international finance exam solutions

8/17/2019 International Finance Exam Solutions

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International Finance Theory and Policy

INTRODUCTION

When studying open economy that trade with other countries, there is a major difference in

the transactions between domestic and foreign residents as compared to those between

residents of the same country. One of the features of international trade is the involvement of

foreign currencies. The subject called International Finance as a part of International

Economics is concerned with monetary and macroeconomics relations among different

countries. International Finance is dynamically evolving discipline and deals with real issues

in business environment related to financing transactions among different nations.

This teaching material, therefore, presents some basic theory and principles of International

Finance that are essential for a better understanding of the subject International Economics.

Such an understanding of the theories and principles would enable students to evaluate and

suggest solutions to improve international economic problems and issues facing the global

economy. Students are expected to appreciate those issues by extending their analysis to

individual countries. The basic knowledge gained from this teaching material will enable

readers to assess the policy implication of the issues and problems.

This teaching material is organized in such a way that, the first two chapters provide basic

knowledge about market for foreign exchange, introduces the major participants in the

foreign exchange market, and types of exchange markets. It also addresses concepts and

issues related to determination of floating exchange rates. It starts by reviewing the basic and

early concepts of purchasing power parity and the law of one price. Version of PPP and

problems associated with PPP in using to determine exchange rate would be explained at the

end of the chapter.

The next three chapters deal broadly with the concept of balance of payment. In these

chapters, the meanings of balance of payment, components of balance of payment and basic

concepts of deficit and surplus of the balance of payment would be explained closely. The

two approaches, the elasticity approach and the absorption approach are dealt is some detail

Adama University, Faculty of Business and Economics, Department of Economics1


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in chapter four of the teaching material. The monetary approach to the balance of payment is

analyzed in some detail in one full chapter-chapter five.

Open economy and Macroeconomic policy, particularly the problem of internal and external

balance and the Mundell -Fleming model is revisited in the subsequent chapter –chapter six.

Finally, the international monetary system is presented briefly in the last part of the material -

chapter seven.

For better understanding of the subject, readers are advised to refer additional materials and

revise basic concepts of Macroeconomics, International Trade and other related literatures in

International Economics.



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CHAPTER I

EXCHANGE RATES AND FOREIGN EXCHANGE MARKET

NTRODUCTION

This chapter will attempt to examine different participants in the foreign exchange market

and explains the basic forces that operate in the market. The concept of exchange rate and the

determination of exchange rate would also be examined in some details. The basic

operational differences between fixed exchange rates and floating exchange rates regime will

be explained as well. The basic concepts of spot exchange rates and forward exchange rate

and the relationship between spot and forward exchange rate will finally be presented.

CHAPTER CONTAINT

1.0. Objective

1.1. Exchange Rates and The Foreign Exchange Market

1.2. Characteristics And Participants of The Foreign

Exchange Market

1.3. The spot and Forward Exchange Rates

1.4. Summary

1.5. Review Question



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1.0. OBJECTIVE

At the end of this chapter readers will be able to

• Explain exchange rate

• Understand characteristics of foreign exchange market

• Know major participants of the foreign exchange market.

• Explain the concept of arbitrage in foreign exchange market

• Understand the essence and difference between spot and forward exchange rates

• Explain how exchange rates are determined.

1.1. EXCHANGE RATE AND THE FOREIGN EXCHANGE MARKET

In an open economy that trade with different countries, there is a major difference in the

transaction of goods and services between domestic and foreign residents as compared to

those between residents of the some country. One of the facture of international trade is the

involvement of foreign currencies.

The Ethiopian importer will generally have to pay to the Japanese exporter in yen, to US

exporter in USD and to Germen exporter in Euro. For these reasons, the Ethiopian importers

will have to buy these currencies with birr in foreign exchange market.

The foreign exchange market is not a single physical place rather it is defined as. a market

where the various national currencies are bought and sold.

In this chapter, we will try to look at some of the basic issues like, the participants in the

foreign exchange market and the basic force that operate in the market. We will also try to

examine the basic determinant of exchange behavior. The spot and forward exchange rates

will also be discussion in some brief way.



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What is exchange rate?

People in different countries use different currencies as well as different languages. The

translator between different currencies is the exchange rate, the price of one country money

in unit of another country’s money.

Generally, exchange rate is simply the price of one currency in terms of another. There are

two methods of expressing the price of one country’s currency. These are,.

• Domestic currency unit per unit of foreign exchange. For instance, taking birr as the

domestic currency, on February 15, 2008 there was approximately 9.22 birr required

to purchase one US dollar. Thus, Exchange rate between birr & US dollar (USD) is

9.22 to 1 USD.

• Foreign currency units per unit of the domestic currency. That is, how much USD can

one Ethiopian birr buy? For example, again taking Ethiopian birr as domestic

currency, on February 15, 2008, One Eth. Birr can only buy 0.11 USD.

We can easily observe that the second method is just the reciprocal of the former. It is not as

such important which method of expressing the exchange rate is employed. What important

is to be careful when talking about a rise or fall in the exchange rate. This is because the

meaning will be very different depending up on which definition is used.

A rise in the Eth birr per dollar exchange rate, say from 9.22 to 9.30 means that more birr

have to be given up in order to obtain a dollar. This means that the birr has depreciated in

value or equivalently the dollar has appreciated in value.

Where as if the second definition is employed, a rise in the exchange rate from USD 0.11/ 1

birr to say 0.12 / birr would mean that more dollars are obtained per birr, so that the birr has

appreciated or equivalently the dollar has deprecated.

To avoid unnecessary confusion the rest of this material will refer to exchange rate as the

price of the foreign currency in terms of domestic currency. That is the price paid in the

home currency for a unit of foreign currency.



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1.2. CHARACTERISTICS AND PARTICIPANTS OF THE FOREIGN

EXCHANGE MARKET

The foreign market is the market in which individuals, firms and banks buy and Sell foreign

currency. The foreign exchange market is a world wide market and is made up of primarily

of commercial banks, foreign exchange brokers and other authorized agents trading in most

of the currencies of the world.

These groups are kept in close and continuous contact with one another through the available

means of communications like, telephone, on line computers, telex and fax and video

conference and the like. The current development in Information Communication

Technology has further made easy the communication among different foreign exchange

participant and economic agents

Among the most important foreign exchange centers are London, New York, Tokyo,

Singapore and Frankfurt.

The most widely traded currency is the US dollar which is knows as a vehicle currency-

because it is widely used to denominate international transaction. Oil and many other

important primary products such as tin, coffee and gold all are priced in dollars However,since its existence Euro( European currency unit) is becoming attractive and getting wider

range of acceptability as well.

Partic ipants in the Foreign Exchange Market

The main participants in the foreign exchange market can be categorized as follows.

Retail Clients: - These are made up of business investors, multi-national corporations and so

on. These need foreign exchange for the purpose of operating their business. Commonly they

do not directly purchase or sell foreign currency themselves; rather they operate by placing

buy/sell orders with the commercial banks.



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Commercial Banks: – The commercial banks carry out buy/sell orders from their retail

clients and buy/sell currencies on their own account so as to alter the structure of their assets

and liabilities in different currencies. Banks may deal either directly with other banks or

through foreign exchange brokers.

Foreign exchange brokers: - Commonly banks do not trade directly with one another, rather

they offer to buy and sell currencies via foreign exchange brokers. Brokers intermediate the

exchange currencies between different clients. The benefits of brokers is that, they collect,

buy and sell order for most currencies from different banks around the world thereby the

most favorable quotation can be obtained quickly and at lower cost.

