Balance of Payments (BOP)-

Issues in Capital Account Convertibility (CAC)

Parity conditions and exchange rate determination

01/27/2022 CIMP 1
B.O.P-Summary Statement

-All the transactions of the residents of a nation with the residents

of all other nations are recorded during a particular period of time
usually a calendar year

- Balance of payment (BoP) comprises of current account, capital

account, errors and omissions and changes in foreign exchange
reserves

BOP Accounts -Double entry Book keeping (credit side and debit
side)

-Provides the foundation to understand the degree of an economy’s

integration with the rest of the world

01/27/2022 CIMP 2
 Current account of the BoP, transactions are classified into
merchandise (exports and imports) and invisibles.

Invisible transactions are further classified into three categories,

namely
(a) Services-travel, transportation, insurance, Government not
included elsewhere (GNIE) and others (such as, communication,
construction, financial, software, news agency,
royalties, management and business services);

(b) Income; and (c)Transfers (grants, gifts, remittances, ets.).

The capital account measures monetary flows between

countries used to purchase financial assets such as stocks, bonds,
real estate and other related items.
01/27/2022 CIMP 3
01/27/2022 CIMP 4
 Net capital Outflow (NCO)

-the purchase of foreign assets by domestic residents minus

the purchase of domestic assets by foreigners.

-The real interest rate

-The perceived economic and political risks

-The government policies that affect foreign ownership of

domestic assets.

01/27/2022 CIMP 5
The Market for Foreign-Currency Exchange and LF
• In the market for foreign-currency exchange, supply comes from net
capital outflow and demand comes from net exports

• The demand curve for foreign currency is downward sloping because a

higher exchange rate (real exchange rate) makes domestic goods more
expensive compare to foreign goods.

• The supply curve is vertical because the quantity of dollars supplied for
net capital outflow is unrelated to the real exchange rate.

• In the market for loanable funds, supply comes from national saving
and demand comes from domestic investment and net capital outflow.
Net capital outflow links the loanable funds market and the foreign-currency
exchange market.

The key determinant of net capital outflow is the real interest rate.

01/27/2022 CIMP 6
The Connection r
Between r2
Interest Rates
and Exchange Rates r1

AnythingKeepthat increases
in mind: NCO
r LF market (not shown)
The NCO
determines NCO2 NCO1
will reduce NCO r.
This valueofofdollars
r E
and the supply S2 S1 = NCO1
in then determines
the foreign NCO
exchange
(shown in upper graph). E2
market.
This value of NCO then E1
Result:
determines supply of dollars D = NX
The real exchange rate
in foreign exchange market dollars
appreciates.
(in lower graph). NCO2 NCO1
01/27/2022 CIMP 77
• Prices in the loanable funds market and the foreign-currency
exchange market adjust simultaneously to balance supply and
demand in these two markets.

• As they do, they determine the macroeconomic variables of

national saving, domestic investment, net foreign investment,
and net exports.

01/27/2022 CIMP 8
 (a) The Market for Loanable Funds (b) Net Capital Outflow

Real Real
Interest Supply Interest
Rate Rate

r r

Demand Net capital

outflow,NCO
Quantity of Net Capital
Loanable Funds Outflow

Real
Exchange Supply
Rate

Demand

Quantity of
Dollars

(c) The Market for Foreign-Currency Exchange

01/27/2022 CIMP 9
 1. A budget deficit reduces
(a) The Market for Loanable Funds (b) Net Capital Outflow
the supply of loanable funds . . .
Real Real
Interest S S Interest
Rate Rate

B
r2 r2

A
r r
3. . . . which in
2. . . . which
turn reduces
increases
net capital
the real Demand
outflow.
interest NCO
rate . . .
Quantity of Net Capital
Loanable Funds Outflow

Real
Exchange S S
Rate 4. The decrease
in net capital
outflow reduces
the supply of dollars
to be exchanged
E2
into foreign
E1 currency . . .
5. . . . which
causes the
real exchange
rate to Demand
appreciate.

Quantity of
Dollars
01/27/2022 CIMP (c) The Market for Foreign-Currency Exchange
10
 Domestic economic variable like; national output and national
spending, money supply exchange rate and interest rate are more
significant in maintaining BOP equilibrium

If NI exceed national spending, the excess saving will be invested

abroad, resulting capital accounting deficit (but current account
surplus), conversely excess national spending over national income
causes borrowings from abroad which would push the capital
account in to a surplus (current account deficit)

Increase in money supply raises price level, export turn un-

competitive (dearer/costly) and fall in export earnings lead to
deficit in the current account, similarly higher prices of domestic
goods makes price of the imported commodities competitive
(cheaper) resulting rise in imports and a deficit in the current
account
01/27/2022 CIMP 11
 Increase in domestic interest rate causes capital
inflow and capital account turns surplus. The reverse
is when an interest rate falls.

