Understanding Balance of Payments, Exchange Rates, and Monetary Policy
Item 7: Balance of Payments and Exchange Rates
The balance of payments reflects a country’s transactions with the rest of the world. The balance of trade is the difference between exports and imports. The balance of goods and services of a country is the difference between exports and imports over a given period. The current account balance is the sum of the balance of goods and services, plus net income, plus net transfers. The financial account balance measures financial flows. The sum of the current account and financial account is, by definition, zero.
Foreign Exchange Reserves
Central banks and deposit institutions accumulate foreign exchange reserves. These are cash or accounts in currencies other than the domestic currency. Countries manage these reserves for various purposes, mainly to alter the exchange rates of the national currency with respect to foreign currencies. In the financial account of the balance of payments, an increase in the volume of foreign reserves is accounted for negatively. This is because increases in assets are reported as negative. The Spanish balance incorporates both the balance against other currencies and a clearing account with the other Eurozone countries.
The Role of Exchange Rates
Currency exchange takes place in the foreign exchange market. The prices at which currencies are traded are exchange rates. When a currency gains value against other currencies, it is said to have appreciated. Appreciation ($) implies that Imports (M) increase, Exports (X) decrease, decreasing the demand for that currency to deal with the acquisition of U.S. exports by Europeans (downward-sloping demand). Appreciation ($) implies that M increases, X decreases, increasing the supply of that currency to cope with increased imports of European goods by Americans (upward-sloping supply). When a currency loses value against other currencies, it is said to have depreciated.
Exchange Rate Regimes
An exchange rate regime is a rule that guides exchange rate policy. A country has a fixed exchange rate if the state keeps the exchange rate constant relative to other currencies or near a specific objective. A country has a flexible exchange rate (or floating exchange rate) when it is allowed to fluctuate freely according to the market.
Item 8: Okun’s Law
According to Okun’s Law, an additional percentage point in the output gap reduces the unemployment rate by a value of less than one percentage point.
This is the modern version of Okun’s Law:
Unemployment Rate = Natural Rate of Unemployment – (0.5 × Output Gap)
Item 9: Monetary Policy and Inflation
Expansionary Monetary Policy
Expansionary monetary policy: Increases Money Supply (M) -> Decreases interest rates -> Increases Investment -> Aggregate demand increases (moving right) -> Real output and potential output increase -> Wages increase -> Aggregate supply shifts to the left -> Long-term increase in prices and lower production. The increase in the money supply is equal to the increase in prices in the long term, so it has no effect on the level of production but on the price level, feeding an inflationary spiral.
Hyperinflation
Hyperinflation is defined as monthly inflation of at least 50%. In a situation of high inflation, the population tends to reduce the demand for money: the general population prefers to keep its wealth in non-monetary assets or in a relatively stable foreign currency. The main cause of hyperinflation is a massive and rapid increase in the amount of money that is not supported by growth in the production of goods and services.
The Costs of Inflation
- Costs of Converting Non-Monetary Assets: Inflation discourages the public from holding money (they keep wealth in goods), making transactions more complicated as they have to sell assets before dealing with large payments.
- Menu Costs: The costs associated with having to change prices frequently.
- Accounting Unit Costs: Inflation reduces the reliability of money as a unit of measure of the value of goods, services, and assets.