A small brokerage fee is paid when banks are dealing through a broker which can be avoided

in a straight bank to bank deal. Each financial center has just a few authorized brokers

through which commercial banks conduct their exchange.

Central banks (monetary authority):- The monetary authority of a country can not be

indifferent to change in the external value of its currency, even if exchange rates of the major

industrial nations have been left to fluctuate freely since 1973.

Central banks frequently intervene by buying /selling their currencies to influence the rate at

which their currency is traded. Under a fixed exchange rate system the authorities are obliged

to purchase their currencies when there is excess supply and sell the currency when there is

excess demand.

Bulls, And Bears in the Foreign Exchange Market

Speculators are usually classified as bulls and bears to their views on a particular currency. If

a speculator expects a currency, for example dollar (spot or forward) to appreciate in the

future he is said to be bullish about the currency. Under this condition, it pays the speculator

to take a long-position on the dollar. That is, to buy the dollar spot or forward at cheap price

today in the hope that he can sell it at a higher price in the future.

But if the speculator expects the dollar (spot or forward) to depreciate in the future he is said

to be “bearish” about the currency in which case it would be better for the speculator to take



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short position on the currency. That is, to sell the dollar at what he believed to be a relatively

high price today in the hope of buying it back at a cheap rate sometimes in the future.

Speculation is the opposite of hedging and it is the act of taking a net asset position (long

position) or a net liability position (short – position) in a foreign currency. Speculation means

committing one – self to uncertain future value of one’s net worth in terms of home currency.

Most of these commitments are based on conscious, expectations about the future prices of

the foreign currency.

Arbi trage in the foreign Exchange market

Arbitrage is the exploitation of price differentials for risk less guaranteed profit. There are

two types of arbitrage, financial center and cross – currency arbitrage. To explain these two

forms of arbitrage let us assume that transaction costs are negligible and that there is only a

single exchange rate quotation ignoring the bid – off spread.

Financial center arbitrage:- This type of arbitrage ensure that the birr – dollar exchange

rate quoted in New York will be the some as that quoted in Addis and other financial centers

(assuming that birr is freely traded currency and Addis is one of the finical centers).

This is because if exchange rate is birr 9.22 in Addis but only birr 9.20 in New- York, it

would be profitable for banks to buy birr in New York and simultaneously sell them in Addis

and make a guarantied profit of 2 cents on every dollar sold and bought. Such process of

buying birr in New York and selling it in Addis continues until the rate quoted in the two

centre concedes to equal level . Such action of buying a currency from a financial center

that offers it at lower rate and selling it at higher rate in other financial centers is called

financial center arbitrage.

Cross – Currency arbitrage:- This form of arbitrage can be better explained with the help

of simple and hypothetical example. Suppose the exchange rate of birr is 9.20 birr/1 USD.And the exchange rate of dollar against Euro is 1.5 USD/1Euro. Currency arbitrage implies

that the exchange rate of birr against Euro will be 13.8 birr/ Euro (1.5 x 9.2). If this were not

the case and the actual exchange rate was for example, 14 birr /Euro, then the US dealer

wanting birr would do better to first obtain Euro with 13.8 birr/Euro (1.5x9.2) which will

then buy birr 14, making 0.2 cents per each Euro sold.



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The increase in demand for Euro would quickly appreciate its rate against the Euro to 1.5217

USD/Euro level at which level the advantage to the US dealer in buying Euro first to then

convert into birr disappears.

1.3. THE SPOT AND FORWARD EXCHANGE RATES.

The exchange rate can be of two types depending on the form of delivery takes place. These

are spot and forward exchange rate.

The Spot Exchange Rate

The spot exchange rate is the quotation between two currencies for immediate delivery. In

other words, the spot exchange rate is the current exchange rates of two currencies vis-à-vis

each other. In practice, there is normally a two-day lag between a spot purchase or sale and

the actual exchange of currencies to allow for verification, paper work and clearing of

payments. In the spot transaction, the seller of the currency has to deliver the currency he has

sold” on the spot”, usually with in two days.

The Forward Exchange Rate

Another important market for foreign exchange is the forward market. It is also possible for

economic agents to agree today to exchange currencies at some specified time in the future.

In forward market, the contract is signed and the seller agrees to sell a certain amount of

foreign currency to deliver at future date at a price agreed up on in advance. Analogously, a

buyer agrees to buy a certain amount of a foreign currencies at a future date and at a

predetermine price. The most common forward contracts are 1 month (30 day), 3 months (90

days), and 6 months (180 days). The rate of exchange at which such a purchase or sale can be

made is known as the forward exchange rate.

Why economic agents may engage in forward exchange transaction and how the forward

exchange rate is determined will be discussed below.



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Simple Model of the Determination of the Spot Rate

Since the adoption of floating exchange rate in 1973, there has developed new set of theories

attempting to explain exchange rate behavior, know as the modern asset market approach to

the exchange rate determination

However, in this chapter we will look at a simple model of exchange rate determination

which was widely used prior to the development of these new theories. Despite its short

coming, the model serves as a useful introduction to exchange rate determination and is some

how a prerequisite for understanding of this chapter.

The underlining assumption of the model is that the exchange rate (the price) of a currency

can be analyzed like any other price of commodities with the help of supply and demand

frame work. That is, the exchange rate of the birr will be determined by the intersection of

the supply and demand for birr on the foreign exchange market(if birr was freely traded

currency in major financial markets). Let us briefly look at each of the market forces turn by

turn.

The Demand for Foreign Exchange

The demand for currency in the foreign exchange market is a derived demand. Since we are

not sure that birr is freely traded in foreign exchange market, let us use dollar in stead of birr

for discussion purposes.

Restating the above statement, the demand for dollar is a derived demand It is derived from

the demand for US product. That is, dollar is not demanded because it has intrinsic valve by

itself, but rather because of what it can buy. To derive hypothetical demand for dollar let us

assume that US is exporting country and Ethiopia being importer. Table 1.1 presents the

derivation of a hypothetical demand for dollar schedule with respect to change in the

exchange rate.



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Table 1.1 Demand for dollar

Price of US Export

good in USD (1)

Exchange

rate (2)

Price of Us

export in birr(3)(1x2)

Quantity of

US expert (4)

Demand for

USD(5)=(1) (4)

10 9.20 birr 92 1500 15000

10 9.30 93 1300 13000

10 9.40 94 1100 11000

10 9.50 95 900 9000

10 9.60 96 700 7000

10 9.80 98 500 5000

10 10.00 100 300 3000

As dollar appreciate against birr, that is when it moves from 9.20 to 10 birr, the price of theUS export to Ethiopian importers increase and this leads to a lower quantity of exports and

with it a reduced demand for dollar. Hence, the demand curve for dollar which is shown in

figure 1.1 . slops dawn wards from left to right.

Birr/USD

10

9.5 -

9.20 - D

3000 9000 15000 Quantity US export

Figure 1.1 The demand curve for dollar

In this simple model the demand for dollar depends upon the demand for US export product.

Any factor which results in increase in demand for US exports will result in an increased

demand for dollars and a shift to the right of the demand curve for dollars. Some of the

factors that result in such a shift are



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a change in ETH income

a change in the price of ETH goods (Which can substitute imports from US)

a change in ETH tastes in favor of US goods

All these factors result in an increase or decrease demand for us export and hence dollar anda shift of the demand schedule either to the right or left.

The Supply of Foreign Exchange

The supply of dollars is similar to ETH or other countries demand for dollars. Table 1.2

presents hypothetical supply of dollar schedule.

