Balance of Payments &

Foreign Exchange

FOREIGN EXCHANGE
Floating Exchange Rate
System
Fixed Exchange Rate System
The Managed Float System
Purchasing Power Parity
Theory of Exchange Rate
Determination

Guess the Currency

Canadian $

Australian $

Euro
US $

Sing $

Thai Baht

Why use Foreign Exchange?

People in different countries speak different
languages, doing business in other countries
require different monies ($, , , ) as well.
Need to convert from one type of currency to
another whenever business crosses
international borders.
The currency of another country needed to
carry out such international transactions Foreign Exchange.

EXCHANGE RATE

Rate at which one

currency can be
exchanged for another
Determined by DD &
SS of S$ in FOREX
Market

FOREIGN EXCHANGE
DD for S$ depends on
foreign DD for our
goods, services or
assets
SS of S$ depends on our
DD for foreign goods,
services and assets

Foreigners Buying
Japanese to buy Singapores goods,
services or assets - have to pay in S$.
need to exchange their currency for
the required amount of S$ - increases
the demand for S$.
Demand for S$ depends on foreign
Demand for the local goods, services or
assets

Singapore Buying
Singaporeans to buy Japanese goods,
services or asset - exchange S$ for Yen
local car dealer to import Japanese
cars- - exchange S$ for the required
quantity of to pay
Since we supply S$ in exchange for
foreign currency, the supply of S$ is
dependant on our demand for foreign
currency - depends on demand for
foreign goods, services and assets.

Review Question (P 3)
Suppose a large car importer in the UK
wants to import 3,000 cars from Japan
costing 15 billion Yen. What will it do?

REVIEW QUESTION (p.3)

Car importer will shop around banks
for best exchange rate
Best exchange rate = most
Yen/pound
The banks in turn obtain their Yen
from Japanese who buy British goods

FLOATING EXCHANGE RATE

SYSTEM
-LOATING EXCHANGE RATE

Demand for S$
Yen/S$
110
100
Demand
for S$
Q1

Q2

Qty of S$

Supply of S$
Yen/ S$

Supply
of SGD

110
10
0

Q1

Q2

Qty
SGD

FLOATING EXCHANGE RATE

SYSTEM
Yen per S$
S$ Supply

100

DD and SS intersection
ER is S$1 = 100 Yen.
100 Yen is required to
purchase 1 S$
Price of 1 S$ is 100
Yen
Value S$ in terms of
another foreign
S$ Demand
currency
Figure 1: DD and SS of S$

Quantity of
S$

Figure 2a: Changes in Demand for S$

Yen per S$

120
100

DD for the S$ increase from D

to D1
S
At S$ = 100 Yen shortage
Initially
results D and S intersect
New equilibrium
S$
appreciates.
=>
S$1
= 100 with
Yen S
D1 intersects
Fall in qty DDed of Spores
exports
S$1 = 120
Yen
and assets
Shortage
Fall in the of
qtyS$
DDed of S$
eliminated
Rise in qty DDed for Jap
imports and assets
Shortage
Increase in qty SSed of S$
D1
D
Quantity of
S$

Figure 2b: Changes in Supply for S$

Yen per S$

Initially D and S intersect

=>forS$1
Yen from S to
SS
the =
S$100
increase

Surplus

100
80
D

S1

S1
At S$ = 100 Yen, surplus results
S$ depreciates
Rise in qty DDed of Spores
exports and assets
Rise in the qty DDed of S$
Fall in qty DDed for Jap imports
and
Newassets
equilibrium

in qty SSed
Decrease
S1 intersects
with of
D S$

S$1 = 80 Yen
Surplus of S$ eliminated
Quantity of
S$

Factors Affecting the DD

and SS of a Currency

 Foreign DD for the

countrys gds,
services & assets
Similar to factors
affecting DD in
micro

DD for a countrys $

DD for a countrys G+S

(trade)
Changes in taste and
preference of foreigners.
Change in quality of exports
Different inflation rates
Disposable income of
foreigners
Import restrictions by
foreigners

DD for the asset market

(Foreign investments)
Interest rates: deposits
and bonds
Business costs or
incentives.
SS side reasons e.g.
educated & skilled
workforce
DD side reasons e.g.
rising incomes because of
strong economic growth.