Similarly if the currency of a country depreciates,

export become competitive and export earning
improves. On the other hand import become
costlier this will lead to deficit in trade balance. How
ever the net effect depend upon how price-elastic is
the demand for export and import.

01/27/2022 CIMP 12
 BOP and Exchange Rate

-A change in country’s BOP can cause fluctuating in the

exchange rate its currency and foreign currency (vice versa)

Exchange rate movement reflect the economy-wide effects

of change in trade flows, world commodity prices, and
capital flows between economies that are highly integrated
both with each other and with global goods, service and
financial markets.

01/27/2022 CIMP 13
Flexible exchange rate or floating exchange-rate system:
Demand and supply determine exchange rates, and there is no
government intervention to manipulate the price

BOP is more effective under floating exchange rate

Shock absorber that helps to maintain stability against overseas

disturbances.

Challenge to monetary policy; Depreciation/ Interest rate/

Fixed exchange rate: Governments determine exchange rates

and make adjustments to domestic variables to achieve those
rates

Fiscal policy/Devaluation
14 of 54
 Correction of BOP deficit
Elasticity approach
EM is the price elasticity of demand for imports
EX is the price elasticity of demand for export

Em+EX>1 (deficit BOP), Devaluation or Depreciation

Costs of Import will rise it will lead to increase in

export , this is known as Pass through effect

Limitation
Time lag, other country also devalue or depreciates
(J Curve Effect)
01/27/2022 CIMP 15
01/27/2022 CIMP 16
 Keyensian approach
Y =C+I+G+X-M

Or Y-C-I-G=X-M,
If M>X or C+I+G > Y, BOT deficit so there is need to increase Y
through Employment
This is Known as expenditure switching policy

But how does Expenditure switching policy will work in case of

Full employment?

Expenditure reducing policy, income distribution effect (in case of

developed economies)

01/27/2022 CIMP 17
 Mundell Flemming Approach

S+M=I+G+X

Left side are considered leakages and dependent upon National Income

I Inversely related to Interest rate

IS, LM and Bp curve in case of flexible exchange rate.

01/27/2022 CIMP 18
Capital Account Convertibility (CAC)

The capital account is understood to be fully open when there are

no restrictions on capital flows.

A country is said to have attained full convertibility of its currency

when residents and nonresidents are allowed to convert the
currency, at prevailing exchange rates, into foreign currencies and
to use the latter freely for international transactions.

Capital account convertibility is accompanied by some risks. Its

benefits are dependent upon the achievement of certain pre-
conditions and sequencing patterns and an orderly liberalization
procedure.

01/27/2022 CIMP 19
Advantages:

a) There would be more and more capital available to the country, and the cost
of capital would decline;

b) just as there are gains from trade, there are advantges to the free movement
of capital, which is, in a way, the freedom to trade in financial assets;

c) the spreads of banks and nonbank financial institutions would come down
due to growing competition, rendering the financial system more efficient;

d) tax levels would move closer to international levels thereby reducing evasion
and capital flight;

e) the cost of government borrowing would fall in response to lower interest

rates, thus lowering the fiscal deficit;

f) it would become quite difficult for a country to follow unwise

macroeocnomic policies, because, under CAC, markets would punish
imprudence.
01/27/2022 CIMP 20
 Conditions/factors affecting CAC

Fiscal Consolidation
Inflation rate
Financial sector reform
Monetary policy
Exchange rate policy
Current Account balance
Foreign Exchange reserves
Prudential norms
Supervision
Lowering Tariff barriers
Diversified Export base

01/27/2022 CIMP 21
 Even after “completely” liberalising the capital account
countries continue to impose certain capital controls.

Integrated approach to reform is pursued involving

macroeconomic stabilization and institutional strengthening.

Another important lesson is that exchange rate flexibility is

important while undertaking capital account liberalization

limiting fiscal imbalances and preventing excessive build-up

of domestic debt is essential to avoid chances of backtracking
subsequent to capital account liberalization.

01/27/2022 CIMP 22
 CAC in India
-Since early 1990s India started liberalizing its capital account as
part of comprehensive economic reforms initiated in the early 1990s
that reversed its 40-year experiment with centrally planned
development.