As the dollar appreciates the cost of US exports will be higher to Ethiopian importers andcost of ETH exports becomes cheaper for US residents (Ethiopian products will be come

cheaper to US consumers). As such, they demand more Ethiopia’s exports (say Coffee ) and

this results in an increased demand for birr which are purchased by increasing the amount of

dollar supplied in the foreign exchange market. This yields an up ward slopping supply of

dollar curve as shown in figure 1.2.

Table 1.2 The supply of dollar.

Price of

ETH export

goods in

birr(1)

Exchange

rate birr

/USD

(2)

Price of ETH export

in USD

(3)=(1)

(2)

Quantity of

ETH

export

(4)

Demand for

birr (5) (1)x(4)

Supply of

USD (6)

(5)(2)

100 9.20 10.9 300 30000 3260.90

100 9.30 10.75 500 50000 5376.34

100 9.40 10.64 700 70000 7446.80

100 9.50 10.53 947.7 947.70 9000.00

100 9.60 10.42 1200 120000 12500.00

100 9.80 10.21 1350 135000 13775.50

100 10.00 10 1500 150000 15000.00



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The supply curve for dollar is depicted using the supply schedule of demand as shown in

table 1.2.

Exchange rate

9.8

9.6

9.5

9.4

9.3

S

9.2

300 900 9473.7 1500 Quantity of dollar

Figure 1.2 The Supply curve of dollar

The supply of dollar depends up on the US demand for Ethiopian good (in the above

example) .

The supply curve can shift to the right or to the left depending on factors like.

Change in US in come

Change in tastes of US residents

Change in prices of US goods (Which are substitutes or complementary to

Ethiopian export commodities)

All the above factors’ change may increase or decrease demand for Ethiopian goods and birr

which is reflected in an increased supply of dollar.

Since the exchange market brings together those people that whish to buy currency (which

represents the demand) with those that wish to sell their currency (which represent the

supply) then the spot exchange rate can easily be considered as being determined by the

intersection of the supply and demand for the currency. The following figure (Fig..1.3)

presents the determination of the birr-dollar exchange rates. The equilibrium exchange rate is

represented by the intersection of the supply and demand curve and this yields a birr- dollar



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exchange rate of 9.5 USD. When the exchange rate is made to float freely, it is determined by

the intersection of the supply and demand curve as shown below.

Birr/dollar

D

Quantity of dollar

S

9.5

9000

Figure 1.3 Determination of birr-dollar sport exchange rate (spot)

Fixed Vs Floating Exchange Rate

At the Breton Wood conference of 1948 the major nations of the western world agreed to a

pegged exchange rate system. Each country fixes its exchange rate against the US dollar with

a small margin of fluctuation around the par value. In 1973 the Breton Woods system broke

down and the major currencies were left to be determined by market forces in a floating

exchange rate world. The basic difference between the two systems can be explained using

the supply and demand frame –work.

Floating Exchange- Rate Regime

Under the floating exchange rate regime the authority do not intervene to buy or sell their

currency in the foreign exchange, market rather, they allow the value of their currency to

change due to fluctuations in the supply and demand of the currency, and this is illustrated in

figure below.



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In figure 1.4 ( a) shows how the exchange rate is initially determined by the equality of

demand (D1) and supply (S1) of dollar at the exchange rate of 9.50 birr per dollar.

Q1 Q2 QUSD Q1 Q2 Q USD

Birr/ $ S birr /$ S1

S29.70

. 9.5D2

D1

(a) (b)

Figure 1.4 floating exchange rate regimes (a) in crease in demand and (b) increase in

supply

If there is an increase in the demand for US exports, there will be a shift in the demand curve

for dollar from D1 to D2 , this increase in demand for dollar will lead to an appreciation of

the dollar from 9.5 say, to 9.70 or depreciation of birr Figure 1.4 (b) shows the impact of

increase in supply of dollar due to an increase demand for Ethiopian export and thus for birr.

The increased supply of dollar shifts the supply curve S1 to the right to S2 , resulting in a

depreciation of dollar from 9.50 to 9.40 .or appreciation of birr In general, the essence of a

floating exchange rate is that the exchange rate adjusts in response to any changes in the

supply and demand for currency.

Fixed Exchange Rate Regime



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In fixed exchange rate regime, exchange rate is fixed by the authorities and can not adjust in

response to the change in supply and demand for currency. Figure 1.5 illustrates the

mechanism of fixing exchange rate.

In figure 1.5 (a) the exchange rate is assumed to be fixed by monetary authorities at the point

where demand intersect the supply curve at birr 9.50. If there is an increased demand for

dollar which shifts the demand curve from D1 to D2, there is a resulting pressure for the

dollar to be revaluated. To control the appreciation of dollar, the National Bank of Ethiopia

will sell Q1 Q2 amount of dollar to purchase birr with dollars in the foreign exchange market.

This save of dollar by National Bank of Ethiopia shifts the supply curve of dollar from S1 to

S2. Such intervention eliminate the excess demand for dollar so that exchange rate will

remain fixed at birr 9.5. This intervention will decrease the amount of birr in circulation anddecreases the National Bank’s dollar reserve.

Similarly figure 1.5 (b) presents a situation where the exchange rate is pegged by the

National Bank at the point where S1 intersects D1 at birr 9.50 per dollar.

Birr/USD Birr/ USD

S1

S1 S2

S2

9.5 9.5D2

D1D2 D1

Q1 Q2 QUSD Q1 Q2 QUSD (a) (b)

Figure 1.5 Fixed exchange rate regime (a) increase in demand (b) increase in supply

If there is an increase in demand for Ethiopian export, there will be an increased demand for

birr and increased supply of dollar which shifts the supply curve to S2. That is excess supply



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of dollar at the prevailing exchange rates and there will be a pressure on the dollar to be

devaluated or domestic currency to be revalued . To avoid this the National (Central) Bank

of Ethiopia has to intervene in the foreign exchange market by purchasing Q1 Q2 amount of

dollar to keep the exchange rate fixed at birr 9.50 per dollar. This intervention is shown by a

right ward shit of the demand curve from D1 to D2 . Such intervention removes the excess

supply of dollar so that the exchange rate remain pegged at birr 9.50 per pound and it leads to

an increase in the Ethiopian National Bank’s reserves of dollar and in the amount of birr in

circulation.

Forward Exchange Rate and its Determination

The forward exchange-market is a market where buyers and sellers agree to exchangecurrencies at some specified date in the future. For example, Ethiopian importer who has to

pay $10,000 to his US supplier at the end of August, may decide on June 1 to buy $ 10,000

for delivery on August 31 of the same year at a forward exchange rate of say birr 9.40 per

dollar. The question that commonly arises is that, why should any one wish to agree today to

exchange currencies at some future date?

To answer this question we need to look at different participants in the forward exchange

market. Traditionally, economic agents involved in the forward exchange market are divided

into three groups based on their motives for participation in the foreign exchange market.

These are

• Hedgers

• Speculators

• Arbitrageurs

Hedger: These are agents (usually firms) that enter the forward exchange market to protectthemselves against exchange rate fluctuation, which entail exchange rate risk.

Exchange risk is the risk of loss due to adverse exchange rate movements. We will explain

why a firm may engage in a forward exchange rate transaction using the following

illustrative example.



