11/09/17 - Open Economies

Third part of course: Open economy (i.e. money flows across borders)

Recall: BOP structure

I. Current Account
A. Goods and services
B. Primary income
C. Secondary income, current transfers
II. Capital Account
A. Loans and repayments
III. Financial Account
A. Direct investment
B. Portfolio investment
C. Other investment
IV. Oicial Adjustments
A. Monetization of gold
B. Asset revaluation
C. IMF credits
D. Changes in reserve position (GIR)

Oicial reserve asset structure

I. Foreign currency reserves (in convertible foreign currencies)
A. Securities
B. Total currency and deposits
II. IMF reserve position
III. SDRs (special drawing rights) - from IMF
IV. Gold
V. Other reserve assets (financial derivatives, loans to nonbank residents, etc.)
Other foreign currency assets: not included in oicial reserve assets

Note on
Portfolio investment:
also called hot money
more volatile than other components
Changes in reserve position
most common adjustment to BOP
drawn on when we need to finance certain deficits
if money is
entering the PH, increases GIR
leaving the PH, decreases GIR
GIR is basically your equity:
credit = increase
debit = decrease
sovereign loans: owned by the govt
Foreign exchange reserves (forex)
assets held by CB in foreign currencies
pays for foreign exchange liabs of govt
back liabilities on their (govts) own issued currency
a monetary policy tool

Note on international reserves

considered as assets in the BOP adjustment, but have associated liabilities
because CB obtains foreign exchange reserves through
(1) borrowing
(2) exchanging with domestic currency
(3) purchasing with domestic currency
(1) - (3) incur debt (or at least, a payment)
small percentage of GIR earned as returns from
BSP forex denominated investments
proceeds from sale of public assets
GIR risky as other investments
(the currency its built on may collapse)

Exchange rate
price of one currency in terms of another
Open economies link through trade, transfers, and financial markets
market for currency X
X on the horizontal axis
local currency (Y) on the vertical axis
demand and supply, regular rules apply
inverse market, i.e. market for currency Y, exists
Y on horizontal axis and X on vertical axis
values on vertical axis are (1/value on vertical axis in market for currency X)
demand for foreign currency
proportional to demand for imports/other foreign assets
ex. if you want to invest abroad
i.e. originators of outflows/debits to BOP
supply of foreign currency
households holding forex (minimal)
commercial banks/other private banks
central banks (in GIR) - main source
global currency market

Currency terms
appreciation of X: strengthening
when price of Y goes down (so 1/Y = price of X => up)
less X needed to buy Y <=> more Y needed to buy X
depreciation of X: weakening
when price of Y goes up (1/Y => down)
more X needed to buy Y <=> less Y needed to buy X
Ex. Demand for peso shifts up => D > S => peso appreciates (and other currency depreciates)

Demand for peso <=> mirror image of demand for dollars

thus, if demand for peso increases, demand for dollars decreases

Some questions re: government intervention

why would the government intervene?
what determines capacity to intervene?
how is this actually done?

These questions depend on

what does appreciation/depreciation mean?
who benefits from a strong/weak currency?
why would we want a strong/weak currency?

Exchange rate regimes

credibility of economic management team is important: creates faith in local currency
exchange rate regime used is a result of economic policy
3 types: fixed, flexible, floating
fixed:
central bank sets and defends the exchange rate of local currency
very strong commitment
flexible:
set according to market forces, i.e. supply and demand
0 intervention
floating:
clean floating: exchange rates freely determined in the forex market (same as flexible)
managed float:
exchange rate has upper and lower limit; govt intervenes if r < lower or r > upper
current PH system

More on the PH system

BSP buys/sells foreign currencies using GIR to
keep exchange rate within limits
prevent wide fluctuations in the local currencys value
current band is unknown, but trend has been increasing upper and lower limits

Terminology
appreciation/depreciation: non-fixed exchange rate regimes
revaluation/devaluation: fixed exchange rate regimes
MISC. NOTES
wed want a strong peso to help in paying debts fixed in terms of the other countrys currency
tradeo: if buying in terms of local currency, interest rate is higher
weak peso to help fuel exports
GIR that can cover 3mo of imports or 3mo of loans = minimum
net international reserves = GIR - short-term liabilities