Balance of Payments and Exchange Rate Systems L7

Question 1

Balance of payments

Answer 1

• A summary of a country’s economic transactions with the rest of the world over a specific period,

Question 2

Components of Balance of Payments

Answer 2

• Current Account transactions
• Capital (or “Financial”) Account transactions
• Official Reserves Account transactions

Question 3

Official Reserves Account transactions

Answer 3

• Official international reserves – gold and foreign currency-denominated assets

Question 4

Capital (or “Financial”) Account transactions

Answer 4

• Capital inflow/outflow
• Capital flight
• Real assets
• Financial assets
• Short-term financial assets

Question 5

Current Account transactions

Answer 5

• Export and imports: balance of trade
• Interest and dividend receipts and payments
• Unilateral transfer payments between countries (e.g., grants, gifts or aid)

Question 6

Short-term financial assets

Answer 6

example: money market securities

Question 7

Financial assets

Answer 7

bank deposits, loans, corporate and government bonds, equities

Question 8

Real assets

Answer 8

factories, real estate, FDI

Question 9

Capital inflow

Answer 9

when foreigners invest in domestic assets

Question 10

Capital outflow

Answer 10

when residents invest in foreign assets

Question 11

Capital flight

Answer 11

large-scale rapid movement of financial assets or capital from one country to another

Question 12

Free Floating

Answer 12

• Exchange rates determined solely by the market forces of supply and demand
• Limited Government intervention
• (i.e., U.S., Japan, European Union,)

Question 13

Exchange rate systems around the world

Answer 13

• Floating currencies
• Managed floating
• Fixed/pegged currencies
• No separate legal tender
• Target zone
• Crawling pegs
• Special arrangements

Question 14

Managed floating

Answer 14

• countries whose Central Banks intervene enough that the IMF can’t classify them as freely floating (i.e., Argentina, Brazil, Columbia, and South Africa)

Question 15

pegged currencies

Answer 15

• A currency ties it’s value to another or a basket of currencies
• (i.e., IMF’s SDR and the Chinese yuan pre-2005)
• Often implemented using a currency board

Question 16

fixed exchange rate

Answer 16

• the governments attempts to maintain exchange rates within 1% of the initially set value

Question 17

No separate legal tender

Answer 17

• Adopt a currency
• (i.e., Ecuador, El Salvador and Panama have adopted the U.S. dollar

Question 18

Target zone

Answer 18

• forex rate is kept within band

Question 19

Crawling pegs

Answer 19

• a fixed exchange rate which is allowed to fluctuate within a band of rates, which are adjusted regularly

Question 20

Special arrangements

Answer 20

• Where a regional central bank controls the forex rate system for several countries i.e. Euro

Question 21

Types of monetary intervention

Answer 21

• Sterilised intervention
• Non-sterilised intervention

Question 22

Sterilised intervention

Answer 22

• An intervention in the foreign exchange market that is offset by an open market transaction in the domestic market to restore the money supply.
• e.g. Central bank buys foreign exchange, while selling government bonds, keeping the domestic money supply steady

Question 23

Non-sterilised intervention

Answer 23

• The buying and selling of foreign exchange by a central bank without any offsetting
• Buying Foreign Currency:
  increases the domestic money supply
• Selling Foreign Currency:
  reduces the money supply.

Question 24

Intervention tools

Answer 24

• Money supply/interest rates
• Attempt to restrict capital movements
• Tax/subsidize international trade to influence demand for foreign currency

Question 25

Direct intervention

Answer 25

• Central banks use their currency reserves to buy/sell a specific currency in the foreign exchange market creating upward/downward pressure on that currency

Question 26

indirect intervention

Answer 26

• A central bank increases/decreases interest rates, thereby attracting/restricting foreign demand for the home currency to buy high-yield securities.

Question 27

Direct effects of central bank intervention

Answer 27

• monetary policy triggers in(de)flation and alters interest rates
• Can effect supply/demand
• Effect is argued negligible due to small amount (i.e., $20 billion versus $4 trillion overall trade in aday)

Question 28

indirect effects of intervention

Answer 28

• affects the exchange rate through expectations
• interventions can reinforce central bank credibility reducing uncertainty and market volatility.

Question 29

Currency risk in Alternative Exchange rate systems

Answer 29

• Floating rate systems: high ER volatility => high currency risk
• Target zones: less than floating but can be big due to devaluations/revaluations
• Pegged/fixed: latent volatility, currency boards frequently collapse