Exchange Rates and Balance of Payment

Why do we need foreign currencies?

 Purchasing materials in foreign countries
 Travelling
 Investment
 Remittances to relatives or friends
Exchange rate
 The price at which two currencies are exchanged
 The price of a foreign currency in terms of the local currency, or vice versa
 Convertibility rate
Foreign exchange rate between two currencies is determined by supply and demand
established in the foreign exchange market consisting of a network of foreign exchange
dealers

What Determines Foreign Exchange Rates

 Imports of a country give rise to a demand for foreign exchange and a supply of the
domestic currency
 Exports result in a supply of foreign exchange and a demand for the domestic currency.
Therefore, trade of the U.S. will be a primary contributor to the demand and supply of dollars
and foreign currency
Why Do Exchange Rates Fluctuate
The exchange rate between the domestic currency and other major currencies varies
considerably over time

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Anything that causes the demand or supply in the foreign exchange market to shift will
change the equilibrium exchange rate
 U.S. residents buying more or less foreign goods will shift the demand curve for foreign
currency
 Changes in foreigner’s purchase of U.S. goods will shift the supply curve of foreign
currency

Factors that influence long-run supply and demand conditions

 Relative prices of U.S. versus foreign goods
 Relative increase in price of U.S. goods will encourage more imports
- Increase demand for foreign currency
- Tends to depreciate the value of the domestic currency or an appreciation of the
foreign currency
 Relative decrease in price of U.S. goods will result in an appreciation of the domestic
currency

 Productivity
 Increased productivity in U.S. will lower price of American goods
 Increased demand for U.S. goods internationally
 Increased supply of foreign currency will appreciate the value of the dollar while
foreign currency depreciates

 Tastes for U.S. versus foreign goods

 Increased tastes for U.S. goods
 Increased demand for U.S. goods and increased supply of foreign currency
 Dollar appreciates relative to foreign currency

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 International capital mobility
 Funds flow freely across international borders and investors can purchase U.S. or
foreign securities
 U.S. investors compare the expected return on domestic securities versus foreign
securities to determine which are the most attractive
 Therefore, changes in preferences of U.S. versus foreign securities will result in a
change in demand and supply of foreign currency and a change in the exchange rate
 In this case, expectations of future exchange rates play a central role in the decision
process.
 When considering investing in foreign securities to take advantage of a higher yield,
one must consider the expected movement of future exchange rates
 In order to invest in foreign securities, must first purchase foreign currency and
eventually re-purchase the domestic currency's to bring currency back to U.S.
 It is possible that a change in the future exchange rate willoffset any increased yield by
holding foreign securities
 In fact, the international mobility of capital will often cause the change in future
exchange rates that was anticipated—self-fulfilling prophesy

Exchange rate
Expression (assume USD and The Egyptian Pound)
The exchange rate of USD
US$ 1 can be converted into L.e 7.8
The Egyptian Pound/USD = 7.8 / 1 = 7.8
The exchange rate of The Egyptian Pound
USD/The Egyptian Pound = 1/7.8
 Appreciation: A rise in the exchange rate
 Depreciation: A fall in the exchange rate
Example:
1 USD = 25 L.E
1 USD = 30 L.E
- US Dollars Appreciates
- Egyptian Pound depreciates
Note that:
 There is only one exchange rate between two currencies.
 Appreciation of one currency = Depreciation of the other

