Chapter 3

The Balance of Payments and the

Effective Exchange Rate
 Objectives

• To study the structure of the balance of payments

• To illustrate how the BOP is related to the FX market
• To introduce the concept of the effective exchange
rate

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 Definition

• The balance of payments (BOP) is a systematic

record of all economic transactions between the
residents of the reporting country and the rest of the
world over a specified period of time.
• BOP records financial flows that affect financial
variables such as interest rates and exchange rates.
• Interest rates and exchange rate in turn affect BOP

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 Definition

• Countries trade multi-laterally more than bi-laterally

• BOP position is affected by the competitiveness of the
economy, and hence we consider real exchange rate
and not nominal rate.
• Position of the current account of the BOP can
indicate the ability of a country to service its debt.
• BOP statistics
4 Assist financial managers to form opinion about a
countries business environment (economic and
financial conditions, level of indebtedness, trade
balance, etc.)
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Balance of Payment Accounts

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 Important elements in the definition

• Rest of the world – international transactions

• Economic transactions – transaction involving
exchange of value
• Resident – definitions matter?
• Flows versus stocks
4 Flows – BOP records exports, imports and transfers
that occur over a reporting period (a month, a quarter
or a year)
4 Records changes in the holdings of assets and
liabilities and not their levels.
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Important elements in the definition (cont.)
• The BOP records changes in assets and liabilities -
flows
• Figures may or may not be seasonably adjusted
4 Seasonally unadjusted figures can obscure true
underlying trends
4 For example, rise in tourism receipts and air travel
during holiday season and decline otherwise.
Seasonally adjusting data will give clarity to the
overall trend.
4 Some methods are available to seasonally adjust
data (not covered in this course)

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 Structure of the BOP
• The BOP consists of the current account and the
financial account.

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Components of the current account – simple
structure
• Merchandise account (trade balance)
• Net services
• Current transfers

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The financial account
• Records official and non-official net financial flows
• A balancing item is added to account for errors and
omissions

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The Australian BOP: Current account
(AUD Million)
5000

-5000

-10000

-15000

-20000

-25000
Dec-72 Dec-78 Dec-84 Dec-90 Dec-96 Dec-02 Dec-08

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The Australian BOP: Financial account
(AUD Million)
20000

16000

12000

8000

4000

0
Dec-72 Dec-78 Dec-84 Dec-90 Dec-96 Dec-02 Dec-08

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The Australian BOP: Balancing item
(AUD Million)
2000

1500

1000

500

-500

-1000

-1500

-2000
Dec-72 Dec-78 Dec-84 Dec-90 Dec-96 Dec-02 Dec-08

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 The BOP and FX market

• The BOP is related to the FX market because

transactions involving trade and capital flows give
rise to the demand for and supply of currencies
• The demand for foreign currency is the supply of
domestic currency, and vice versa

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 Derivation of the demand and supply curves

• The demand for foreign exchange is equivalent to

import expenditure
• The demand curve is derived from the supply and
demand for imports

(cont.)
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 Derivation of the demand and supply curves
(cont.)
• The supply of foreign exchange is equivalent to
export revenue.
• The supply curve is derived from the supply of and
demand for exports.

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 The demand side equations
The following equations are used to derive the demand
curve:
Df  Pm*Qm Qm a  bPm Pm  SPm*
Where Df = demand for foreign exchange, P*m = price of import in
foreign country, Qm = quantity demand of the domestic country,
Pm = price of Qm in domestic currency; S = exchange rate
measured in direct quotation as the price of one unit of the foreign
currency. A lower S implies depreciation of foreign currency.

Read p.47 of previous chapter. S(x/y) = number of units of x per 1

unit of y. S implies appreciation of currency y (or depreciation of
currency x, domestic currency), and S implies depreciation of
currency y or appreciation of x, domestic currency
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 The supply side equations

The following equations are used to derive the supply

curve:

* Px
Sf Px* Qx Qx c  dPx Px 
S

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The demand for and supply of foreign
exchange curves

100.0

90.0

80.0

70.0

60.0

50.0

40.0
1.00 1.05 1.10 1.15 1.20 1.25 1.30 1.35 1.40 1.45 1.50 1.55 1.60

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 Factors affecting the current account
• Economic growth: A country with a higher growth
rate than its trading partners will experience
deterioration in the current account.?

• But why China, Japan, Singapore have current

account surplus?

(cont.)
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 Factors affecting the current account (cont.)
• The exchange rate: The effect of the exchange rate
depends on the elasticities of demand for exports
and imports.
4 i.e the responsiveness of the quantities of exports and
imports to changes in prices.