However, some controls remain in place to varying degrees for both

foreign and domestic corporates and individuals, with resident
corporates facing a more liberal regime than resident individuals.

Domestic savings and taxes are inadequate to cater country’s huge

investment needs.

-FDI, ADRs, GDRs, ECBs, Bonds and FII

01/27/2022 CIMP 23
 1997-CAC (S S Tarapore) This Committee had chalked
out three stages, to be completed by 1999-2000.

It had indicated certain signposts to be achieved for the

introduction of CAC. The three most important of them
were:

fiscal consolidation,

a mandated inflation target

and strengthening of the financial system.

01/27/2022 CIMP 24
 In April, 2006 a committee was formed again under the chairmanship of
former Deputy Governor of the Reserve Bank of India (RBI) Mr. S. S.
Tarapore to revisit the issue of CAC and suggest a road map for it.

The committee proposed that India shift to Fuller Capital Account

Convertibility (FCAC) in five years beginning 2006/07.

In its report submitted to the RBI on July 31, 2006, the committee
suggested that the proposed regime be embraced in three phases—
2006-07 (phase I), 2007-08 and 2008-09 (phase II) and
2009-10 and 2010-11 (phase III).

The committee has pointed out that the concomitants for a move to fuller
CAC would be fiscal consolidation, setting of medium-term monetary
policy objectives, strengthening of the banking system, maintaining an
appropriate level of current account deficit as well as reserve adequacy.

01/27/2022 CIMP 25
 The centre and states should graduate from the present system of computing
fiscal deficit to a new measure of Public Sector Borrowing Requirement
(PSBR).

• Substantial part of the revenue surplus of the centre should be earmarked

for meeting the repayment liability under the centre’s market borrowing
programme, thereby reducing the gross borrowing requirement.

• Revenue deficits of the states should be eliminated by 2008-09 and fiscal

deficits of the states should be reduced to 3 percent of GDP.

• To strengthen the banking system, the minimum share of the

government/RBI in the capital of Public Sector Banks (PSBs) should be
reduced from 51 percent (55 percent for State Bank of India) to 33 percent.

• All commercial banks should be subject to a single legislation and all

banks, including state owned banks, be incorporated under the Companies
Act.

01/27/2022 CIMP 26
 • The RBI should evolve policies to allow, on merit, industrial houses to have
stakes in Indian banks or promote new banks.

• The limits for banks’ overseas borrowing should be linked to their paid-up
capital and free reserves, and not to unimpaired tier I capital at present, and
raised to 50 percent in phase I, 75 percent in phase II and 100 percent in
phase III.

• To make Indian corporates compete in the global arena on an equal footing,

the limits for corporate investments abroad should be raised in phases from
200 per cent of net worth to 400 per cent.

• All individual non-residents should be allowed to invest in the Indian

markets through SEBI-registered entities.

01/27/2022 CIMP 27
 • Non-resident corporates should be allowed to invest in the Indian stock
markets through SEBI-registered entities, including mutual funds and portfolio
management schemes.

• Apart from multilateral institutions being allowed to raise rupee bonds in

India, other institutions/corporates should also be permitted to raise such bonds
(with an option to convert into foreign exchange), subject to an overall ceiling,
which should be slowly raised.

• The annual limit of remittance by individuals to open foreign currency

accounts overseas be raised to US$ 50,000 in phase one from the current level
of $25,000 and further raised to US$ 100,000 in phase two and US$ 200,000 in
phase three.

• The limit for mutual funds to invest overseas should be increased from the
present level of US$ 2 billion to US$ 3 billion in phase one, to US$ 4 billion in
phase two and to US$ 5 billion in phase three and these facilities should be
available to SEBI registered portfolio management schemes apart from mutual
funds.
01/27/2022 CIMP 28
 Disadvantages

Depreciation in Rupee
Volatility in Stock market
Inflation
Assets liability miss match

01/27/2022 CIMP 29
Exchange rate determination

Exchange rates are influenced by product prices and interest

rates which in turn are determined by several factors

Parity relationships-equlibrium relationships between

Exchange rates, product prices, interest rates

Parity relations are driven by arbitrage and

governed by law of one price
Demand and supply of currency

Factors affecting Exchange rates

Inflation rates
Economic growth rate
interest rates
Political factors
Social factors
Government controls (Sterilize/non-sterilize)

Purchasing Power parity (Gustav cassell 1900)

states that spot exchange rates between currencies will
change to the differential in inflation rates between
countries.
 There is no transaction costs

There is no transportation costs

There is no tariffs, no restrictions

Free flow of information

No product differentiation

01/27/2022 CIMP 32
Absolute PPP

Price levels adjusted for exchange rates should be equal between

countries

One unit of currency has same purchasing power globally.