SS of a countrys $ depends on:

Local DD for foreign goods
services and assets

SS of $ depends on:
Changes in taste
and preference of
locals
Changes in quality
of imports
Different inflation
rates
Disposable income
levels of locals
Import restrictions
by locals

Change in SS of local
currency due to foreign asset
market
Interest rates of
foreign assets
Business costs or
incentives overseas.
e.g. business outlook

Appreciation or Depreciation?
Depends on the DIRECTION &
MAGNITUDE of the shifts in the
DD &SS curves of a currency.
E.g.
If dd S$ ss S$ S$
Depreciates against Yen

REVIEW QUESTION (p.8)

Q1
Donations / Humanitarian Aid
Forex speculation. Currency traders
buy & sell foreign exchange in an
attempt to profit by changes in exch.
rates

REVIEW QUESTION (p.8)

Q2
Fall in DD for S$ and/or increase in SS of S$:
Increases in domestic prices vs. foreign
prs.
Increases in domestic Y vs. foreign Y
Reductions in domestic i/r vs. foreign i/r
Worsening I prospects at home vs. abroad

Fixed Exchange Rate

System
Freely floating ER:

Volatile - fluctuate daily as

market conditions change
Country prefer to fix ER:
Eliminate fluctuations
Facilitate international
trade and investments
E.g. China RMB &Malaysia
RM peg to the US $
previously
Central bank intervention
needed to fix ER.
CENTRAL BANK MUST
MAINTAIN SUFFICIENT
FOREIGN RESERVES TO
DEFEND THE FIXED RATE

Figure 3: Maintaining an Undervalued Exchange Rate

DD for the HK$

S
increase from D to D1
ER fixed at E
Shortage of QQ1 of
HK$
CB of HK need to SS
this shortage
Sell HK$ for US$ in
the FOREX market.
D1
Foreign reserves of
D
US$ increase.

US$ per HK$

Q1

Quantity of HK$

HK$ undervalued
HK$ below the free
market value
To increase value =>
revalue

Can undervalued
currency be
maintained?
Yes in theory
No limit to accumulation
of foreign reserves
In reality, protectionist
threats from export
markets facing BOP
deficit
Lower potential SOL as
imports are expensive

REVIEW QUESTION (p.10)

Chinas X cheaper
USs M more expensive
Chinas (X-M) increases leading to a higher
trade surplus & foreign reserves
Retaliation or threat by US?
Keeping Chinas e/r undervalued will lead
to an increase in Chinas domestic money
SS Inflation
Ref ST 23/4/11 Call for China to curb forex
reserves

Figure 4: Maintaining an Overvalued Exchange Rate

US$ per HK$

S

D
D
Q

DD for HK$
decrease from D to
D
ER fixed at E
Surplus of QQ
Prevent the HK$
from depreciating
CB buy HK$ with
foreign reserves.
CB will lose
foreign
reserves.
Quantity
of
HK$

HK$ overvalued:
ER above free
market value
Lower value =>
devalue its currency
downwards
Not possible have
overvalued currency
indefinitely:
Need to run down on
foreign reserves
When reserves run
out currency forced to
devalue

REVIEW QUESTION (p.11)

Speculators sold Baht leading to
depreciation
Bank of Thailand defended by selling
its foreign currency to buy Baht
Fixed exchange rate had to be
abandoned once foreign reserves ran
low

The Managed Float System

ER is allowed to fluctuate within

an undisclosed band
If value of $ is within that band,
Central Bank will not intervene

Yen per S$
S

E1
E2

If ER reaches
the
If DD for
S$upper
increase
limit/lower
fromlimit:
D to D:
CentralCentral
Bank will
sell
Bank
selloff
off
or to buy
S$
S$back
(in exchange
for
Yen)
Meet the shortage of
Q1Q2
Prevent the
exchange rate from
rising above E1
D

Quantity of S$
Q11

Q2

REVIEW QUESTION (p.12)

MAS intervenes to sell S$ for
Yen so as to at least meet the
shortage of Q1Q2 of S$ &
prevent e/r from rising above
E1

Why countries adopt a

manage foat system?
Enjoy flexibility in
exchange rates
Avoid sudden
massive detrimental
fluctuations
Large rise in $ value
cause exports to be
uncompetitive
Large fall in $ value
cause severe
imported inflation

The Singapore Exchange Rate

System

Managed float regime

S$ pegged against a
basket of currencies major trading
partners and
competitors
Weights depend on
extent of trade
dependence
Composition of
basket is periodically
changed as our trade
patterns change

