MGEC61 International Economics: Finance

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1 MGEC61 International Economics: Finance Introduction International finance is a study of problems and policies of an open economy. International finance studies the issues like unemployment, savings, trade imbalances, money and price levels (include exchange rates). Organization of the course 1) Introduction chapter 13 2) Interest rate parity (how exchange rate is determined by the flows of capital) and exchange rate overshooting chapters 14 & 15 3) Purchasing power parity and the exchange rate in the long run (how exchange rate is determined by the flows of goods and the determinants of exchange rate in the long run) chapter 16 4) The DD-AA model (the model that explains how exchange rate and output are determined in general equilibrium setting) chapters 17 &18 Flexible exchange rate chapter 17 Fixed exchange rate chapter 18 5) International macroeconomic policy chapters 19 & 21 Arguments for and against flexible exchange rates chapter 19 Interdependence of macroeconomic policies chapter 19 Arguments for and against common currency chapter 21 MGEC61 Chapter 13 Iris Au 1

2 Chapter 13: National Income Accounting and the Balance of Payments The National Income Identity for an Open Economy The national income identity for an open economy is: Output (Y) = C + I + G + (EX IM) A country s current account (CA) balance shows the difference between exports of goods and services and imports of goods and services (including net income on foreign investments), plus net unilateral transfer. CA = EX IM + Net unilateral transfer Foreign aid received Foreign aid gave out If net unilateral transfer = zero, CA = EX IM, then: Y = C + I + G + CA Saving and the Current Account National saving (S): the amount of output that is not devoted to private consumption and government spending, i.e., S = Y C(Y T) G. For an open economy, national saving does not need to equal to investment. An open economy can save either by building up its capital stock (increase in I) or by running a CA surplus (acquire foreign wealth). MGEC61 Chapter 13 Iris Au 2

3 Example: Suppose the country runs a CA surplus, CA > 0: Exports of goods and services > Imports of goods and services. Export revenues earned > Import payments made. The Balance of Payments Accounts (BOP Accounts) The balance of payments (BOP) accounts record a country s international transactions with the rest of the world in a given time period. The BOP accounts record a country s payments to and its receipts from foreigners. The BOP accounts also show the sources of demand and supply of a country s currency in the foreign exchange market. The BOP accounting uses the system of double-entry bookkeeping: every international transaction automatically enters the BOP accounts twice, once as a credit and once as a debit. It is because if we buy something from a foreigner, we must pay him/her in some way, and the foreigner must then spend or store our payment, and vice versa. Credit entry: any transaction resulting in a receipt from foreigners. Examples include exports of goods, services, or assets. Debit entry: any transaction resulting in a payment to foreigners Examples include imports of goods, services, or assets. MGEC61 Chapter 13 Iris Au 3

4 Components of BOP Accounts BOP accounts Current Account Financial Account Capital Account (CA) (KA) Non-Reserve portion of KA, KA non-res Reserve portion of KA, ORT Definitions: Current account (CA): the difference between exports of goods and services and imports of goods and services (including net income on foreign investments), plus net unilateral transfer. Financial account (KA): the difference between sales of assets to foreigners and purchases of assets from abroad. Capital account: the transfers of wealth between countries. It usually arises from non-market activities such as changes in ownership of existing assets, represents the acquisition or disposal of non-produced, non-financial, and possibly intangible assets. MGEC61 Chapter 13 Iris Au 4

5 The Financial Account (KA) The financial account consists of 2 portions (KA = KA non-res + ORT): 1) The non-reserve portion (KA non-res ) the purchases and sales of assets by the private sector (households and firms). 2) The reserve portion (ORT) the purchases and sales of foreign assets by the country s monetary authority. The financial account records movement of financial capital across national borders. When foreigners purchase assets from us: When we purchase assets from foreigners: Note: Change in a country s net foreign wealth = KA When a country runs a KA deficit (KA < 0), the exports of assets < the imports of assets the country is a net importer of assets holding of foreign assets. MGEC61 Chapter 13 Iris Au 5

6 Reserve Portion of KA Official Reserve Transactions (ORT) Official reserves//foreign exchange reserves: foreign-currency denominated assets (foreign assets) held by central banks, examples include foreign currencies, government bonds issued by foreign governments. Central bank holds official reserves as means to affect the economy. How? Note: The stock of official reserves plays a crucial role for country that has a fixed exchange rate regime since the central bank uses official reserves to maintain the fixed exchange rate. If the central bank runs out of official reserves, the country may experience a currency crisis. Examples include England in the early 1992, Mexico in 1994, the Asian countries in 1997, Brazil and Russia in 1997, and Argentina in The Fundamental Balance of Payments Identity Owing to the double-entry bookkeeping in the BOP accounts, the sum of all items that enter the BOP accounts must sum up to zero. The BOP identity: CA + KA + Capital account + statistical discrepancy = 0 CA + KA non-res + ORT + Capital account = 0 CA + KA non-res + Capital account = ORT Net exports of goods, services and assets, excluding transactions carried by the central bank MGEC61 Chapter 13 Iris Au 6

7 Example: If a country runs a balance-of-payments deficit (BOP < 0). Question: What happens to the country s exchange rate? Answer: BOP < 0 implies (CA + KA non-res + Capital account) < 0 In the absence of central bank s international transactions, exports of goods, services and assets < imports of goods, services and assets. Question: What happens to the country s stock of official reserves? Answer: BOP identity: BOP = ORT MGEC61 Chapter 13 Iris Au 7

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