Spot exchange rate (USD/INR) = Price in India/price in USA

Price in India= Price in USA* Spot rate (USD/INR)

PPP- in absolute version states that the exchange rate at any time
exactly reflects the ration of price indices in two countries or the
purchasing power of two countries
Relative PPP

states that the exchange rate of one currency against another will
adjust to reflect changes in the price levels of the two countries.

Percentage change in the ratio of price indices in the two

currencies.

Exchange rate/foreign currency depreciates when the inflation rate

in the foreign currency is more than the domestic inflation and vice
versa

A relative change in price indices between two countries over a

particular period of time should result in the change in the
exchange rate between their currencies over that period.
Spot exchange rate (B/A)t/Sport exchange rate (B/A)0= [Px (t)/Px (0)]/[Py
(t)/Py(0)]

Px (t)/Px(0)=1+ix
Py(t)/Py (0)=1+iy

[Spot Exchange rate (t) (B/A)]/Spot Exchange rate (0) (B/A)]=[1+ix]/[1+iy]

{[ Spot Exchange rate (t) (B/A)] -Spot Exchange rate (0) (B/A)]/Spot Exchange
rate (0) (B/A)]}

=[ix-iy]/[1+iy]

For example if the inflation rate is 6 percent in India and 4 percent in US,
applying the PPP theory, we would conclude that the INR value of the US dollar
must rise by about (0.02/1.04) percent or 1.92 percent

01/27/2022 CIMP 35
 The consumer price in India rose from 200 to 216 over the
period 1 January to 31st December and the US consumer
price index increased from 100 to 105 over the same period.
The exchange rate between USD/INR on 1 January was INR
65. What should be the exchange rate between the Indian
rupee and the US dollar on 31st December?

01/27/2022 CIMP 36
 Real Exchange rate

The real Exchange rate between two currencies, say INR and USD

Rt (USD/INR) =St (USD/INR) * {(1+iF)t/(1+ih)t

Rt= real Excahneg Rate

St= Nominal Exchange rate
If= rate of inflation in the foreign country in period t
Ih= rate of inflation in the home country during the period t

Example: between 1st January and 31st December the rate of inflation in
India was say, 5 percent and in US it was 3 percent. Between the same
period the exchange rate of INR and the dollar changed from INR 66 to
68.

The Real exchange rate between INR and USD on 31st December was =

68 * (1.03/1.05) = 66. 70

01/27/2022 CIMP 37
 If the PPP hold

(1+ih )/ (1+e) (1+if)=1

Where e= percentage change in nominal exchange rate

01/27/2022 CIMP 38
The Expectation form of Purchasing power parity

The expected percentage change in the exchange rate equals the

expected inflation differential in the two countries, provided the
market participants are risk-neutral and the markets are perfect

Expected Spot Exchange rate (A/B)= Expected Ix-Expected Iy

Suppose a firm buys a standard basket of goods in country X and

holds it for a year. The firm can expect to get a return equal to the
expected inflation rate (Expected ix). Alternatively , if buys the
same standard basket of goods in country Y, hold it for one year,
and then converts its return in Currency B in to currency A at the
expected exchange rate [Expected exchange rate S (A/B)], its
expected return will be equal to the sum of the expected inflation
rate in country Y and the expected change in the spot exchange
rate.
 The Big Mac index
THE Big Mac index was invented by The Economist in 1986 as
a light hearted guide to whether currencies are at their “correct”
level.

It is based on the theory of purchasing-power parity (PPP), the

notion that in the long run exchange rates should move towards
the rate that would equalise the prices of an identical basket of
goods and services (in this case, a burger) in any two countries.

For example, the average price of a Big Mac in America in July

2016 was $5.04; in China it was only $2.79 at market exchange
rates. So the "raw" Big Mac index says that the yuan was
undervalued by 45% at that time. 

01/27/2022 CIMP 40
NEER/REER

whether a currency is “over valued” or “under valued” compared

to its major trading partners needs to be determined.

This is done by calculating exchange rate indices. These indices

are calculated by trade weighing bilateral exchange rates between
the currency and its trading partners.

Two types of Exchange rate indices are calculated

NEER (Nominal Effective Exchange Rate) and REER (Real
Effective Exchange Rate).

