Exchange Rates and the Balance of Payments

 

Just as the basic determinants behind the supply of and demand for wheat are critical in fully understanding the behavior of wheat prices, so it is important to understand the factors behind the supply of and demand for foreign exchange to determine the price of a foreign currency. Again, it should be stressed that the factors determining the demand for Euros are also the factors determining the supply of dollars, and the factors determining the supply of Euros also determine the demand for dollars.  The balance of payments is a systematic array of all the factors that determine the foreign exchange rate.  That array follows long established conventions and is all-inclusive and mutually exclusive among the individual factors.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 


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Assuming the supply of Euros constant (demand for $$ is constant) the effect of an increase in any of the factors determining the demand for Euros (supply of $$) would cause the $ price of the Euro to rise (the Euro price of the dollar to fall). Hence, if there is an increase in U.S. imports of goods from Germany, imports of services from Germany, more U.S. gifts to Germany, more U.S. long‑term investment in Germany, or more U.S. short‑term investment in Germany, the demand for Euros increases (the supply of $$ increases) and causes the $ price of the Euro to rise (the Euro price of the $ to fall). This would be termed a depreciation of the dollar in respect to the Euro (appreciation of the Euro in respect to the U.S. Dollar).

 

Similarly, assuming the demand for Euros constant (supply of dollars constant), the effect of an increase in any of the factors determining the supply of Euros (demand for $s) would cause the dollar price of the Euro to fall (Euro price of the dollar to rise). Thus, if Germany increases imports of American goods, imports of U.S. services, gives more gifts to the U.S., Germany increases its long‑term investment in the U.S., or increases its short‑term investment in the U.S., the supply of German Euros increases (demand of $$ increases) and causes the $ price of the Euro to fall (the Euro price of the $ to rise). This would be termed an appreciation of the dollar in respect to the Euro or a depreciation of the Euro in respect to the U.S. Dollar.

 

It should be obvious that a U.S. import from Germany is identical to a German export to the U.S., and that a German import from the U.S. is identical to a U.S. export to Germany. If you have trouble understanding why U.S. investment in Germany and U.S. gifts to Germans are listed with U.S. imports of goods and services from Germany, think of U.S. investment in Germany as the import of financial claims and U.S. gifts to Germany as the U.S. importation of thank you notes or goodwill. All of these result in a demand for Euros as well as a supply of dollars.

 

There are even more basic factors that lie behind the determinants of the demand for and supply of foreign exchange. For example, what can cause the U.S. to import more German goods? The rate of wage increases in the U.S. could exceed that in Germany, which if occurring while rates of labor productivity increase are the same in both nations, results in unit labor costs rising more rapidly in the U.S. In turn, this would tend to cause a higher inflation rate (lower deflation rate) in the U.S. than in Germany. Of course equivalent increases in wage rates while the Germans are experiencing high rates of productivity increases would cause similar consequences. More rapid rates in growth in money and credit in the U.S. than in Germany would also tend to result in higher inflation rates in the U.S. than in Germany. Serious and prolonged strikes in the U.S. could lead to more imports of some goods. If the U.S. were at capacity while the Germans had idle capacity, it would tend to result in an increase in U.S. imports.

 

Similarly, a number of factors lie behind the amount of U.S. investment in Germany as well as their investment in the U.S. If real interest rates rise more in the U.S. than in Germany, it will tend to cause less U.S. investment in Germany and more German investment in the U.S.  Shifts in the political climate that increase the riskiness of investment will likewise effect investment flows. For example, if a radical socialist party assumes control of the German government and threatens nationalization of business, the U.S. investment in Germany will drop precipitously and a flood of German investment in the U.S. will occur.

 

Shifts in foreign policy or changing ethnic concerns can cause substantial shifts in gifts from one nation to another (called unilateral transfers). U.S. Marshall Plan aid after World War II caused a sharp rise in U.S. gifts to other nations. An outflow of funds from Jews and those sympathetic to the Arab cause always rise when Middle East tensions reach the flash point. These can cause shifts in the demand and supply of foreign exchange thus causing changes in the exchange rates.

 

The determinants of the demand for and supply of foreign exchange, and thus the exchange rate, are also determinants of the various balances within the overall balance of payments. The factors that would tend to cause an increase in the supply of foreign exchange would also tend to cause a surplus (or reductions in a deficit) in the balance of payments. Factors causing an increase in the demand for foreign exchange would tend to cause balance of payments deficits (or reductions in surpluses).

 

The factors that were numbered one in the list of factors determining the demand for and supply of foreign exchange, when netted out, give what is called the Merchandise Balance. If the dollar value of goods (merchandise) exported to Germany exceeds the dollar value of goods (merchandise) imported from Germany, it is termed a surplus on U. S. merchandise balance. Thus, when we draw the line under the factors numbered one in our list above, the net or balance is called the merchandise or goods balance.  A surplus in this means that more Euros are being supplied by German importers of U.S. goods than are being demanded by American importers of German goods (this could also be called a surplus on merchandise or goods account). In the absence of any other factors, it means that the dollar price of the Mark would fall (dollar is said to appreciate) and the Euro price of the $ would rise (Euro said to depreciate). But other factors play their part in the overall picture.