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Consider the Ethiopian importer who is going to pay for goods imported from the US to the

value of US $ 10,000 in one year time. Suppose the spot exchange rate is 9.5 birr while the

one year forward exchange rate is birr 9.4. By buying dollars forward at this rate the importer

can be sure that he only has to pay birr 94000. If he does not buy forward today, he might run

the risk that in one year’s time the spot exchange rate may be higher that birr 9.4 such as birr

9.50 which would mean he has to pay birr 95000. Of course, the spot exchange rate in one

year’s time may be changed in favor of the importer and may be birr 9.20 in which case he

would only has to pay birr 92000. But by engaging in a forward exchange contract the

importer can be sure of the amount of birr he have to pay for the imports, and therefore can

protect himself against the risk of exchange rate fluctuation.

One may ask why the importer does not immediately by US$

10,000 at spot at birr 9.40 andhold for 1 year. One reason is that he may not at present have the necessary funds for such a

spot purchase and is reluctant to borrow the money, knowing that he will have the funds in

one year’s time from sales of goods. By engaging in a forward contract he can be sure of

getting the dollars he requires at known exchange – rate even though he does not yet have the

necessary birr.

In effect, hedgers avoid exchange risk by matching their asset and liability in the foreign

currency. In the above example, the Ethiopian importer buys 10,000 USD forward (his asset)

and will have to pay 10,000 for imported goods (his liability).

Arbitrageurs:- These are agents (usually banks) that aim to make a risk less profit out of

discrepancies between exchange rates differences and what is know as the forward discount

or forward premium.

A currency is said to be at a forward premium if its forward exchange rates represents an

appreciation as compared to the spot rate quotation. On the other hand a currency is said to

be at forward discount if its forward exchange rate quotation shows depreciations as

compared to its spot- rate quotation.

The forward discount or premium is usually expressed as a percentage of the spot exchange

rate. That is,



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Forward discount/Premium = 100S F

S X −

Where F is the forward exchange rate quotation and S is the spot exchange rate quotation.

The presence of arbitrageurs ensures that the covered interest parity (CIP) condition holds

continuously.

CIP is the formula used by banks to calculate their exchange quotation and is given by the

following

F =( * )

(1 )

r r s

r s−+ +

Where,

• F is the one - year forward exchange rate quotation in domestic currency per unit of

foreign currency,

• S is the spot exchange rate quotation in domestic currency, per unit of foreign

currency, r is the one year foreign interest rate and

• r* is the one – year domestic interest rate

The above formula has to be amended by dividing the three months interest rate by 4 to

determine the three – month forward exchange rate quotation and dividing by 2 to calculate

the six moth forward exchange rate.

As an illustrative example of the determination of the forward exchange rate, suppose that

the Euro interest rate is 5%, and the birr interest rate is 3%, and the spot rate birr against Euro

is birr 10 per euro. The one year forward exchange rate can be calculate as follows.

F =(0.03 0.05)10 0.2

(1 0.05 1.0510 10 9.81F

− −+

+ => = + =

Forward discount/premium =9.8110

10100 0.019 100 x− X =− which is nearly – 0.02. The one

year forward rate of euro is at an annual forward discount of 2%.

To understand why covered interest parity (CIP) must be used to determine the forward

exchange rate, consider what would happen if the forward rate was different from that of

calculated in the above example, for example birr 10.1/Euro. In this instance an Ethiopian

investor with birr 1000 could earn 1050 birr at the end of the year, but by buying Euro spot at

birr 10 per euro, and simultaneously selling pounds forward at birr 10.10 at spot exchange



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rate he would buy 100 Euro (1000/10) and will earn 105 at the end of the year at 5% Euro

interest rate (1.05x100=105). Selling 105 at forward rate of 10.1 giving him birr 1060.5

(105x10.1).

Clearly, it pays Ethiopian investor to buy Euro at spot and sell Euro forward. With sufficient

numbers of investors doing this, the forward rate would gradually depreciate until such

arbitrage possibilities were eliminated. With a spot rate of investors doing this, the forward

rate would gradually depreciate until such arbitrage possibilities were eliminated. With a spot

rate of birr 10/Euro, only the forward rate is at 9.81 birr will yield in Ethiopia and in

European Union time deposit be identical (since 105x9.81=1030). Only at this forward rate

there is no risk-less arbitrage profits to be made.

Since the denominator in the above equation is very close to one (unity), the equation can be

modified to yield an approximate expression for forward premium /discount

( * ) ( * ) 5

( 1 )

*

5,

r r s r r S S

r S

F S

F s

T h u s r r

− −

+

−

= + ⇒

= −

+ −

This approximate version of CLP says that, if the country interest rate is higher than the

foreign interest rate, then its currency be at forward premium by equivalent percentage ;

while if the domestic interest rate is lower than the foreign interest rate, the currency will be

at forward discount by an equivalent parentage. In our example, the Ethiopian, interest rate of

3% less than Euro interest rate of 5% indicate an annual forward discount on Euro of 2%,

which is an approximation to the actual 1.9 percent discount obtained using the full CLP

formula.

Speculators: - speculators are agents that hope to make a profit by accepting exchange raterisk. They engage in the forward exchange market because they believe that the future spot

rate corresponding to the date of the quoted forward exchange rate will be different from the

quoted forward rate

Consider the situation where the one year forward rate is quoted at birr 9.40/ USD and a

speculator fells that the dollar will be rather birr 9.20 /USD in one years time. In this case he



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may sell $1000 forward at birr 9.40 so as to obtain birr 9400 one year and hope to change

them back into dollar in one year’s time at birr 9.20 /USD, and so obtain US $1021.74

making $21.74 profit.

In fact the speculators may be wrong in his expectation and find that in one year’s time spot

exchange rate is rather above 9.40, say birr 9.50 /USD, in which case his 9400 birr are worth

only 989.47 USD implying a loss of USD 10.53

Generally, speculator hops to make money by taking and open position in the foreign

currency. In our example, he has a forward asset in Birr which is not matched by a

corresponding liability of equivalent value.

The Relation Between Spot and Future Exchange Rate

Why spot and forward exchange rate are different in most cases?

The answer is that, the spot and forward exchange rate should differ by about as much as

interest rate differs in the two countries currencies as explained earlier.

Here is an explanation for difference between spot and forward rates. A country with one

percent higher interest rate will tend to have a one percent forward discount (short fall of the

forward rate below the spot rate) on its currency. In fact, Euro did have a forward discount in

our previous example (and this is a forward premium to birr).

The relationship between spot and forward rate is thus, dictated by the international interest

rate gap. As long as this gap stays the same, the spot and forward rates will keep differing by

the same percentage, and whatever moves the spot rate up and down will do the same to the

forward rate.

Interest rate parity :- The forward exchange value of a currency will tend to exceed its spot

value by as much (in percent) as its interest rate are lower than the foreign interest rate.

For our better understanding how interest rate parity condition works let us have one moreexample.

i. We can convert present dollar into future birr by selling them at the spot

exchange rate (r s, measures birr per dollar) and investing those birr at the

Ethiopian interest rate. In the case future birr per present dollar Or.(1 )sr ia= +

Adama University, Faculty of Business and Economics, Department of Economics

21


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ii. We can convert present dollar into future birr by investing the dollar in US at

the interest rate i b and selling the later earnings right now at the forward

exchange rate f r again measured in birr per dollar.

In this case future birr value per present dollar (1 ). f ib r = +

If you can get from present dollar to future birr in either of the two ways, you will take the

more profitable way. But every body thinks the same way. Since investor have choices, the

exchange rates and interest rates will adjust so that the two future dollar values are equal.

That is.

.(1 ) (1 ). (1 ) /(1 ) f s f as

r r ia ib r or i i

r + = + = + + b

This is called the interest rate parity condition.