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Key Factors that Affect Foreign Exchange Rates
1. Inflation Rates
 Prices shoot up when goods and services are scarce or money is in excess supply.
 If prices increase, it means the value of the currency has eroded and its purchasing power
has fallen.
 A fall in purchasing power due to inflation reduces consumption, hurting industries.
Imports also become costlier. Exporters, of course, earn more in terms of local currency.
2. Interest Rate
 Increases in interest rates cause a country's currency to appreciate because higher
interest rates provide higher rates to lenders, thereby attracting more foreign capital,
which causes a rise in exchange rates.
3. Country’s Current Account / Balance of Payments
 A country’s current account reflects balance of trade and earnings on foreign investment.
It consists of the total number of transactions including its exports, imports, debt, etc.
 A deficit in the current account due to spending more of its currency on importing
products than it is earning through sale of exports causes depreciation.
 Balance of payments fluctuates exchange rate of its domestic currency.
4. Government Debt
 Government debt is public debt or national debt owned by the central government.
 A country with government debt is less likely to acquire foreign capital, leading to
inflation.
 Foreign investors will sell their bonds in the open market if the market predicts
government debt within a certain country.
 As a result, a decrease in the value of its exchange rate will follow.
5. Terms of Trade
 Related to current accounts and balance of payments, it is the ratio of export prices to
import prices.
 A country's terms of trade improve if its exports prices rise at a greater rate than its
imports prices.
 This results in higher revenue, which causes a higher demand for the country's currency
and an increase in its currency's value. This results in an appreciation of exchange rate.
6. Political stability and Performance
 A country's political state and economic performance can affect its currency strength.
 A country with less risk for political turmoil is more attractive to foreign investors, as a
result, drawing investment away from other countries with more political and economic
stability.
 An increase in foreign capital, in turn, leads to an appreciation in the value of its domestic
currency.
 A country with sound financial and trade policy does not give any room for uncertainty in
value of its currency.
 But, a country prone to political confusion may see a depreciation in exchange rates.

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7. Recession
 When a country experiences a recession, its interest rates are likely to fall, decreasing its
chances to acquire foreign capital.
 As a result, its currency weakens in comparison to that of other countries, therefore
lowering the exchange rate.
8. Speculation
 If a country's currency value is expected to rise, investors will demand more of that
currency in order to make a profit in the near future.
 As a result, the value of the currency will rise due to the increase in demand. With this
increase in currency value comes a rise in the exchange rate as well.

Balance of Payments (BOP)

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Balance Of Payments: Theoretical Framework
BOP or Balance of International Payments is the systematic and summary record of a
country’s economic and financial transactions with the rest of the world over a period of time.

Balance of Payments
A summary of payments to foreigners for imports and receipts from foreigners for exports
1. Current Account—international transactions involving trade
2. Capital Account—international transactions involving financial assets
Deficit
 Paying out more abroad than we are taking in (imports > exports—trade deficit)
 Demand for foreign currency is greater than supply
 As a result, the price of foreign currency will rise—the foreign currency will appreciate
relative to the domestic currency and the domestic currency will depreciate
 Result in depreciation of the domestic currency
 Encourages exports and discourages imports
 Eventually the trade balance is in equilibrium at the new exchange rate
Surplus
 Receiving more from abroad than we are spending (exports > imports—trade surplus)
 This will result in an appreciation of the domestic currency and a depreciation of the
foreign currency
 Appreciation of the domestic currency
 Discourages exports and encourages imports
 The trade will be balanced at the new exchange rate
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When exchange rates freely react to supply and demand for foreign currency, a new
equilibrium exchange rate will tend to eliminate balance of payments and bring trade into
balance (exports = imports)
Nature of BOP accounting
- Follows double entry book keeping system.
- Each transaction has a debit and credit
- Has to balance (if not: errors & omissions entry)
Theoretically, the BOP should be zero, meaning that assets (credits) and liabilities (debits)
should balance. But in practice this is rarely the case and, thus, the BOP can tell the observer
if a country has a deficit or a surplus and from which part of the economy the discrepancies
are stemming.
All trades conducted by both the private and public sectors are accounted for in the BOP in
order to determine how much money is going in and out of a country
Usually, the Balance of Payments is calculated every quarter and every calendar year.
Debit and credit are the two fundamental aspects of every financial transaction in the
double-entry bookkeeping system in which every debit transaction must have a
corresponding credit transaction(s) and vice versa.
- Debit: an expense, or money paid out from an account. (-)
- Credit: is used to mean positive cash entries in an account. (+)

1. Current Account
The current account includes four components:
a. Trade in goods: visible account consists of physical items.
b. Trade in services: invisible account consists of transport, tourism and insurance etc.
c. Net Income flows: Income flows consist of wages, interest and profits flowing into and out
of the country.
d. Current transfers of money: Government contributions to and receipts from international
organizations and international transfers of money by private individuals and firms.
A deficit in the current account shows the country is spending more on foreign trade than it is
earning, and that it is borrowing capital from foreign sources to make up the deficit.
In other words, the country requires more foreign currency than it receives through sales of
exports, and it supplies more of its own currency than foreigners demand for its products.
The excess demand for foreign currency lowers the country's exchange rate until domestic
goods and services are cheap enough for foreigners, and foreign assets are too expensive to
generate sales for domestic interests.
A current account surplus occurs when the country’s exports are more than its imports. This is
a desirable condition, however it has its own problem associated with it.
A surplus in the long run will lead to the appreciation of the country’s currency which will
reduce its export competitiveness.