01/27/2022 CIMP 41
The NEER is the weighted geometric average of the bilateral
nominal exchange rates of the home currency in terms of foreign
currencies. Specifically,

n
NEER = II (e/ei ) wi
i =1

The REER is the weighted average of NEER adjusted by the ratio

of domestic price to foreign prices.

Specifically,
n
REER = II [(e / ei ) (P / Pi ) ]wi
i=1
01/27/2022 CIMP 42
Where e : Exchange rate of Indian rupee against a numeraire,
i.e., the IMF’s Special Drawing Rights (SDRs) in indexed form,

ei : Exchange rate of foreign currency ‘i’ against the numeraire (SDRs) (i.e., SDRs
per currency i) in indexed form,

wi : Weights attached to foreign currency/ country ‘i’ in the index

n
II wi = 1
i =1

P : India’s price index (CPI),

Pi : Consumer Price Index of Country i , and

n : Number of countries/currencies in the index other than India.

01/27/2022 CIMP 43
01/27/2022 CIMP 44
01/27/2022 CIMP 45
 Limitations of Purchasing power parity

Assumptions regarding transportation costs, transaction costs,

tariff

Non traded items such as immovable goods (land, building),

highly perishable commodity

Need same basket of goods

Effects of other factors like, interest rate, political and social

factors

01/27/2022 CIMP 46
 Exchange rate and interest rate

Investor borrow in markets where interest rates are low and then exchange
the local currency to invest in markets where interest are higher-Carry trade

One year Swiss franc LIBOR is quoted at 2.22 percent while the US dollar
LIBOR is at 4.68 percent

Investor need to take into consideration future payments in the foreign

currency, as well as any change in the relative value of the two currency.

Investors have to considered interest rates as well as the expected change in

the foreign exchange rate over the period during which the investment is held.

An INR of the deposit will become INR (1+rh/2) after six months where rh is
the domestic interest rate per annum.

01/27/2022 CIMP 47
 Suppose he or she deposits INR 1 million at 6 percent rate of interest for
six months , his or her wealth after six months will be INR 1 million
(1+0.06/2)=INR 1.03 million.

Alternatively if the investor decide to invest in a USD denominated bank

deposits for six months, which offer an interest rate of 8 percent per annum.
The spot exchange rate is USD/INR 65. So each INR invested for six
months in the US dollar deposit will give

USD [1/65 (1+0.08/2)]=USD 0.016

Calculate how much will be return in USD and in INR after six month,
considering forward exchange rate USD/INR = 67, and USD/INR=58

{Ft (USD/INR)/S0 (USD/INR)](1+rf/2)}

01/27/2022 CIMP 48
 The process involves following sequence

1. Convert home currency to foreign currency at the current spot rate

2. Invest the foreign currency denominated amount at the foreign currency
interest rate (rf)
3. Sell forward at Ft, the maturity value of the foreign currency denominated
investment

All these operations take place at the time of investment

Assuming At as the return on investment

At= Ft (A/B)/S0(A/B)* (1+rf)t

Or (Ih/S0) (1+rf) {(s0 (1+P)}

Ih (1+rf) (1+P)
Ih=investment amount
P=Forward premium

(1+rh)t>Ft(A/B)/S0(A/B)*(1+rf)t decision to invest in domestic assets

Inverse
01/27/2022 is for borrowing CIMP 49
 Covered Interest Arbitrage

Investing in securities denominated in another currency with the currency risk

covered (or hedged) in the forward market

1. Investor borrowed USD 10 million in USA for one year at the rate of
interest 6 percent per annum

2. Converted USD 10 million into British pounds at an exchange rate of

GBP/USD 1.75 and received GBP 5.72 million

3. Invest GBP 5.72 million in GBP denominated bank deposit for one year at
an interest rate of 8%

4. Sold forward the maturity value of the deposit in exchange for the US
dollar at the forward rate of GBP/USD 1.80

01/27/2022 CIMP 50
 Interest rate Parity

(1+rh)t= {Ft (A/B)/S0(A/B)} *(1+rf)t

Ft (A/B)=S0(A/B) {(1+rh)t / (1+rf)t }

{Ft (A/B) - S0(A/B)/S0 (A/B} = rh-rf

rh=rf + {Ft(A/B)-S0(A/B)/S0 (A/B)}* (1+rf)t

Interest rate differential will provide Forward premium or Forward discount

P= (1+rh/1+rf) – 1

Ft= S0 (1+P)

01/27/2022 CIMP 51
 Interest rate parity

Like PPP (law of one price in market for goods and services), IRP-law of one
price in financial market

The currency of the country with a higher interest rate should be at forward
discount in terms of the currency with a lower interest rate

Spot rate and forward rate are closely linked to each other and to interest rates
in different currencies through the medium of arbitrage

The spread between the spot rate and forward rate is influenced by the interest
rate differential between the two countries.