1.4. SUMMARY

As trade among counties (international trade) increases the need the need for foreign

exchange market becomes very important activity of economic agents. Trade with financial

assets always involves the exchange of different national currencies. If the world economy

had a single currency then a foreign exchange market would not exist. The modern foreign

exchange market is truly a global market and is characterized by a large volume of dailytransactions.

Most topics in international finance focuses on the forces that determine exchange – rate

movement, and the implication of these movement for trade and economic growth and the

development of the world economy. Conducting Economic analysis of the effect of

exchange- rate changes, require making distinction between the real and nominal exchange

rate and between bilateral and effective exchange rates depending on the purpose of the

particular analysis being undertaken.

Even if exchange rate may change significantly at time, this is not necessary disruptive to the

international trade as traders can protect themselves against exchange risk by hedging in the

forward exchange market. For many countries the depreciation / devaluation of their



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currencies is an important mechanism for maintaining their international competitiveness and

trade volume.

1.5. REVIEW QUESTIONS

1. How do you understand Exchange- rates?

2. What are the major participants of foreign Exchange market and explain their

characteristics?

3. What do you understand by Bulls and Bears in the foreign exchange market ?

4. Explain the difference between the act of speculation and Hedging in the foreign

exchange market ?

5. Explain the difference between financial center and cross-currency arbitrage.

6. What do you understand by spot exchange rate?

7. Explain the essence of determination 7 spot exchange- rate.

8. What is for-ward exchange Rate?

9. What are factors affecting demand for foreign exchange ?

10. What are factors affecting supply of foreign exchange?

11. What are the economic agents participating in the foreign exchange market?

12. Explain the relationship between spot and future exchange rate.

13. Suppose you are a speculator in the foreign exchange market and suppose that Euro can

be purchased sold to day at a for ward rate of 15 birr/ Euro in one Years time and you

expect the spot rate to be 14.5 birr/Euro after one year. If you have 10,000 Euro at hand

today, how can you earn benefit from it?

How would your answer change if the expected spot rate after one year were birr

16/Euro?

CHAPTER II

DETERMINATION OF FLOATING EXCHANGE RATE



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INTRODUCTION

This chapter presents one of the earliest and simplest models of exchange rate determination

know as purchasing power party (PPP) theory. Common understanding of PPP is essential to

the study of international finance.

In fact this theory has been advocated as an appreciate model of exchange rate determination

for the long-run exchange rate theories. The concept of Purchasing power parity (PPP) is

linked to what we call it the law of one price The purchasing power parity, has its original

date back to nine teeth – century – by David Ricardo. The basic concept underlying PPP

theory is that arbitrary forces will lead to the equalization of goods prices internationally

once the price of goods are measured in the same currency. As such this chapter presents the

theory of PPP and the application of the “law of one price “. It also summarizes some of the

problems associated with the concept and with the measurements of PPP.

CHAPTER CONTENT

2.0. Objective

2.1. The law of one price and purchasing power parity

2.1.1. Absolute purchasing power parity



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2.1.2. Relative purchasing power parity

2.2. The Generalized version of purchasing power parity

2.3. Measurement problems and poor performance of the

theory of PPP.

2.4. Summary

2.5. Review Question

2.0. OBJECTIVE

At the end of this chapter the reader will be able to.

• Explain the law of one price and the concept of purchasing power parity. • Explain the difference between the absolute and relative purchasing power

parities.

• Understand generalized version of the purchasing power parity.

• Explain the reason why the theory of purchasing power parities perform poorly in

the real world condition

• Explain the problem of measuring purchasing power parity

2.1 THE LAW OF ONE PRICE

The law of one price state that in the presence of a competitive market structure and the

absence of transport costs and other barriers to trade, identical products which are sold in

different markets will be sold at the same price when expressed in terms of a common

currency . The law of one price is based up on the idea of perfect goods arbitrage.

Arbitrage occurs when economic agents exploit price differences to provide a risk less profit.

Examples

If a car costs $20,000 in US and the identical model costs birr 180,000 in Ethiopia, then

according to the law of one price the exchange rat should be 180,000/ 20,000, which is birr

9/USD.



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Suppose the actual exchange rate were higher than this at birr 9.20 /USD, then it would pay

US citizens to buy a car in Ethiopia, because with 19565 USD he can buy a car

(1800,000/9.20) by doing so he will save 435 USD compared to purchasing the car in the US

market.

According to the law of one price, US residents will exploit this arbitrage possibility and start

purchasing birr and selling dollars. Such a process will continue until the birr appreciates to

birr 9/USD at which point arbitrage profit opportunities are eliminated.

Conversely, if the exchange rate is birr 8.50/USD then US car cost the Ethiopian residents

21176 USD if he purchases the car in Ethiopia. But if he purchases in US the Ethiopian

resident may save 1176 USD. Thus, Ethiopian residents will purchase dollar and sell birr

until the dollar appreciates and exchange rate becomes 9 birr/USD.

The proponents of PPP argue that the exchange rate must adjust to ensure that the law of one

price which applies, to individual good, also holds internationally for identical bundles of

goods.

Purchasing power parity (PPP) theory comes in two forms on the basis of strict interpretation

of the law of one price

Absolute purchasing parity

Relative purchasing power parity

2.1.1. ABSOLUTE PURCHASING POWER PARITY (PPP)

This is a strict form of interpretation of the law of one price. In this approach, if one takes a

bundle of goods in one country and compares the price of that bundle with an identical

bundle of goods sold in a foreign country converted by the exchange into a common currency

measurement, then the price will be equal.



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For example, if a bundle of goods costs birr 20 in Ethiopian and the same bundle costs $2 in

the US, then the exchange rate defined as birr per dollar will be 20 birr/2 USD = birr

10/USD . Algebraically, the absolute version of PPP can expressed as

* pS

p=

Where,

• S represents the exchange rate defined by domestic currency units (birr) per unit of

foreign Currency (USD)

• P – is the price of bundles of goods expressed in the domestic currency ( price in

birr)

• P*- is the price of identical bundle of goods expressed in the foreign currency (USD).

According to the absolute PPP a rise in the home price level relative to the foreign price

level will lead to a proportional depreciation of the home currency against the foreign

currency.

In the above example, if the price of Ethiopian bundle of goods rise say to 21 birr while the

price of the same bundle remain unchanged , that is $ 2 then the birr will depreciate to birr

10.5 / USD ( 21/2).

2.1.2. RELATIVE PURCHASING POWER PARITY (PPP)

Many economist are some how skeptical as to the application of the absolute version of PPP,

According to them the absolute version of PPP is unlikely to hold precisely because of the

existence of transportation cost, imperfect information and the distorting effect of tariffs and

other forms of protectionism.

However, it is argued that a weaker form of PPP known as relative PPP can hold even in the

presents of such distortions

In other words, the relative version of the theory of PPP argues that the exchange rate will

adjust by the amount of the inflation differentials between two economies. This can be

expressed as follows

% %S p∆ = ∆ − ∆ * p



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Where,

% s∆ − The percentage change in the exchange rate

% p∆ − The percentage change in the domestic inflation rates

% ∆ P* The percentage change in the foreign inflation rate

According to the relative version of PPP, if the inflation rate in the US is 10 percent that of

Ethiopia is 5 percent, the birr per dollar exchange rate should be expected to appreciate by

the approximately 5 percent .

The absolute version of PPP does not have to hold for this to be the case. For example, the

exchange rate may be birr 10/ USD while the Ethiopia bundle of goods costs birr 120 and the

US bundle of identical goods cost, USC 10 so that absolute PPP to hold it would require

(120

12 / )10

US = . But if Eth price goes up 10 percent to birr 132 and the US bundle of goods

goes up 5 Percent to 10.5 USD, the relative version of PPP predicts the birr will deprecate by

5% to birr 10.5 /USD.

