follows:

Credit (+): A flow for which the country is paid: inflow of funds.

E.g.: Exports of goods, services to foreigners, income generated from investing abroad, sales of assets to foreign investors

Debit (-): A flow for which the country pays: outflow of funds.

E.g.: Imports of goods, travel expenses in foreign countries, income paid to foreign investors, purchases of foreign assets

That is, if a transaction earns or generates foreign currency for the nation, it is called a credit and is recorded as a plus item. If a transaction involves spending foreign currency, it is a debit and is recorded as a negative item.

All credit items in the BOP have to be accounted for by the debit items. So the sum of all the plus numbers in the BOP has to be equal to the sum of the entire debit numbers in absolute values.

Therefore, the BoP is actually an identity:

BoP = CA + KA + FA = 0

The sum of all the entries in the three sub accounts (CA, KA, FA) must be equal to zero since every entry has a counterpart with the opposite sign in some other section of the BoP.

Technically, all the accounts in the balance of payments must sum to zero.

This is analogous to an individual’s personal account. Suppose by the end of the year, you review your household’s income and spending for the year. An inflow of funds is a credit while spending is a debit. Your total inflow has to be accounted for by your spending or saving. The following is a hypothetical illustration:

Credit Debit

Salary 800 Housing -300

Interest earnings 100 Food -200

Other income 100 Travel -200

Other -200

Saving -100

Total 1000 Total -1000

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[email protected] 3 Your total inflow is $1,000 including your salary ($800), your interest earnings ($100), and other income ($100). On the right-hand side, your total spending including housing ($300), food ($200), travel ($200), other ($200) and saving ($100) sums up to $1000 as well. Note that your saving is included on the debit side because it accounts for what you have done with the money you have earned. It is important to recognize this – a negative number has no connotation of being bad or negative; it is simply a way of systematically recording the characteristics of the transaction.

Suppose we change the situation as follows:

Credit Debit

Other -200

Saving 0

Is this possible – your total income is $1000 but your total spending is $1100? This is possible if you can borrow. But the above balance of personal payments is not consistent: it does not show where the extra money ($100) comes from. So we need to include the borrowing in the above balance so that your balance of personal payments looks like this:

Credit Debit

Borrowing 100 Other -200

Saving 0

Now your balance of personal payments is balanced. Note the $100 you borrowed is recorded as positive number since it represents an inflow of funds to you.

Let us now go back to the initial situation, but change it to one like the following:

Credit Debit

Other -100

Saving -100

In the above situation, your total debits are $100 short of the credits. Have you ever been in a situation in which your numbers simply do not add up to account for a specified total? You

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[email protected] 4 spent the money but simply cannot recall the transaction. Something is missing but you cannot figure out what. Your balance of personal payments is not balanced. What you need to do now is to create an item called “errors or omissions,” or “statistical discrepancy” to make up the difference so that your balance of personal payments will look like this:

Credit Debit

Other -100

Saving -100

Net errors and omissions -100

That is, you recognize the error and omission in your balance of personal payments and make it balanced.

To repeat, the key idea here is that all the credits (positive numbers) and the debits (negative numbers) in the balance of payments have to sum up to zero. Different accounts within the BOP may have positive or negative balances, but the entire BOP has to sum up to zero.

If the balance of payments has to be zero, how come we often hear or read statements like this: “U.S. Chalks Up Record Balance of Payments Deficit (Wall Street Journal headline)?”

We know now that technically the balance of payments is zero; it cannot have a surplus or deficit. What is often referred to by the media, and by academics as well, is really the overall balance deficit or surplus when they talk about balance of payments deficit or surplus. We will define and discuss the overall balance shortly.