B * *
 Px Qx  *
PmQm    
Qm em Pm Q x e x Px
*

(cont.)
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 Factors affecting the current account (cont.)
• Inflation: A country that has a higher inflation rate than its
trading partners will experience deterioration in the current
account.
• Inflation erodes the competitive position of the current account
by making domestic good more expensive, and less
competitive in the foreign markets.
• Foreign and domestic inflation leads to higher and.
• If the domestic inflation rate is higher than the foreign inflation
rate, than rises faster than .
• Imported items can be cheaper in the domestic market relative
to domestic goods, and exports expensive, thus decline in
exports, and increase in imports, affecting the current account
balance.
• Also, the relative elasticity can worsen the current account balance?
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Improving current account
(zero domestic inflation)

50

40

30

20

10

0
1 2 3 4 5 6 7 8 9 10 11
-10

-20

-30

-40

-50

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Deteriorating current account
(high domestic inflation)
0
1 2 3 4 5 6 7 8 9 10 11

-40

-80

-120

-160

-200

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 Factors affecting the current account (cont.)

• Trade restrictions: One reason for imposing trade

restrictions, such as tariffs and quotas, is the desire
to protect the current account.
4 Tariffs are taxes on imports and quotas put restrictions
on quantities that can be imported.
• Can improve current account balance but …. ????
4 Trade war?
4 Violation of free-trade agreements

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 Factors affecting the financial/capital
account

• Taxes: Taxes that are imposed on capital gains

and/or income from dividends and interest payments
may adversely affect the financial account.
4 This is because foreign investors no longer find it
attractive to invest in the underlying country’s
securities.
4 Some governments impose taxes to discourage
borrowing by foreigners from the domestic market –
prevent capital outflows
4 Giving tax incentives to attract FDI.
(cont.)
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 Factors affecting the financial account (cont.)

• Capital controls: Capital controls are imposed

typically to deal with a chronic weakness in the
balance of payments.
4 Capital controls have been dismantled or reduced by
many countries, especially the developed economies
like the US, the UK since early 1980s.
4 To promote liberalization and deregulation of financial
system

(cont.)
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 Factors affecting the financial account (cont.)

• The expected change in the exchange rate:

4 If a currency is expected to appreciate, the expected
rate of return on investment in securities denominated
in that currency will be higher, attracting capital flows.

4 Thus, a country’s financial account will improve if that

country’s currency is expected to appreciate.

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 The effective exchange rate
• So far, we have considered only bilateral exchange rates,
unadjusted for changes in prices.
4 But trade occurs multilaterally.

• Real exchange rate can be computed by combining the

nominal exchange rate and the price variables.
4 Real exchange rate affects the competitiveness of the economy
and the current account.
4 The effective exchange rate is an index of a weighted average of
the nominal exchange rates against the currencies of major trading
partners.
4 Effective exchange rate captures multilateral trade gains and
loses.

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 The EER equations:

The following equations are used to calculate the EER:

m
Et = ∑ wiVi ,t Arithmetic approach
i =1
m
Et = Π (Vi ,t ) wi
i =1 Geometric approach
where is the weight assigned to Si,t
currency i and is the exchange rate Vi, t 
relative of currency i at time t such Si ,0
that (cont.)
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 The EER equations (cont.)

The following equations are used to calculate the

weights:
Xi Mi where is the value of
wi  m wi  m domestic exports to
 Xi 
Mi country i and is the
Tr i1
i1 value of imports from
we ad
ef ig e country i
ex fect hted
ra cha ive Xi  Mi
te ng wi  * wi
e m
w 
 Xi  Mi i m

i1  wi Normalized weights =

individual weights/sum
i 1 of weights
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 What does the RBA do in practice?
• The RBA calculates a nominal effective exchange
rate called the trade-weighted index (TWI).
4 Index is calculated on the basis of bilateral trade
shares of Australia’s major trading partners
4 Major trading partners are those accounting for at
least 90% of Australia’s trade (X+ M)
4 Weights re revised annually to account for changes in
the pattern of trade.

(cont.)
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The weights used by the RBA to calculate the
TWI
0 2 4 6 8 10 12 14 16 18

Japan
Euro Area
China
US
Korea
NZ
UK
Singapore
Malaysia
Taiwan
Thailand
India
Indonesia
Hong Kong
Vietnam
Canada
Saudi Arabia
South Africa
PNG
Sweden
UAE
Switzerland
Philippines

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The RBA’s trade-weighted index, January (1970
= 100)

140

120

100

80

60

40
May-70 May-75 May-80 May-85 May-90 May-95 May-00 May-05 May-10

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 The real exchange rate
• The real exchange rate is the nominal exchange rate
adjusted for differences in prices or inflation rates:
 Py 
Q ( x / y ) S ( x / y )  
 Px 
Where and are price levels of the countries whose currencies are y
and x, respectively
4 A rise in the real exchange rate, Q (real appreciation of y) results in
the nominal rate S (nominal appreciation of y), and/or rise in the
price level in country y, i.e.

4 Both a higher nominal exchange rate and a higher price level

erode the competitiveness of the economy.

