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International Macroeconomics

Chapter 3: Open Economy Macroeconomics -

Exchange Rates and the Balance of Payments

3.0 Pre-Lecture Reading: Exchange Rates and the Balance of

Payments*

* The pre-lecture slides summarize ideas you should already know from your bachelor
studies. If you have problems, read
• Mankiw & Taylor (2020) Chap.25: Open Economy Macroeconomics
Definitions
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Nominal exchange rate

 Definition: The exchange rate is the price of (domestic) currency

expressed in another currency.
• Quantity quotation: price of 1 unit of domestic currency in units of the foreign
currency (EF/1D); examples E$/€
• Price quotation: price of 1 unit of foreign currency expressed in domestic currency
(ED/1F); example EDM/$
• Convention: In this course, we use quantity quotation and usually regard Germany
/ Eurozone as being the domestic economy, i.e. the $ represents foreign currency!

 Appreciation and depreciation:

• Appreciation of domestic currency: increasing value (“strengthening”), EF/1D ↑
• Depreciation of domestic currency: decreasing value, (“weakening”), EF/1D ↓

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Determinants of exchange rates 3

 Determinants:
• The exchange rate of a freely convertible currency is determined by supply and
demand in currency markets.
• All cross border economic transactions influence the exchange rate.

 Examples:
• Trade in goods and services
- Demand for foreign currency: Importers of goods need foreign currency (in exchange for domestic
currency)
- Supply of foreign currency: Exporters were paid in foreign currency – they supply it in exchange
for domestic currency

• Capital flows (Short-run - arbitrage, long-run - FDIs)

- Demand for foreign currency: Domestic residents that want to invest into foreign assets need
foreign currency
- Supply of foreign currency: Foreign residents that want to invest into domestic assets

• Central bank interventions, speculations

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Determinants of exchange rates
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Adjustments to changes in trade and capital flows
€: domestic currency
Goods Trade: $: foreign currency
• EXEU ↑ ⇒ S$ ↑ , D€ ↑ ⇒ E$/€ ↑: € appreciates, $ depreciates
• IMEU ↑ ⇒ D$ ↑ , S€ ↑ ⇒ E$/€ ↓: € depreciates, $ appreciate
Capital Flows:
• CapIM,EU ↑ ⇒ S$ ↑ , D€ ↑ ⇒ E$/€ ↑ : € appreciates, $ depreciates
• CapEX,EU ↑ ⇒ D$ ↑ , S€ ↑ ⇒ E$/€ ↓: € depreciates, $ appreciates

D€
E$/€ S€ E$/€ S€
D€ D€

S€

€ €
Euro appreciation Euro depreciation
Effects of appreciations and depreciations
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Trade in goods and services and capital flows

 The exchange rate influences ceteris paribus (c. p.) international goods trade
• Appreciation of domestic currency:
- Domestic goods become c.p. more expensive in foreign currency, exports decrease.
- Foreign goods become cheaper (in domestic currency), imports increase
- The trade balance c.p. deteriorates
• Depreciation
- The trade balance c.p. improves

 How are interest rates, capital flows and the exchange rate related?
• ∆ monetary policy ⇒ ∆ interest rates ⇒ ∆ capital flows ⇒ ∆ exchange rate
(1) iEU ↓ ⇒ CapEX,EU ↑ ⇒ D$ ↑, S€ ↑ ⇒ E$/€ ↓ : € depreciates
(2) iEU ↑ ⇒ CapIM,EU ↑ ⇒ S$ ↑, D€ ↑ ⇒ E$/€ ↑ : € appreciates

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The forward exchange rate 6

 Spot rate 𝐸𝐸𝑡𝑡 : Exchange rate for a transaction that takes place today and
is due up to 2 days.
 Forward rate 𝐹𝐹𝑡𝑡 :
• Exchange rate for a transaction that takes place today and is due in three days or later
(30 / 60 / 90 days).
• Market participants definitely know how much they have to pay in the future.
• The forward rate can be higher or lower than the current spot rate, depending on the
𝑒𝑒
expected spot rate 𝐸𝐸𝑡𝑡+1

 Agents involved in the forward exchange market: hedgers, arbitrageurs,

speculators
𝐹𝐹𝑡𝑡 −𝐸𝐸𝑡𝑡
 Forward discount / premium: � 100 (%)
𝐸𝐸𝑡𝑡
• If forward quotation represents an appreciation compared to spot rate: premium
(depreciation – discount)

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The Balance of Payments of Germany 7
(2018, € bill.)

 A country’s balance of payments  Current Account: + 246

accounts for its payments to and its • Balance on trade in goods (+222)
receipts from foreigners.
• Trade in services (- 20)
 The balance of payments accounts • Net primary income (+ 92)
are separated into 3 broad
• Net secondary income (- 48)
accounts:
• Current Account: accounts for flows  Financial Account: + 226
of goods and services (imports and • Net foreign direct investment (+ 43,5)
exports).and income (profits, rents,
wages, unilateral transfers) • Net portfolio flows (+ 113)

• Financial Account: accounts for • Other capital flows ( + 69)

flows of financial assets (financial • Change in official reserves (+ 0,5)
capital).
• Capital Account: flows of special
 Capital Account: -2
categories of assets , e.g. debt
forgiveness, copyrights and
trademarks.  Errors and Omissions: + 22

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National Accounting 8
Saving, investment and the current account
 Gross Domestic Product ≡ Y: Y = C + I + G + (EX – IM)
 GDP equals the income of households. This can be used for consumption C,
private saving SP and tax payments T:
Y = C + SP + T
 Equating these two equations: C + I + G + (EX – IM) = C + SP + T
 Solving for savings S: identity for the usage of savings

𝑺𝑺𝑷𝑷 = 𝑰𝑰 + (𝑮𝑮 − 𝑻𝑻) + (𝑬𝑬𝑬𝑬 − 𝑰𝑰𝑰𝑰)

𝒃𝒃𝒃𝒃𝒃𝒃𝒃𝒃𝒃𝒃𝒃𝒃 𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅𝒅 𝒏𝒏𝒏𝒏𝒏𝒏 𝒆𝒆𝒆𝒆𝒆𝒆𝒆𝒆𝒆𝒆𝒆𝒆𝒆𝒆
Private savings can be used

• to finance domestic investment

• to finance a government deficit (if G>T)
• to lend to foreigners (if net-exports are positive)
 Defining (T-G) as public savings SG:

𝑺𝑺𝑷𝑷 + 𝑺𝑺𝑮𝑮 = 𝑰𝑰 + (𝑬𝑬𝑬𝑬 − 𝑰𝑰𝑰𝑰)

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Review questions 9

(1) Why is a depreciation favorable for the trade balance?

(2) Who gains and who looses from a depreciation?
(3) Suppose that a government starts to run a higher budget deficit. What
happens c.p. with investment?