2.2. THE GENERALIZED VERSION OF PPP

One of the major problems with PPP is that it is supposed to hold for all types of goods.

However, a more generalized version of PPP provides some useful insights and makes

distinction among goods traded. According to general version of PPP goods can be

categorized into traded goods and non-traded goods.

Traded goods:- These are goods which are susceptible to international competition. Here

belongs most manufacturing goods like.

• Automobile

• Electronics products and fuels and the like

Non traded goods:- are those that can not be traded internationally at a profit. Their price

will not be affected by the international competition. These includes different goods and

services like



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Hair cut (hair dressing)

Restaurant food service

Houses

Etc

The distinction between them is due to the fact that the price of traded goods will tend to be

kept in line with the international competition, while the price of non-traded goods will be

determined predominantly by domestic supply and demand considerations.

For instant, if a car costs 15,000 Pound in the UK and $ 30,000 in US arbitrage will tend to

keep the pound-dollar rates at 2 USD/Pound.

However, arbitrage forces do not play a role in the case of house trade. Similarly, if a hair-cut

cost birr 10 in Ethiopia but $10 in US and the exchange rate is birr 10/USD,

No one in the US will travel to the Ethiopia for a haircut knowing that they can save $9

because of the time and transport costs involved.

When aggregate price-indices is determined both tradable and non-tradable are considered.

Assuming that PPP holds for tradable we have the following locations.

*T T p sp=

Where,

• T p − price of traded goods in the domestic country measured in terms of the domesticcurrency

• the price of traded goods in the foreign country measured in-terms of the foreign

currency.

*

T p −

• S - The exchange rate defined as domestic currency units per unit of foreigncurrency.

The aggregate price index ( ) I p for the domestic economy is made up of a weighted average

of the price of both tradable ( )T p and non-tradable goods ( priced in the domestic

currency. Likewise, the foreign aggregate price index ( is made up of a weighted

average of the prices on tradable ( priced in the foreign currency. This is shown as

), N P

( *), I p*) N P

...............(1 ) (1) I T p N pPα α = + −

Where, α is the proportion of non-traded goods in the domestic price index



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* *

* (1 ) .........(2) I T

p PN P β β = + −

Where, β is the proportion of non-traded goods in the foreign price index.

Dividing equation (1) and (2) we obtain

* *

*

(1 )

(1 ) I T

I T

P PN P

P PN P

α α

β β

+ −=

+ −

If we divide the numerator by and the denominator by which because of the

assumption of PPP for tradable goods are equivalent expression, we obtain

T p *T SP

* * *

( / ) (1 )......(3)

( / ) (1 ) N T I

I N T

P PPS

P P P

α α

β β

⎡ ⎤+ −= ⎢ ⎥

+ −⎢ ⎥⎣ ⎦

This can be rearranged, to give the solution for the exchange rate as

* *

*

( / ) (1 )........(4)

( / ) (1 N I I

I N T

P PPS

P P P

β β

α α

+ −⎡ ⎤= ⎢ ⎥

+ −⎣ ⎦

The above equation is an important modification to the initial PPP equation. This is because

PPP no longer necessary holds in terms of aggregate price indices due to the terms on the

right hand side. Further more, the equation suggests that the relative price of non –tradable

relative to tradable will influence the exchange-rate.

Testing for PPP using price indices based on tradable goods prices is likely to lead to better

results than when using aggregate price indices made up of both types of goods.

2.3. MEASUREMENT PROBLEMS AND POOR PERFORMANCE OF

THE THEORY OF PPP

Many of the proponents of PPP argued prior the adoption of floating exchange rate changes

would be in line with those predicted by the theory of PPP.



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However, there are problems faced when it is applied practically. One of such problems is

that, whether the theory is applicable to both traded and non-traded goods.

At the beginning PPP seems readily applicable to traded goods. However, some people

argued that the distinction between tradable and non tradable is fuzzy, because in most cases

they are linked to each other. Moreover tradable goods are used as input into the production

of non-tradable goods.

Money researchers have tried to test whether PPP can be used to predict exchange rate or not.

They used graphical evidence, simplistic data analysis and more sophisticated econometric

evidences and the results are summarized as follows.

• PPP performs better for countries that are geographically close to one another

and where trade linkages are high• Exchange rates have been much volatile than the corresponding national prices

level. This is against the PPP hypothesis in which exchange rates are only

expected to be as volatile as relative price.

• PPP holds better in the long-run than in the short-run.

• The currencies of countries with very high inflation rates relative to their trading

partners, mostly likely would experience depreciation reflecting their high

inflation rate. This suggests that PPP is the dominant force in determining their

exchange rate.

• Overall , PPP holds better for traded goods than non-traded goods

• Strikingly, it was observed that the price of non-traded goods tends to be more

expensive in rich countries than in poor countries once they are converted into a

common currency.

There have been many explanation put forward to explain the reasons for poor performance

of the theory of purchasing power parity. Some of these reasons are,

• Statistical Problem,

• Transport Costs and Trade Impediment

• Imperfect competition

• Difference Between capital and goods markets.



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• Productivity Differentials.

Statistical Problems

The theory PPP is based on the concept of comparing identical baskets of goods in two

economies. The problem facing researchers is that different countries usually attach different

weight to various categories of goods and services when constructing their price indices. This

factor is very significant when testing for PPP between developing and developed nations.

People in developing countries usually spend a high proportion of their income on basic

goods like food and clothing, while these take up a much smaller proportion of people’s

expenditure in developed economies.

Transportation Cost and Trade Impediments

Studies by Frenkel (1981) showed that PPP holds better when the countries are

geographically close and trade linkage are high, can partly be explained by transport costs

and the existence of other trade barrier such as tariff.

For example, if a bundle of good costs birr 100 in Ethiopia and $ 10 in US then the PPP

suggests that the exchange rate would be birr 10/USD. If transport costs are birr 20 then theexchange rate would be between birr 12/USD and birr 8/USD. Without bringing arbitrage

forces in to play. However, since transportation costs and trade barriers do not change

dramatically over time they are not sufficient reason for the failure of the relative version of

PPP .

Imperfect Competition

The main idea behind PPP is that there is sufficient international competition to prevent

major departure of the prices of goods among countries. However, it is know that there areconsiderable variations in the degree of competition internationally. In fact these conditions

are necessary for successful price determination.

Difference between Capital and Goods Market



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Purchasing power parity is based on the concept of goods arbitrage and has nothing to say

about the role of capital movement. Rudiger D. (1976) hypothesized that in a world where

capital market are highly integrated and goods markets exhibit slow price adjustment., there

can be substantial prolonged deviation of the exchange rate from PPP.

The basic idea is that in the short-run good price in both home and foreign country can be

considered as fixed , while the exchange rate adjusts quickly to new information and change

in economic policy , This is the case being exchange rate changes represent deviation from

PPP which can be quite substantial and prolonged .

Productivity Differentials

The other striking result obtained is that when prices of similar basket of both traded and

non-traded goods are converted in to a common currency, the aggregate price indices tend to

be higher in rich countries than in poor countries. In other words, a dollar buys more goods in

say, Ethiopia than in US. The over all higher prices in rich countries is mainly due to the fact

that non-tradable goods prices are higher in developed than in developing countries.

An explanation for the lower relative price of non-tradable in poor countries is due to their

lower labor productivity between developing and developed countries. In other words higher price of non-traded goods in developed countries is mainly due to their higher labor

productivity in the traded sector as compared to developing countries.