01/27/2022 CIMP 52
 Forward rate parity

Ft (X/Y)= ESt (X/Y)

Ft (X/Y) = Forward rate of one unit of currency X in terms of Currency Y for

delivery in t days/months

ESt (X/Y) = Expected spot rate of one unit of currency X in terms of currency Y on
the maturity date of the forward contract

01/27/2022 CIMP 53
 Fisher Effect

(1+ Nominal rate of interest) = (1+ real rate of return ) (1+ Expected rate of inflation)

(1+r) = (1+R) (1+i)

(1+R)= (1+r)t/(1+i)t

r = R+i+Ri

Nominal rate of Interest = Real rate of return+ Expected rate of Inflation +(Real rate of
return * Expected rate of Inflation)

(rh-rf ) = (ih-if)

Assume that an investor expects a 5% real return on his investment when the
economy is experiencing a 10% inflation rate. The fisher equation indicates that the
investor should get a nominal interest rate of 15.5 per cent.

So, r = R+I (when R and I are small), so Nominal rate of return= Real rate of return+
Expected inflation
01/27/2022 CIMP 54
 If the law of one price holds for real rates of return in different countries, then
rh=rf. If the real rates of interest are different in different countries, arbitrage
activities (carry trade) would cause capital to flow from the country with the
lower real return to the country with the higher real return.

The PPP implies that the real interest rate is the same across the world, and it
is only the nominal interest rate which varies from country to country,
depending on the expected inflation rate.

Ft/S0= E (St)/S0=[1+ E(ih)]t/[1+E (if)]t=(1+rh)t/(1+rf)t

01/27/2022 CIMP 55
01/27/2022 CIMP 56
 Exchange rate Forecasting

Forward rates are available only for short maturities and therefore
their forecasting Horizon is limited to short periods (up to one year).
Although long-term forward rates can be deduced from the interest
rate differential, the factors that affects exchange rate in the long run
cannot be factored into forward rates and therefore such forward
rates may not correctly estimate the future spot rate.

Fundamental Analysis
Technical Analysis

01/27/2022 CIMP 57
 The monetary Model
The monetary model attempts to predict a proportional relationship between
nominal exchange rate and relative supplies of money between nations

Economies that follow a relatively expansionary monetary policy will observe

depreciation of their currencies, while those that follow relatively restrictive
monetary policy will observe appreciation of their currencies

Relative money supply

Relative interest rate
Relative national output

Log e= a+ b1 log (Md-Mf)+ b2 log (id-if)+ b3 log (yd-yf)

There are two version of the monetary model one is flexible-price monetary
model (PPP hold, and real exchange rate is constant over time)
And the other one is sticky price monetary model (price is sticky in the short run
and PPP hold in the long run)

01/27/2022 CIMP 58
 The asset market model

Views foreign exchange as a financial asset and accordingly, its price

(exchange rate) is determined by the demand and supply for the stock of
foreign exchange

Exchange rates, as with other financial asset prices are determined by

expectations of future events.

This model is based on the assumption that asset markets are efficient and
fully reflect all available information.

01/27/2022 CIMP 59
 The Portfolio balance Model

People divide their total wealth between domestic and foreign money, and
domestic and foreign bonds, depending on their expected return and risk.

TW= M+Bh+SFh
= Bm+SFm+Bh+SFh

The monetary authority of a country can increase the money supply in the
economy by buying either domestic bonds (through OMO) or foreign bond (a
non-sterilize foreign exchange operation). A sterilize foreign exchange
operation refers to keeping money supply in the economy to its original level .

01/27/2022 CIMP 60
 Technical analysis is the study of the technical characteristics that are
expected at major market turning points This method focuses on
studying historical data of exchange rates and volume of trade. The
foreign exchange markets have cyclical movements.

An active market participants who is able to identify the turns in the

market would be able to buy at bottoms and sell at peaks.

Unlike fundamental analysis where factors like interest rates and

inflation rates are studied, technical analysis is based on purely on the
study of the behaviour of past exchange rates (through charts, trend
analysis, moving averages etc.) and the volume of currencies traded.

01/27/2022 CIMP 61