 

If we also consider the import and export of services along with the imports and exports of goods (that is we draw the line below one and two above), we get the balance on merchandise (goods) and service account. This balance is more inclusive of the factors affecting exchange rates but still leaves out unilateral transfers and capital flows. Before we include these items it would be helpful to give some examples of the goods and service balances. Assume that U.S. import of German goods or merchandise is 20 and an U.S. export of merchandise to Germany is 15.  Also assume that U.S. imports of services from Germany is 4 and the U.S. exports of services is 7. The U.S. merchandise balance with Germany would be in deficit by 5, the services balance would be in surplus by 3. However, the goods and service balance would have a deficit of 2.  In our examples, we would consider only such items between the U.S. and Germany.

 

While the merchandise account is pretty easily understood the services account is much more complicated. American tourist expenditures abroad (Germany in our limited balance of payments examples), U.S. expenditures on foreign shipping and related services, foreign income on their past investment in the U.S. (on German investment in the U.S. in our limited balance of payments with Germany are all included in the services as they constitute a supply of dollars and a demand for Euros. Note that only the income on past investments is included in the Services Account. The investment expenditures themselves are included in the capital account. The income on foreign investments constitutes a supply of foreign exchange while a nation's investment in the rest of the world constitutes a demand for foreign exchange.  Similarly, German tourists in the U.S., German use of American transportation and U.S. firms' repatriation of income from past capital investments in Germany are the other side of the Services Account.

 

Capital flows should be considered in determining the balance of payments.  By drawing the line under the first four items listed above and netting them out, we arrive at what is termed the basic balance. In this balance only long‑term capital flows are included above the line.  Short‑term flows are considered accommodative and determined by items in the basic balance. The treatment of short‑term capital flows will be considered later. The factors leading to a surplus in the balance of payments are factors that supply foreign exchange. The factors leading to a deficit in the basic balance are factors that demand foreign exchange in the foreign exchange markets.

 

It is crucial to see that the same forces determine exchange rates and balances in the balance of payments. The balances in the balance of payments are just a systematic arrangement of these factors, which were listed above. A deterioration of the U.S. balance of payments will cause in a system of floating exchange rates, a depreciation of the value of the dollar in the foreign exchange markets.  In the absence of other factors, the dollar would depreciate ($$/Euro would rise and the Mark appreciate).

 

Assume U.S. exports of goods to Germany are 15, U.S. imports of goods from Germany are 12. Thus, the U.S. merchandise balance is in surplus by 4. Further assume that U.S. exports of services to Germany are 9 and imports from Germany of services are 15. The U.S. services balance is in deficit by 6, but the balance on goods and services account is in deficit by 2. There are many other possible combinations of goods and services balances.

 

The line could be drawn farther down on our list of factors affecting the exchange rates. If in addition to goods and services we include unilateral transfers, we arrive at what is called the Current Account Balance. That balance consists of: U.S. exports of goods and services to Germany plus German unilateral transfers to U.S. less the sum of U.S. imports of goods and services and U.S. gifts to Germany. Again there are a number of combinations of deficits and surpluses in the goods, services, and deficits and surpluses in the goods, services, and unilateral transfer accounts that would lead to a surplus, deficit or balance in the current account.

 

The history of the U.S. is rich in different variations of such combinations. The early 1800s often showed deficits in the current account balance because of deficits in the accounts for goods, services, and unilateral transfers. The early 1900s showed a surplus in the goods account, deficits in the services account and unilateral transfers, but a surplus in the overall current account balance. Recently, the U.S. has had deficits in the goods and unilateral transfers accounts partially offset by a surplus in the services account leading to a deficit in the more inclusive current account balance.

 

Before considering capital flows, it would do well to consider what is included in the term services (sometimes called intangibles or invisibles). The most important items are tourist expenditures, shipping or related expenditures and income on foreign investment made in previous periods. U.S. exports of services would include: foreign tourist expenditures in U.S., foreign expenditures on U.S. transportation services and related activities such as foreign payment of premiums to U.S. insurance companies, and repatriated profits, dividends, and interest on U.S. investments overseas. The short‑term capital flows assure that the balance of payments will balance if there is no government intervention. Should the demand for foreign exchange not equal the supply of foreign exchange at the prevailing exchange rate, the exchange rate will change until demand and supply equal each other. An important policy question is how to treat these short‑term capital flows. If the U.S. were not a key currency country, one could argue that short‑term capital flows are merely accommodative of the items making up the basic balance.

 

It should be noted that basic balance items as well as short‑term capital flows are influenced by speculative motives. In the case of the U.S., since its currency is an international medium of exchange and a primary store of value in foreign portfolio holdings of non‑Americans, short‑term capital can change independent of the changes in the factors determining the basic balance; that is, short‑term capital flows are not simply accommodative. To the extent that the rest of the world desires larger or smaller amounts of short‑term dollar assets, short‑term capital flows will not be simply a balancing item. They can be exogenous factors influencing the exchange rate.

 

Assuming that the rest of the world wants more dollars as either a store of value or as a medium of exchange, foreign investment in short‑term dollar assets in this nation (such as U.S. Treasury Bills) will increase, thus increasing the demand for the dollar and the supply of foreign exchange, with the result of an appreciation of a dollar and a depreciation of the market value of foreign exchange. In fact, there is some justification for treating short‑term capital flows that occur as a result of the demand for dollars as the international medium of exchange and store of value, as exports of dollars. This would show these flows above the basic balance line and in fact could put them in the merchandise balance much as South Africa would show gold exports in the trade balance.

 


                       


 

 

 

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