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Relatively stronger currency will induce people to go in for imported goods, thus harming the
domestic consumption and investment.
In the long run, it will harm the domestic industry and increase unemployment.
2. Capital Account
a. Capital transfers are transactions, either in cash or in kind, in which the ownership of an
asset (other than cash and inventories) is transferred from one institutional unit to
another, or in which cash is transferred to enable the recipient to acquire another asset, or
in which the funds realized by the disposal of another asset are transferred.
b. Non-financial assets are entities, over which ownership rights are enforced by institutional
units, individually or collectively, and from which economic benefits may be derived by
their owners by holding them, or using them over a period of time, that consist of tangible
assets, both produced and non-produced, and most intangible assets for which no
corresponding liabilities are recorded.
c. Non-produced assets are non-financial assets that come into existence other than through
processes of production; they include both tangible assets and intangible assets and also
include costs of ownership transfer on and major improvements to these assets.

3. Financial Account
a. Direct investment is a category of international investment made by a resident entity in
one economy (direct investor) with the objective of establishing a lasting interest in an
enterprise resident in an economy other than that of the investor (direct investment
enterprise).
b. Portfolio investment is the category of international investment that covers investment in
equity and debt securities, excluding any such instruments that are classified as direct
investment or reserve assets.
c. Reserve assets - capital held back from investment in order to meet probable or possible
demands

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Example:
Category Balance / billions of $

Imports of goods 550

Import of services 400

Export of goods 380

Export of services 550

Income -130

Current transfers 70

Direct investment 40

Portfolio investment -80

Capital transfer 90

Transaction in non-produces, non- -25

financial assets

Reserve assets ?

Balance of payments ?

Calculate the following balances:

 Current account
 Financial account
 Capital account
 Reserve assets
 Balance of payments
Does the country have a trade deficit or surplus?
Determine the amount needed for the reserve assets if any and explain why its either
positive or negative.

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Answer
Current account:
Current account balance =

Export of goods 380

Export of services 550

Import of goods 550

Import of services 400

Income balance -130

Current transfer 70

Current account balance = -$80 billion

Financial account:
Financial account balance =

Direct investment 40

Portfolio investment -80

Financial account balance = -$40 billion

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Capital account:
Capital account balance =

Capital transfers 90

Transaction in non-produces, non- financial assets -25

Capital account balance = $65 billion

Current account + financial account + capital account + change in reserve assets = 0,

therefore:
-80 + -40 + 65 + reserve assets = 55
Change in reserve assets is $55 billion.
Balance of payments = current account + financial account + capital account + change in
reserve assets
BOP = -80 + -40 + 65 + +55 = 0
The country has a trade deficit. It purchased more goods and services from the rest of the
world than the rest of the world bought of its goods and services.
The country’s reserve assets must have changed by $55 billion. This number is positive
because the country overall had a net deficit in its current, capital and financial accounts of
$55 billion, meaning that more money left the country for all its international transactions
than came into the country.
Factors influencing the balance of payments
1. Income: as national income rises the demand for imports rise shifting the current account
toward a deficit.
2. Changes in relative prices: as domestic prices rise relative to foreign prices, imports
appear cheaper and exports more expensive and the current account will move toward a
deficit.
3. Changes in relative investment prospects: as return on investment rises, foreign capital
will be attracted into the country and the capital account will move toward a surplus.
4. Changes in relative interest rates: as domestic interest rates rise, short term capital is
attracted moving the capital account toward a surplus.
5. Changes in exchange rates which alter the relative prices of imports and exports

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 a. If the foreign exchange rate is rising (domestic currency appreciating), the central bank
may intervene by selling more domestic currency.
b. If the foreign exchange rate is falling (domestic currency is depreciating), the central
bank may intervene by buying domestic currency with the reserve of foreign currency.
6. The impact of the level of economic activity in overseas markets on exports
7. The impact of the level of domestic economic activity on imports
8. Relative domestic and foreign rates of inflation
9. Changes in the pattern of comparative advantage and overseas competition

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