2.4. SUMMARY

When major country abandon fixed exchange rate regime and adopt floating exchange rate, it

was widely believed that the exchange rate would adjust in line with change in national price

levels as provided by PPP theory.

The basic concept underlying PPP theory is that arbitrage forces will lead to the equalization

of goods prices internationally once the price of goods are measured in the same currency.



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As such the theory represents the application of the law of one price. According to this law in

the presence of a competitive market structure and the absence of transport costs and other

barrier to trade, identical products which are sold in different market will be sold at the same

price when expressed in terms of a common currency.

Purchasing Power Parity theory comes in two forms, relative and absolute PPP. Absolute

purchasing power parity holds that if one takes a bundle of goods in one country and

compare the price of that bundle with an identical bundle of goods sold in a foreign country

and converted into common currency, then the price will be the same (equal) Relative PPP

which is a weaker form of PPP state that the exchange rate will adjust by the amount of the

inflation differential between two counties.

One of the major problems with PPP theory is that it is suggested to hold for all types of

goods. However, the more general version of PPP makes distinction between traded and non-

tradable goods. By considering these two types of goods the generalized version. suggests to

use the aggregate price index to estimate the exchange rate, tend to be higher in rich

countries than in poor countries. In other words, a dollar buys more goods say, in Ethiopia

than in US. The over all higher prices index in rich countries is mainly due to the fact that

non-tradable goods prices are higher in developed than in developing countries. An

explanation for the lower relative price of non-tradable goods in poor countries is due to their

labor productivity between developing and developed countries.

In other words higher price of non-traded goods in developed countries is mainly due to their

higher labor productivity in the traded sector compared to developing countries

2.5. REVIEW QUESTIONS

1. Explain the concept of the law of one price.

2. Explain the essence of Absolute purchasing power parity using appropriate example.

3. Suppose one kilogram of coffee costs birr 10 in Ethiopia, 40 shillings in Kenya,

determine the exchange rate defined as birr per Kenyan shelling using Absolute

purchasing power approach .

4. Explain how Relative purchasing power parity differs from Absolute purchasing power



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Parity!

5. What are traded goods?

6. Explain the importance of traded goods in determining exchange rate.

7. What are problems faced when purchasing power party theory is applied practically.

8. List some of the empirical test results concerning the applicability of PPP to predict

exchange rates.

9. The poor performance of purchasing power parity in predicting exchange rate has been

explained by many factors. Explain them.

CHAPTER III

BALANCE OF PAYMENT AND NATIONAL INCOME

ACCOUNT



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INTRODUCTION

The Balance of payment accounts are an integral part of the national income account for an

open economy. Balance of payment is one of the most important economic indicators for

policy-makers in the open economy. The balance of payment (BP) records all transactions

among residents of different counties are broadly interpreted as all individuals, business, and

governments and their agencies, international organizations are also included as well.

What is happening to a country’s balance of payment often captures the news headlines and

can become the focus of attention particularly in most industrialized countries. A good or a

best set of figures can have an effect on the exchange rate and can lead policy-makers tochange their economic policy. BP deficit may lead to the government raising interest rater or

reducing public expenditure to reduce expenditure on imports. Deficit may also lead to

protectionism against foreign imports or capital controls to defend the exchange rate.

Before, considering various policy options to deal with the perceived problems in the balance

of payments, we need to consider what the balance of payment figure are and what is meant

by the notion of a surplus or deficit. This chapter will try to look at the components of

balance of payment, how they are compiled and interpretation of different statistical figures.

CHAPTER CONTENT

3.0. Objective

3.1. What is Balance of Payment?

3.2. Balance of payment Account

3.2.1. The Current Account Balance



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The balance of payment is one of the most important statistical statements for any country. It

reveals how many goods and services the country has been exporting and importing and

whether the country has been borrowing or lending money to the rest of the world. In

addition, whether or not, the monetary authority ( National Bank ) has added to or reduced

its reserves of foreign currency is reported in the statistics. It is important to note that

citizenship and residency are not necessarily the same from the view point of the balance of

payments statistics.

Thus, a key definition that needs to be resolved at the outset is that a domestic and foreign

residents.

The term residents refers to individuals, house holds, firms and the public authorities. The

problem arising from the definition of residents is those multinational corporations are by

definition resident in more than one country.

For the purpose of balance of payment reporting, the subsidiaries of a multinationals are

treated as being residents in the country in which they are located even if their share are

actually owned by foreign residents. Another distinction regarding the treatment of

international organizations such us, the International Monetary Fund, the World Bank,

United Nations and the like, these institutions are treated as being foreign residents even

though they may actually be located in the reporting country. Tourists are regarded as being

foreign residents if they are in the reporting country for at less than a year.

Collection, Reporting of the Balance of Payment

The balance of payments statistics record all of the transaction between domestic and foreign

residents, be they purchases or sales of goods, services or of financial assets such as bonds,

equities and banking transactions.

Reporting figures are usually in terms of the domestic currency of the reporting country. The

authorities collect their information from the custom authorities, survey of tourist numbers

and expenditure, and data on capital in-flow outflow is obtained from banks, pension funds,



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multinationals and investments houses. The responses from different sources are compiled by

government statistical agencies.

3.2. BALANCE OF PAYMENT ACCOUNTING

An important point about balance of payment statistics is that in an accounting sense they

always balance. This is because they are based up on the principle of double-entry book-

keeping. Each transaction between domestic and foreign residents has two sides to it, a

receipt and payment, and both these sides are recorded in the balance of payment statistics.

Each receipt of currency from residents of the rest of the world is recorded as a credit item

(carries a plus in the account) while each payment to residents of the rest of the world is

recorded as a debt item (carries a minus in the accounts).

Components of Balance of Payment

Before considering some examples of how different types of economic translations between

domestic and foreign residents get recorded in the balance of payment, we need to consider

the various sub-accounts (components) that make up the balance of payment.

Traditionally, the statistics are divided into two main sections, the current account and the

capital account. Each of them can be further subdivided. The explanation for division into

these two main parts is that the current account refers to income flows, while the capital

account records change in the assets and liabilities.

Example of a simplified annual balance of payment for Europe as a whole is presented in

table 3.1

Table 3.1. Balance of payment of Euro land

Current Account

1. Export of goods +150

2. Import of goods - 200

3. Trade balance - 50 (1+2)

4. Export of services + 120



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5. Import of services - 160

6. Interest, profit and Dividend received + 10

7. Interest, profit and dividend paid -10

8. Unilateral receipts +30

9. Unilateral payment -20

10. Current Account balance -70 (sum 3-9)

Capital Account

11. Investment abroad -30

12. Short –term lending -60

13. Medium and long –term lending -80

14. Repayment of borrowing than Row -70

15. Inward foreign investment +170

16. Short-term borrowing +40

17. Medium and long-term borrowing +30

18. Repayment on loans received from Rest of the world +50

19. Capital Account Balance +50 (sum (11-18)

20. Statistical Error +5 (zero minus (10+19+24)21. Official settlement balance -15 (10 + 19+ 20)

22. Change in reserves rise (-) fall (+) -10

23. IMF borrowing from (+) repayment to (-) -5

24. Official financial balance +15 (22+23)

The Trade balance

The trade balance some time referred to as the visible balance because it represents the

difference between receipts from export of goods and expenditure on imports of goods which

can be visibly seen crossing frontiers.

The receipts for exports are recorded as a credit in the balance of payment, while the

payment for import is recorded as a debit. When the trade balance is in surplus this meant



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that a country has earned more from its exports of goods than in has paid for its imports of

goods.

