Lecture 11: International Business Environment Balance of Payments and Exchange Rates PDF

REMINDER DR.DEBOSHREE GHOSH 1 FLIPPED CLASSROOM You are required to watch the lecture video provided on myTimes by Wednesday, December 11th. The content in the video will form the basis for the upcoming lecture and tutorials. The next class is a continuation of lecture 11 and will be based...

REMINDER DR.DEBOSHREE GHOSH 1 FLIPPED CLASSROOM You are required to watch the lecture video provided on myTimes by Wednesday, December 11th. The content in the video will form the basis for the upcoming lecture and tutorials. The next class is a continuation of lecture 11 and will be based on the assumption that you have watched the video. We will dive straight into the discussion and activities related to The International Business Environment: Balance of Payments and Exchange Rates The tutorials for the upcoming session will also be based on the assumption that you have viewed the video. Please come prepared for interactive discussions and problemsolving exercises. If you have any questions about the video content or if you encounter difficulties accessing the materials, please reach out to me ahead of the next class. DR.DEBOSHREE GHOSH 2 Lecture 11 The International Business Environment: Balance of Payments and Exchange Rates (Part 1) References : Hubbard and O'Brien Chapters 29 and 30 Learning outcomes of today’s lecture Balance of Payment Exchange rate determination DR.DEBOSHREE GHOSH 4 Balance of Payment (BoP) and why do we need it? To understand the effects of globalization as using the standard measurement such as the GDP is not enough. From going local to global, one needs to understand how international money flow- the BoP framework complements the GDP framework. For example, your clothing may originate from France, your shoes crafted in Japan but raw material is from China, and your investments might be situated in India. How do these interconnected global exchanges impact France, China, India, and your country of residence simultaneously? DR.DEBOSHREE GHOSH 5 Balance of Payments While the total balance of payments should be zero, this does not always occur in practice. This can be due to measurement errors, because it is difficult to accurately record every single transaction between domestic citizens and the rest of the world. A country’s balance of payments accounts records its international trading, borrowing, and lending. Consist of two main accounts: 1. Current account : The part of the balance of payments that records a country’s net exports, net income on investments, and net transfers. 2. Capital and Financial account : Capital account : The part of the balance of payments that records relatively minor transactions, such as migrants’ transfers and sales and purchases of non produced, nonfinancial assets (example patents, copyrights, trademarks etc.) Financial account : The part of the balance of payments that records purchases of assets a country has made abroad and foreign purchases of assets in the country. For example, portfolio investments DR.DEBOSHREE GHOSH 6 Components of Current account Trade Balance: Records the difference between the value of a country's exports and imports of goods. Services Balance: Tracks earnings and payments from international trade in services such as tourism, transportation, financial services, and consulting. Income Balance: Includes earnings from foreign investments (e.g., dividends, interest) and payments to foreign investors. Unilateral Transfers: Involves one-way transfers of funds between countries without any reciprocal exchange. DR.DEBOSHREE GHOSH 7 Foreign exchange market- terminology Exchange rate is the rate at which one currency trades for another on the foreign exchange market. For example, the rate of exchange between RM and the US. Currency depreciation (DOMESTIC) means domestic currency is loosing value as compared to foreign currency. For example, if 2022, 1 Dollar = 4 Ringgit and in 2023, 1 Dollar = 4.70 Ringgit (more expensive to buy imports) Currency appreciation (DOMESTIC) means domestic currency is gaining value as compared to foreign currency. DR.DEBOSHREE GHOSH 8 Foreign exchange market- determination Domestic to foreign exchange rate Y axis is how much domestic currency for each foreign currency. For example, 4.5 Ringgits for each Dollar if we consider MYR as the domestic currency X axis is quantity of foreign currency in this case Exchange rate RM/$ S RM 4.7 /$ a RM 4.5 /$ RM 4.2 /$ D Remember from microeconomics we know that : Y axis show the price of commodity in the x axis. In this case Y axis shows the price of each Dollar in terms of Ringgits DR.DEBOSHREE Local currency is Ringgit Foreign currency is Dollar GHOSH Quantity of Dollars 9 Foreign exchange market- determination Foreign to domestic exchange rate Y axis is how much foreign