Exchange rate Regimes / Systems

Freely Floating
ER System
ER determined by
the forces of
demand & supply

No government
intervention

Fixed
ER System

Managed Float
System

ER is pegged /
fixed at a given rate
against (usually)
the US$

ER is allowed to
fluctuate within
a certain band

Government
intervention

Periodic
Government
intervention

Purchasing Power Parity Theory

of Exchange Rate Determination

Purchasing Power Parity

Theory
Assumption of
unrestricted trade
& fully flexible ERs
Predicts that ER in
LR reflects different
price level between
countries.
ER adjust in LR to
equalize purchasing
power between
currencies

Foreign exchange price of the S$

(measured in Yen /S$)
= Price level in Japan
Price level in Singapore

Example:

Basket
of
goods
costs
Adjustment mechanism
Yen in Japan &
of 10000
PPP theory
S$50 in
in Japan
Spore rise but
Prices
1 Singapore
dollar
Spore
prices unchanged
worth 200goods
yen.
Singapore
PPP predicted
LR ER is
relatively
cheaper
S$1 = 200
Yen more
Japanese
import
from
Spore
If the
same basket
Increase
S$ Yen
increaseDD
to for
12500
S$in
appreciate.
Japan
Appreciation
But price in continues
Spore still
until
pricesinare
= S$50
Singapore,
equalized
in
both
Predicted ER is 250
countries
Yen = S$1.

In general,
Higher infation rate causes
depreciation
Fall in the internal value leads to fall

Criticisms of PPP
theory
1.Many goods are not
traded internationally
BUT:
Higher prices of nontraded products will
raise cost of living
Higher wages and
hence higher price of
traded products
results

Criticisms of PPP
theory
2.Distortions by
taxes, subsides,
transport costs
BUT:
Taxes, subsidies,
transportation on
overall cost are
usually quite small

Criticisms of PPP
theory 3.International
capital movements
BUT:

Fluctuations ST
In LR, financial
markets adjust to true
economic performance
of the country
Hence ER depends on
price and output levels
in the real sector in LR

Balance of Payments
Statement of
international
transactions over
a year.
Records the
international
inflows and
outflows of S$

Outfow of S$
Debit item
(denoted with
negative sign)
Purchase
foreign goods,
services or
assets Exchange S$ for
foreign currency
- S$ flows out

Infow of S$
Credit item
(denoted with
positive sign)
Foreigners
purchase our
goods, services
and assets
Pay us in S$
Inflow of S$

BOP made up of:

Current account
Capital account
Balancing item
Total currency flow
Official financing
account

Current Account
Visible Balance
Exports and imports
of goods
Invisible Balance
Exports and imports
of services,
Property (asset)
income paid to and
received from abroad
Unilateral transfers
paid to and received
from abroad

Capital Account
ST K fowssales &
purchase of
liquid assets
LT K fows
Portfolio
Investments
Direct
Investments

Balancing Item
Errors and omissions or statistical
discrepancies - occur as information needed
for the accounts are from millions of reports

Total Currency Flow =

Current Account + Capital Account +
Balancing Item

TCF shows whether there is a net inflow

or outflow

 Under managed
foat system:
TCF = 0
BOP in equilibrium - no
pressure on the currency
to appreciate or
depreciate since the total
demand for the currency
(represented by inflow) is
equal to the supply
(represented by outflow).

 TCF = 0 BOP equilibrium.

TCF > 0 BOP surplus (+)
Due to undervalued
currency Qd S$ > Qs of S$
MAS sells S$ & increase
foreign reserves.

TCF < 0 BOP deficit ( - )

Due to overvalued currency
Qs of S$ > Qd of S$
MAS buys S$ & decreases
foreign reserves

Official Financing
Account
In reality, all countries
manage their ER
Central banks try to
prevent their ER
from sudden and
severe fluctuation
Forex transactions
by Central Bank
recorded under OFA

-ve OFA means MAS losing S$ but gaining

foreign reserves
+ve OFA means MAS gaining S$ but losing
foreign reserves

Relationship between TCF &

OFA
BOP surplus (+) due to
Spore exports.
Excess DD for S$ =>
shortage of S$
To prevent
appreciation of S$,
MAS sells S$ to for
foreign exchange
Accumulation of
foreign reserves
-ve OFA

