The relationship between BoP & Exchange Rate

[Klexos]

Need help with the relationship is BoP and exchange rates - I have no clue about anything on this relationship.

Does anyone know if Tim Riley or Pearson textbooks cover this as well? I hear about this difficult combination but never know how to connect it!

[isaacdelatorre]

Need help with the relationship is BoP and exchange rates - I have no clue about anything on this relationship.

Does anyone know if Tim Riley or Pearson textbooks cover this as well? I hear about this difficult combination but never know how to connect it!

Hey,

Basically, under a floating exchange rate (such as Australia); equilibrium between the supply and demand for $A occurs to set the exchange rate. When changes to either occur, the exchange rates moves to the new equilibrium price. Equilibrium occurs when:
The supply of $A (represented by Imports, Income debits and Capital outflows) = the demand for $A (made up of Exports, Income credits and Capital inflows).

From this,
Supply of $A = Demand for $A
M + Y debits + K outflow = X + Y credits + K inflow
M-X + Y debits - Y credits = K inflow - K outflow

This equation is better known as:

Balance of goods and services + Primary Income Account + Secondary Income Account = Capital account + financial account

Current Account Deficit = Surplus on the Capital and Financial Account

Therefore, when these CAD equals the surplus on the KFA, equilibrium occurs and allows an floating exchange rate to be set
Tell me if this doesn't make any sense to you

[Klexos]

Hey,

Basically, under a floating exchange rate (such as Australia); equilibrium between the supply and demand for $A occurs to set the exchange rate. When changes to either occur, the exchange rates moves to the new equilibrium price. Equilibrium occurs when:
The supply of $A (represented by Imports, Income debits and Capital outflows) = the demand for $A (made up of Exports, Income credits and Capital inflows).

From this,
Supply of $A = Demand for $A
M + Y debits + K outflow = X + Y credits + K inflow
M-X + Y debits - Y credits = K inflow - K outflow

This equation is better known as:

Balance of goods and services + Primary Income Account + Secondary Income Account = Capital account + financial account

Current Account Deficit = Surplus on the Capital and Financial Account

Therefore, when these CAD equals the surplus on the KFA, equilibrium occurs and allows an floating exchange rate to be set
Tell me if this doesn't make any sense to you

Thanks for the help, Isaac!

So to clarify, when a CAD persists, it's due to the increased outflow of the Current Account (which can generally be due to borrowing from foreigners to fulfil investment needs...and Australia's increased demand for imports?), and will also change the supply and demand of AUD - hence shifting and then a new equilibrium.

Now with this change that I put (the CAD and all), does the AUD depreciate? And if so, could you explain how? I'm a little confused on how the BoP shifts the value of the AUD!

[birdwing341]

Thanks for the help, Isaac!

So to clarify, when a CAD persists, it's due to the increased outflow of the Current Account (which can generally be due to borrowing from foreigners to fulfil investment needs...and Australia's increased demand for imports?), and will also change the supply and demand of AUD - hence shifting and then a new equilibrium.

Now with this change that I put (the CAD and all), does the AUD depreciate? And if so, could you explain how? I'm a little confused on how the BoP shifts the value of the AUD!

There are a large numbers for Australia's persistent CAD, but basically the primary reason for the high CAD, is the low level of national savings which Australia has. Having low levels of national savings, mean there aren't many domestic funds to be invested into firms (because most of it is being spent via consumption). In order to grow, firms need to bring in investment, and since there isn't enough in Australia, they need to bring it in from overseas (on the Financial Account). However in order to loan funds, lenders demand returns, which are paid off in the Net Primary Income sector of the Current Account.

In the case of increased import expenditure/decreased export revenue or increased servicing costs (on overseas investment), the CAD will worsen (like you said - with increased outflows, which are basically increased income debits and imports).

Thus if the CAD worsens, there will be an increase in demand for foreign currency (which needs to be brought into Australia to continue the level of growth), and therefore also an increase of supply of AUD into the FOREX market, leading to a depreciation. Does that make sense?

[Klexos]

Ah! So, because they are buying foreign currencies...to buy imports, their exchanging injects more AUD into the FOREX market which devalues the AUD?

[birdwing341]

Ah! So, because they are buying foreign currencies...to buy imports, their exchanging injects more AUD into the FOREX market which devalues the AUD?

Yup In order to buy foreign currency, AUD needs to be changed into that foreign currency, which happens in the FOREX market. And because there is now more AUD in the market, its price decreases (because if there's more of something, the price for it goes down - Law of Supply and Demand).

[Klexos]

Yup In order to buy foreign currency, AUD needs to be changed into that foreign currency, which happens in the FOREX market. And because there is now more AUD in the market, its price decreases (because if there's more of something, the price for it goes down - Law of Supply and Demand).

Awesome! Thanks for the help, Bird ! Much appreciated

[Klexos]

Also! To decipher what Isaac has said about capital inflows and outflows, shouldn't there be capital inflows when we have a depreciation and CAD? Regarding foreign borrowing to fund Australian investment, wouldn't there be a capital inflow?

[birdwing341]

Also! To decipher what Isaac has said about capital inflows and outflows, shouldn't there be capital inflows when we have a depreciation and CAD? Regarding foreign borrowing to fund Australian investment, wouldn't there be a capital inflow?

Foreign borrowing is actually just an example of a capital inflow! So in times of CAD (and high level of foreign borrowing) there is a net capital inflow (i.e. more money is coming into Australia than being invested overseas because like we said before, it needs to be brought in to finance the debt).

But when we talk about a depreciation, we have to divide it into short-term and long-term. In the short term, a depreciation causes increased prices of imports and because consumers don't have the time to change their consumption patterns, expenditure on imports increases, worsening BOGS and CAD leading to more capital inflows. However in the long term, Australian exports become more internationally competitive and more foreign nations purchase them, leading to an increase in total export revenue, and import substitutes have had a chance to be created, leading to decreased spending on imports, improving the BOGS and CAD. In the long term, this means there is a reduction in capital inflows (although Australia itself will always remain a capital importer due to a number of factors, i.e. in Australia capital imports > capital exports).

[Spencerr]

the correct technical terminology to what birdwing explained is called the J0curve, you can use it as a diagram in your essays!