currency for each domestic currency. For example, $0.22 for each RM if we consider MYR as the domestic currency X axis is quantity of domestic currency in this case Exchange rate $/RM S $ 0.24 /RM a $ 0.22 /RM $ 0.18 /RM D Remember from microeconomics we know that : Y axis show the price of commodity in the x axis. In this case Y axis shows the price of each Ringgit in terms of Dollars DR.DEBOSHREE Local currency is Ringgit Foreign currency is Dollar GHOSH Quantity of Ringgit 10 Exchange rate conversions Assume the MYR / USD exchange rate is 4.5 MYR = 1 USD If Malaysian imports are 108.18 billion MYR and exports are 118.13 billion MYR. Then net exports is a trade deficit of MYR 9.95 billion In terms of USD the import bill conversion is *We can similarly convert export and the net exports (Deficit/surplus) 4.5 𝑀𝑌𝑅 = 1 𝑈𝑆𝐷 1 1 𝑀𝑌𝑅 = 𝑈𝑆𝐷 4.5 1 𝑀𝑌𝑅 = 0.22 𝑈𝑆𝐷 108.18 billion 𝑀𝑌𝑅 = 0.22 𝑋 108.18 billion 𝑈𝑆𝐷 DR.DEBOSHREE 108.18 billion 𝑀𝑌𝑅 = 23.80 𝑏𝑖𝑙𝑙𝑖𝑜𝑛 𝑈𝑆𝐷 GHOSH 11 Foreign exchange market- determination – supply and demand (Domestic to foreign exchange rate ) Supply of Dollars is upward sloping because when Ringgit price per Dollar increases then people want to supply more Dollars. This happens because foreigners (US citizens in this case) can get more Ringgit in exchange for Dollars. For example, at point b , US citizens can 4.7 Ringgits for each Dollar they supply DR.DEBOSHREE Exchange rate RM/$ Local currency is Ringgit Foreign currency is Dollar S b RM 4.7 /$ a RM 4.5 /$ D GHOSH Quantity of Dollars 12 Foreign exchange market- determination – supply and demand (Domestic to foreign exchange rate ) Demand for Dollars is downward sloping because when Ringgit price per Dollar decreases then people want to demand more Dollars. This happens because domestic citizens (Malaysians in this case) can get more Dollars in exchange for Ringgit. For example, at point b , Malaysians can buy 1 Dollar by supplying RM 4.5 instead of RM 4.7 before DR.DEBOSHREE Local currency is Ringgit Foreign currency is Dollar Exchange rate RM/$ RM 4.7 /$ RM 4.5 /$ a b D GHOSH Quantity of Dollars 13 Foreign exchange market- determinationcase of disequilibrium Suppose we have an exchange rate higher than the equilibrium a (example RM 4.7) The quantity of Dollars demanded is Qd and quantity of Dollars supplied is Qs. There is an excess supply of Dollars. Due to excess supply, foreign currency (Dollars) starts loosing value (depreciates) because too many people supplying Dollars S b c RM 4.7 /$ a RM 4.5 /$ D The Dollars keeps depreciating till the time we reach the equilibrium exchange rate 4.5 Ringgit for each Dollar. DR.DEBOSHREE Local currency is Ringgit Foreign currency is Dollar Exchange rate RM/$ Qd GHOSH Qs Quantity of Dollars 14 Foreign exchange market- determination Floating exchange rate policy is one that permits the exchange rate to be determined by demand and supply shifts with no direct intervention in the foreign exchange market by the central bank. Fixed exchange rate Under a fixed exchange rate, the central bank announces a fixed value (also known as pegs) for the exchange rate and stands ready to buy and sell the domestic currency to keep the exchange rate at its announced level. DR.DEBOSHREE GHOSH 15 FLOATING EXCHANGE RATE (Domestic to foreign exchange rate ) Determination of foreign exchange when supply or demand shifts – under floating exchange rate Exchange rate RM/$ Demand shifts Assume demand of foreign exchange (Dollars in this case) shifts to the right implying that domestic citizens (Malaysians in this case) demand more Dollars and therefore exchange Ringgit for Dollars. S b RM 4.7 /$ RM 4.5 /$ The exchange rate changes from RM 4.5/$ to RM 4.7 /$ indicating Ringgit has depreciated US Dollar has appreciated DR.DEBOSHREE a D2 D1 GHOSH Quantity of Dollars 17 Determination of foreign exchange when supply or demand shifts – under floating exchange rate Demand shifts - the mechanism If exchange rates remained at RM 4.5 /$ when demand for Dollar shifted out, then we will have excess demand (c) and the price of Dollar (in terms of RM) will start increasing i.e. Dollar appreciates until we reach b. Exchange rate RM/$ S b RM 4.7 /$ RM 4.5 /$ The is an upward movement along the demand (c to b) and supply curve (a to b) of Dollar to reach RM 4.7 /$ when demand shifts to the right. DR.DEBOSHREE a c D2 D1 GHOSH Quantity of Dollars 18 Determination of foreign exchange when supply or demand shifts – under floating exchange rate Exchange rate RM/$ Supply shifts Assume supply of foreign exchange (Dollars in this case) shifts to the right implying that foreign citizens (U.S citizens in this case) supply their Dollar in exchange of Ringgit The exchange rate changes from RM 4.5/$ to RM 4.2 /$ indicating Ringgit has appreciated US Dollar has depreciated DR.DEBOSHREE S1 S2 a RM 4.5 /$ RM 4.2 /$ b D GHOSH Quantity of Dollars 