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 The real effective exchange rate
• The real effective exchange rate can be calculated
from the real bilateral exchange rates:

m  Qi ,t 
Qt ∑ wi   Arithmetic approach
i 1  Qi ,0 
wi
m  Qi ,t 
Qt    Geometric approach
i 1
 Qi ,0 

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Example 3.1
• Let and . Initial level of exchange rate is . Since ,
• hence current account balance is:
• .
• (current account deficit)
• Note:

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Suppose S increases to 1.80,
and .
• Scenario 1: a low elasticity:
4 and
4 ,
4 and ; New and
• , and and
• This means new quantity is:
• i.e. 20%
• hence decreases to:
4 And

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Suppose S increases to 1.80, with and .
• Initially:
4 Let and . Initial level of exchange rate is . Since ,
4 hence current account balance is:
4 .
4 (current account deficit)
4 Note:
• Scenario 2: a high elasticity:

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Suppose S increases to 1.80, with and .
• and
4 ,
4 , and and
4 This means new quantity is:
4 i.e. 20%
• 30 hence
4 decreases to:

• And

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Continuing … lecture
• We will:
4 calculate Nominal Effective Exchange Rate
4 calculation of Appreciation/depreciation
4 calculation of normalized weights
4 calculation of Real exchange rate
4 Calculate real effective exchange rate

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 Example: Consider Australia with Major
Trading Partners
• Trade weights : Yen (0.1636), US dollar (0.1194) and
Euro (0.1308)
Exchange Rate Jan. 2007 Jan 2009 % change
JPY/USD 120.7 90.00

AUD/USD 1.2953 1.5533

EUR/USD 0.7672 0.7814

USD appreciated against AUD and EUR, and depreciated against JPY
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 Bilateral Exchange rate for AUD with respect to
major trading partners
Exchange Rate Jan. 2007 Jan 2009 % change Exchange
Rate
Relative
(difference
form base)
JPY/AUD= 120.7/1.2953= 90.00/1.5533
(JPY/USD)/ 93.18 = 57.94
(AUD/USD)

USD/AUD= 1/1.2953= 1/1.5533

1/(AUD/USD) 0.7720 =0.6438

EUR/AUD= 0.7672/1.2953 0.7814/1.5533

(EUR/USD)/ =0.5923 =0.5031
(AUD/USD)

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Calculating Normalized Weights

Exchange Rate Original Weight Normalized Weight

(given)
JPY/AUD 0.1636 =0.1636/0.4138
=0.3954
USD/AUD 0.1194 =0.1194/0.4138
=0.2886
EUR/AUD 0.1308 =0.1308/0.4138
=0.3160

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Calculating Effective Exchange Rate
• Recall: m
Et = ∑ wiVi ,t
i =1 Arithmetic approach
m
Et = Π (Vi ,t ) wi Geometric approach
i =1
• Arithmetic Approach: Since AUD has depreciated by 24.50
per cent (=100-75.49) in effective terms.

• Geometric Approach: AUD has depreciated by 25.30% in

effective terms

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 Calculating Real Exchange Rates
Price level measured by CPIs in Jan 2007 (base
period) and Jan 2009

Country Jan. 2007 Jan 2009 % change

Australia 121.18 133.06
Japan 97.59 98.13
United States 119.26 128.84
Europe 118.33 126.99

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Adjusting Price level since 2007 is base period
Country Jan. Jan 2009 Price Ratio
2007
Australia 100 --

Japan 100

United 100
States

Europe 100

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Slide 43: Nominal Exchange Rate with 2007 as base
period – Conversion to Real Exchange Rate
Exchange Jan. 2007 Jan. 2007 Jan 2009 Jan 2009 (Real) [Nominal
Rate (Nominal) (Real) (Nominal) Rate times price ratio]
[=Nominal (% change) and
Rate x Exchange Rate Relative
price ratio
(base period
=1)]
JPY/AUD= 120.7/1.2953 90.00/1.5533
(JPY/USD)/ = 93.18 = 57.94
(AUD/USD)

USD/AUD= 1/1.2953= 0.7720x1=0.772 1/1.5533

1/(AUD/ 0.7720 0 =0.6438 (-15.24%)
USD)

EUR/AUD= 0.7672/1.2953 0.5923x1=0.592 0.7814/1.5533

(EUR/USD)/ =0.5923 3 =0.5031 (-13.10)%
(AUD/USD)

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Nominal Exchange Rate with 2007 as base
period – Conversion to Real Exchange Rate
• AUD has depreciated against the three
currencies.
• The difference between nominal and
real changes in the three exchange
rates are accounted for by the changes
in the prices (i.e. differences in inflation
rates)

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Real Effective Exchange Rate of AUD against
three currencies
Exchange Jan 2009 (Real) Real Exchange Normalized
Rate [Normal Rate rate relatives (See Weights (See
times price ratio] Slide 48) Slide 44)
(% change)
(See slide 48)

JPY/AUD 0.3954
(-32.10%)

USD/AUD 0.2886
(-15.24%)

EUR/AUD 0.3160
(-13.10)%

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REER and Currency Appreciation/Depreciation
- Conclusion
• REER:
• AUD has depreciated by 21.23 per cent (=100-75.49) in real
effective terms.
• The depreciation (21.23%) based on REER is less the
depreciation in Nominal terms (24.50%) because Australia has
higher inflation than other countries.
• Can use geometric approach to conclude the same
• Higher inflation increases depreciation in nominal terms
• REER increasing implies currency is strengthening whereas
REER decreasing implies currency is weakening.
• REER (and NEER) < 100 implies currency has depreciated
with respect to trading partners and vice-versa.

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