Table 1 Balance of Payments Singapore 2010

S$ million
A

Current Account Balance

Goods Balance

67,430.8
63,596.3

Exports of Goods

487,972.1

Imports of Goods

424,375.8

Services Balance

21,606.1

Income Balance

-11,221.2

Net Current Transfers

-6,550.4

Capital and Financial Account Balance

Net Capital Account
Net Financial Account*

-9,458.0
-454.5
-9,003.5

Direct Investment

25,768.4

Portfolio Investment

-29,815.6

Other Investment

-4,956.3

Net Errors and Omissions

-492.3

Overall Balance (A+B+C)

57,480.5

Official Reserves (Net)

-57,480.5

 Drawing on Official Reserves (positive

sign)
Addition to Official Reserves (negative
sign )

Always balance
When all the individual accounts (Current,
Capital and Official Financing) are summed up
together with the balancing item, the total sum
must be equal to zero since any discrepancy is
accounted for by the balancing item.
Current
Account

(A)

Capital
+
Account

(B)

Balancing
Item

(C)

Official
=
Financing
Account

Zero

(E) (Refer to table 1)

BOP Adjustments in a
Floating Exchange Rate
System

Floating Exchange
Rates
Any BOP
disequilibrium is
only temporary
ER adjusts to
bring BOP back
to equilibrium
state

Yen Per
S$

SS$
SS$1

Deficit
Eo
E1
DS$
Q1 Q3

Q2

Qty of
S$

Rise in DD for
Japanese M
Increase in
SS of S$ to
SS$1
Temporary
BOP deficit of
Q1Q2
S$
depreciate

As S$ depreciate
Singapores
products and assets
become cheaper
Increase inflows
into CA & KA
Foreign products
and assets more
expensive
Reduced outflows
from our CA and
KA

Increased inflows
and reduced
outflows
BOP deficit will
decrease.
Depreciation stop
when ER reaches
E1.
Qty DDed = Qty
SSed (at Q3)
BOP reach new
equilibrium.

Marshall-Lerner Condition
AS long as the sum of the price elasticity
of demand coefficients for exports &
imports is greater than one, then a fall in
the exchange rate will improve the BOP &
a rise will worsen it.

Fixed Exchange
Rate

Persistent BOP surplus

is sustainable
Central bank merely
accumulates foreign
reserves
Persistent BOP deficit
may not be sustainable
May be forced to
devalue

Yen Per
S$

SS$
SS$1
Deficit

DS$

Q1

Q2

Qty of
S$

Increase in
DD for
Japanese M
Supply of
S$ increase
to SS$1
Surplus of
S$ = Q1Q2
(BOP deficit)
To fix ER at
E, MAS
purchases
the excess
S$

 BOP deficit imply

ER is overvalued
MAS can maintain
ER if it has
sufficient foreign
reserves
If run out reserves
it must
Borrow from IMF
or from other
country
OR forced to
devalue S$

In LR BOP deficit may

clear by itself
MAS buys back the S$
=> Ms will fall
Contractionary effect
on economy
Real income and price
levels fall
DD for foreign
products and assets
fall
Foreign DD for
Singapores products
and assets rise
BOP deficit eventually
clears

Balance of Payment
Problems

Causes Current Account

disequilibrium I.Prices of gds & services at home &
abroad
II.Incomes of consumers at home
& abroad
III.The foreign exchange rates e.g.
S$ appreciates XM
IV.Taste :Consumers preferences for
foreign & domestic gds and services
due to quality or other reasons. E.g.
preference for holiday destinations.
V.Other factors like transportation
costs or government policies
(e.g. tariffs)

Capital Account disequilibrium

( short-term & long-term capital flows)
(a)Real interest rates paid on foreign and
domestic assets
(b)Perceived risks of holding foreign assets
(c)Business expectations
(d)Other factors e.g. govt. policies

Current Account
Deficit
A fall in equilibrium
national income
Higher living
standard
Increased liabilities
to foreigners or
decreased
ownership of
domestic assets

Current Account
Surplus
a) A rise in Ye
b) Depression of
domestic living
standards
c) Inflation
(X-M)AEddpull inflation
(near full
employment)
c)Retaliation e.g.
US vs Japan
US vs China

Capital Account Deficit

Less employment
opportunities for the
domestic economy

Capital Account Surplus

excessive expansion of aggregate demand
or macroeconomic overheating
- Inflationary pressure
- appreciation of currency
- widen current account deficits
S-t capital inflows increases financial volatility
However, FDI increases output and
employment if economy is below full
employment.