19 Determination of foreign exchange when supply or demand shifts – under floating exchange rate Supply shifts – the mechanism If exchange rates remained at RM 4.5 /$ when supply for Dollar shifted out, then we will have excess supply (c) and the price of Dollar will start decreasing i.e. Dollar depreciates until we reach b. The is a downward movement along the demand (c to b) and supply curve (a to b) of Dollar to reach RM 4.2 /$ when supply shifts to the right. DR.DEBOSHREE Exchange rate RM/$ S1 S2 a RM 4.5 /$ RM 4.2 /$ b c D GHOSH Quantity of Dollars 20 FIXED EXCHANGE RATE Exchange rate determination– due to shift of demand – fixed exchange rate system Under flexible exchange rate system : Outward shift of demand for Dollars would lead to a Dollar appreciation (point a to point b) If Bank Negara (Central Bank of Malaysia) started following fixed exchange rate system (assuming at RM 4.5 /$) , the Dollar appreciation (to RM 4.7 /$ ) would not have taken place. DR.DEBOSHREE Exchange rate RM/$ S1 b RM 4.7 /$ RM 4.5 /$ a D2 D1 GHOSH Quantity of Dollars 22 Exchange rate determination– due to shift of demand – fixed exchange rate system Bank Negara would have adjusted the exchange rate back to RM 4.5 /$ by supplying more Dollars (supply curve shifts out) by selling Dollars in the forex market (using Dollars to buy Ringgit) Now new demand and new supply again meet at the fixed rate of RM 4.5/$. New equilibrium is at c Exchange rate RM/$ S1 S2 b RM 4.7 /$ RM 4.5 /$ a c D2 D1 DR.DEBOSHREE GHOSH Quantity of Dollars 23 Exchange rate determination– due to shift of supply – fixed exchange rate system Under flexible exchange rate system : Outward shift of supply for Dollars would lead to a Dollar depreciation (point a to point b) If Bank Negara (Central Bank of Malaysia) started following fixed exchange rate system (assuming at RM 4.5 /$) , the Dollar depreciation (to RM 4.2 /$ ) would not have taken place. DR.DEBOSHREE Exchange rate RM/$ S1 S2 RM 4.5 /$ RM 4.2 /$ a b D1 GHOSH Quantity of Dollars 24 Exchange rate determination– due to shift of supply – fixed exchange rate system Bank Negara would have adjusted the exchange rate back to RM 4.5 /$ by demanding more Dollars (demand curve shifts out) by buying more Dollars in the forex market (using Ringgit to buy Dollars) Now new demand and new supply again meet at the fixed rate of RM 4.5/$. New equilibrium is at c DR.DEBOSHREE Exchange rate RM/$ S1 S2 RM 4.5 /$ RM 4.2 /$ a b c D2 D1 GHOSH Quantity of Dollars 25 Comparing fixed and floating exchange rate system Example of case when demand for foreign currency has increased Fixed exchange rate system Floating exchange rate system Exchange rate RM/$ Exchange rate RM/$ S1 b RM 4.7 /$ RM 4.5 /$ a S1 S2 b RM 4.7 /$ RM 4.5 /$ c a D2 D2 D1 D1 Quantity of Dollars D R. D E B O S H R E E GHOSH Quantity of Dollars 26 Balance payment and currency fluctuations BOP Surplus : Exports > Imports OR Foreign Investments Inflow > Outflow This would mean that there is an increased demand for domestic currency because the foreigners (in this case US citizens) would buy domestic goods and services. This would result in increased supply of foreign currency in the Ringgit-USD market Therefore, domestic currency appreciates DR.DEBOSHREE GHOSH 27 Domestic BOP Surplus would mean increased demand for domestic currency and increased supply of foreign currency (Foreign to domestic exchange rate) Exchange rate $/RM (Domestic to foreign exchange rate ) Local currency is Ringgit Foreign currency is Dollar Exchange rate RM/$ S1 S1 b $0.24/RM $0.22/RM = a S2 a RM 4.5 /$ RM 4.2 /$ b D2 D D1 Quantity of Ringgit DR.DEBOSHREE GHOSH Quantity of Dollars 28 Balance payment and currency fluctuations BOP Deficit : Exports < Imports OR Foreign Investments Inflow < Outflow This would mean that there is a decreased demand for domestic currency because the foreigners (in this case US citizens) would buy other foreigner goods and services (instead of Malaysian domestic goods) therefore demanding less of domestic currency. This would result in decreased supply of foreign currency in the Ringgit-USD market Therefore, domestic currency depreciates DR.DEBOSHREE GHOSH 29 Domestic BOP Deficit would mean decreased demand for domestic currency and decreased supply of foreign currency (Foreign to domestic exchange rate) (Domestic to foreign exchange rate ) Local currency is Ringgit Foreign currency is Dollar Exchange rate $/RM Exchange rate RM/$ S2 S1 S1 = a $0.22/RM $0.20/RM RM 4.7 /$ RM 4.5 /$ b a b D D1 D2 Quantity of Ringgit DR.DEBOSHREE GHOSH Quantity of Dollars 30 Summary Understanding balance of payment of a country helps to understand international market transactions Exchange rates can be determined under fixed or floating exchange rate regime DR.DEBOSHREE GHOSH 31 Next Week Shifts of demand and supply in the foreign exchange market. DR.DEBOSHREE GHOSH 32