3.2.1 THE CURRENT ACCOUNT BALANCE

The current account balance is the sum of visible trade balance and the invisible balance. The

invisible balance shows the difference between revenue received from export of services and

payment made for imports of services such as

• Shopping,

• Tourism

• Insurance and Banking

• Transport

In addition receipts and payments of interest, dividends and profits are recorded in the

invisible balance as they represent the rewards for investment in overseas companies, bonds

and equities. Payment represents the reward to foreign residents for their investment in the

domestic economy.

From table 3.1 we can observe an item called unilateral transfers included in the invisible

balance. These are payment or receipts for which there is no corresponding transaction or

activity. Examples of such transactions are migrant workers’ remittances to their family back

home, the payment of pensions to foreign residents, and foreign aid. Such receipts and

payments represent a redistribution of income between domestic and foreign residents. A

unilateral payment can be considered as a fall in domestic income due to payment to

foreigners and so are recorded as a debit, while unilateral receipts can be viewed as an

increase in income due to receipts from foreigner and consequently are recorded as credit .

3.2.2. THE CAPITAL ACCOUNT BALANCE

The capital account records transactions concerning the movement of financial capital into

and out of the country. Capital comes into the country by borrowing, sales of foreign assets



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and investment in the country by foreigners. These items are referred to as capital in flows

and are recorded as credit items in the balance of payment.

Capital inflows are a decrease in the country’s holding of foreign assets or increase in

liabilities of to foreigners. Usually capital inflows are recorded as credit in the balance of

payment - it presents some confusion to many readers.

The easiest way to minimize this problem is that to think of investment by foreigners as

export of equity or bonds and sales of foreign investment as an export of those investments to

foreigners.

Capital leaves the country due to lending, buying of overseas asset, and purchase of domestic

assets owned by foreign residents. These items are recorded as debits as they are represent

the purchase of foreign bonds or equities, and the purchase of investment in the foreign

country.

Items in the capital account are normally classified on the basis of their origin as private or

public sector. On the basis of the time period the capital account items are classified as

short-term or long-term capital items. The summation of the capital inflows and outflows are

recorded in the capital account gives the capital account balance.

3.2.3 OFFICIAL SETTLEMENTS BALANCE

Due to huge statistical problems involved in compiling the balance –of – payment statistics,

there will be a discrepancy between the sums of all the items recorded in the account. To

ensure that the credits and debits are equal, it is necessary to incorporate a statistical

discrepancy for any difference between the sum of credit and debits.



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There are different sources of such error. One of the most important is that it is impossible to

keep record of all the transactions between domestic and foreign residents, many of the

reported statistics are based on sample estimate derived from separate sources; as a result

some errors are unavoidable. Another problem is that due to the desire to avoid taxes some of

the transactions in the capital account are under reported. Moreover, some dishonest firms

may deliberately under invoice their exports and over invoice their imports to artificially

deflate their profit.

The balance of payments records receipts and payments for a transaction between domestic

and foreign countries, but most of the time goods are imported but the payment delayed.

Since the import is recorded by the customs authority and the payment by banks, the time

discrepancy may mean that the two sides of the transaction are not recorded in the same setof figure.

The summation of the current balance, capital account balance, and the statistical discrepancy

gives the official settlements balance. The balance on this account is important because it

shows the money available for adding to the country’s official reserves or paying off the

country’s official borrowing. The central bank normally holds a stock of reserves made up of

foreign currency assets like different government Treasury-Bills (T-bills).

Such reserves are held primarily to enable the central bank to purchase its currency in order

to prevent the depreciation of its currency.

Any official settlements deficit has to be covered by the authorities drawing on their reserves,

or borrowing money from foreign central banks or from the IMF (recorded as plus in the

account).

If, on the other hand, there is an official settlement surplus then this can be reflected by the

government increasing official reserves or repaying debts to the IMF or other sources (a

minus since money leaves the country).

Reserve increases are recorded as a minus, while reserve fall are recorded as a plus in the

balance of payment statistics. Such recording is a source of confusion for many students. For

better understanding we can think that reserves increase when the authorities purchase

foreign currency.



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3.3. RECORD OF TRANSACTIONS IN THE BALANCE OF PAYMENT

To understand exactly why the sum of credits and debits in the balance of payment should

sum to zero we consider some examples of economic trisections between domestic and

foreign countries

There are basically five types of such transactions that can take place. These are

i. Exchange of goods/services in reform for a financial asset.

ii. An exchange of goods/services in return for other goods/ services

iii. An exchange of a financial item in reform for a financial item

iv. A Transfer of goods or services with no corresponding transaction (aid (frod or

military) )

v. A unilateral transfer of financial asset with no corresponding transaction.

Let us look at how each transaction is recorded twice once as a credit and once as a debit.

Consider the case of different types of trisections between two countries, USA and UK

residents and table 3.2 shows how each transaction is recorded in each of the two countries

balance of payment. The exchange rate between these two countries at the time of transaction

was $ 1.60 /pound. Since each credit in the accounts has a corresponding debit elsewhere, the

sum of all items should be equal to zero.

This by itself raises the question as to what is means by a balance of payments deficit or

surplus.

Table 3.2 Example of balance of payment account as provided by Pilbeam (1998)

US balance of payment UK balance of payment

Current Account Current Account

Export of goods + 80 m Import of goods -50m

Capital Account

Reduced US bank liability – 80 m



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Example 2 :- The US exports $ 1000 of goods to the UK in exchange for $1000 of services

US Balance of payment UK Balance of payment

Current account Current Account

Export of goods +$ 1000 Import of goods -£ 625

Import of services -$ 1000 Export of services +£ 625

Example 3:- A US investor decides to buy £ 500 of UK T- bills and to pay for them by

debiting his US bank account and crediting the account of the UK T-bill held

in New York

US balance of payment UK balance of payment

Capital Account Capital Account

Increase in UK T-bills holding - $ 800 - Increase UK liability + £ 500 US

Increase in US liability +$ 800 resident

- Increase in US T-bill holdings - £ 500

Example 4- The US makes gift of $ 1.6 million of goods to a UK charitable organization

US balance of payment UK balance of paymentUS Current Account UK Current Account

Export + $ 1.6 million Import -£ 1 million

Unilateral Transfer -$1.6 million Unilateral receipt + £1 million

Example 5:- The US pays interest, profit and dividend to UK investor of $ 80 million by

debiting US bank account which are then credited to UK resident bank

account held in US

US balance of payment UK current account

Current Account Current Account

Interest, profit, dividend Interest, profit, dividend

Paid -$ 80 m receipts + £ 50m



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US Capital account UK Capital account

Increased US bank liability + 80 m Increased US bank deposit -£ 50m

3.4. WHAT IS A BALANCE OF PAYMENT SURPLUS OR DEFICIT?

As we have seen in table 3.2, the balance of payment always balances, since each credit in

the account has a corresponding debit. However, this does not mean that each of the

individual accounts that make-up the balance of payment is necessarily in balance. For

instance the current account can be in surplus while the capital account is in deficit.

Economist make a distinction between autonomous (above line item) and accommodating

(below the line) items. The autonomous items are transactions that take place independently

of the balance of payments. While accommodating items are those transactions which

finance any difference between autonomous receipts or payment.

Surplus in the balance of payment is defined as excess of autonomous receipts over

autonomous payment. The deficit is an excess of autonomous payment over autonomous

receipts. That is,

• Autonomous receipts > Autonomous payment = Surplus

• Autonomous receipts < autonomous payment = Deficit

The major issues raised here is that which items are categorized in autonomous and which

one in a commendation items. There is no agreement among economists as to the

c

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