Overall BOP Deficit

Drawing down on
reserves

Impact of
Globalisation
Interdependence
through trade
Interdependence
through financial
markets

BOP Application Questions

Component of
BOP Affected

An
increase
in the
domestic
inflation
rate

Current Account
Trade balance
(less exports
due to higher
prices export
earnings
depend on
price elasticity
of dd; more
imports for
cheaper
alternatives)

Changes to
Inflow /
Outflow

inflow
outflow

Effect on
BOP (i.e.
deficit or
surplus )

Impact on
DD/and SS
of Domestic
Currency

BOP deficit

demand
supply

BOP Application Questions

Component of
BOP Affected

An
increase
in the
domestic
inflation
rate

Changes to
Inflow /
Outflow

Capital Account
DD-pull inflation:
If mild inflation,
may boost FDI

inflow

Cost-push
inflation:
Foreign
investment (long
term capital inflow)
may fall as cost of
production rises
Short term capital
may be affected
due to speculation

inflow
outflow

Effect on
BOP (i.e.
deficit or
surplus )

BOP deficit

Impact on
DD/and SS of
Domestic
Currency

Mild inflation:
demand
Cost-push
inflation:
supply
demand

BOP Application Questions

Component of
BOP Affected

A fall in
unit
labour
cost

Changes to
Inflow /
Outflow

Effect on
BOP (i.e.
deficit or
surplus )

Current Account inflow

BOP surplus
Trade balance Likely outflow
(more exports
due to improved
cost
competitiveness
export
earnings
depend on
price elasticity
of dd; less
imports)

Impact on
DD/and SS of
Domestic
Currency

demand
likely
supply

BOP Application Questions

Component of
BOP Affected

A fall in
unit
labour
cost

Capital Account
More foreign
investment (FDI)
due to better cost
competitiveness,
less investment
overseas

Changes to
Inflow /
Outflow

inflow
outflow

Effect on
BOP (i.e.
deficit or
surplus )

BOP surplus

Impact on
DD/and SS of
Domestic
Currency

demand
supply

BOP Application Questions

Component of
BOP Affected

Political
instability
in the
home
country

Current Account
X may fall if
production is
disrupted.
Capital Account
Short term capital
flight and long
term capital
investment falls
due to poorer
business climate

Changes to
Inflow /
Outflow

inflow

outflow
inflow

Effect on
BOP (i.e.
deficit or
surplus )

BOP deficit

Impact on
DD/and SS of
Domestic
Currency

demand

supply
demand

Explain how China keeps the yuan

undervalued. (8)
Undervalued currency-ER fixed below free
market rate
Explain how intervention is done.
-C/A surplus that China runs with various
countries esp. US dd for yuan
-To stop yuan fr. appreciating, China central
bank intervenes by selling yuan.
This ss prevents yuan fr appreciating & keeps
yuan value fixed.
This means China gains foreign reserves & the
yuan is fixed at a level below the equilm ER

Figure 3: Maintaining an Undervalued Exchange Rate

DD for the yuan

S
increase from D to D1
ER fixed at E
Shortage of QQ1 of
Yuan
CB of China need to
SS this shortage
Sell Yuan for US$ in
the FOREX market.
D1
Foreign reserves of
D
US$ increase.

US$ per
Yuan

Q1

Quantity of
Yuan

APPENDIX

APPENDI
X

FLOATING VERSUS FIXED

EXCHANGE RATE SYSTEMS :
AN ASSESSMENT

Problems with foating

exchange rate
Uncertainty in International trade
and Investment

unsure of levels
in bus.
dealings
deter LT contracts / investments
vol. of trade

Problems with foating

exchange rate
Speculation
undesirable for firms
recourse made to forward
market
Lack of discipline on the domestic
economy
Floating sys BOP in eq.
To N AD may excessively

Problems with fixed

exchange rate
Need for adequate foreign
reserves

Makes monetary policy ineffective

Speculation
Esp. for ctries with persistent BOP
deficits trying to maintain
overvalued currency

Advantages of foating
exchange rate system
Automatic correction of BOP
disequilibria

No need to hold foreign reserves

Advantages of foating
exchange rate system
Protects the economy against
external shocks to a certain
extent
Eg: UK on floating
sys. & rest of

world in recession
UK Xs dep. of UK Xs
cheaper AD
Hence impact of world recession
on UK
Domestic policy is not constrained
by BOP

Advantages of fixed
exchange rate system
Certainty in international trade
and investment

Imposes discipline on government

macroeconomic policies