Understanding Balance of Payments, Exchange Rates, and Philips Curve

Ch 31: Balance of Payments

The balance of payments is a systematic record of all economic transactions between residents and non-residents of a country over a period. It is categorized into:

• Goods and Services (Trade Balance): This is the most significant component.

NX = NCO + Reserve Asset

Vehicle currency: $, Yen, Euro, Yuan

Real Exchange Rate: P / (P*e), where an increase in the Real Interest Rate (RIR) leads to a decrease in Net Capital Outflow (NCO), and a decrease in RIR leads to an increase in Net Exports (NX).

Purchasing Power Parity (PPP): This theory suggests that the nominal exchange rate is determined by the equation RER = P / (P*e) = 1.

Problem: The existence of non-tradable goods.

Arbitrage: Risk-free investment that leads to the Law of One Price.

Why PPP doesn't apply in the short term:

1. No Arbitrage (services, high transaction costs, unique products).
2. Nominal Exchange Rates are significantly influenced by capital flows.

Big Mac Index (Latte Index)

Ch 32: Foreign Exchange Market

Gold Standard: Value fixed to gold.

Foreign Exchange Market Characteristics:

1. Largest Market
2. Round-the-clock Market
3. Decentralized (transactions occur via computers)

Wholesale Market: Decentralized market where banks and large corporations trade.

Retail Market: Bank counters.

Factors increasing Demand for foreign currency:

1. Increase in income of domestic residents.
2. Increase in foreign investment by domestic residents.

Factors increasing Supply for foreign currency:

1. Increased preference for domestic products.
2. Increase in income by foreigners.
3. Increase in investment by foreigners.

Capital Flight: A large and sudden outflow of capital.

Fixed Exchange Rate System: The government or central bank determines the exchange rate.

Advantages: No uncertainty about foreign exchange rates, facilitating long-term planning.

Disadvantages:

1. Vulnerability to speculative attacks: When devaluation or revaluation is imminent (e.g., 1997 crisis in Thailand).

Methods to reduce Excess Demand:

1. High interest rates to attract foreign investment.
2. Devaluation of the domestic currency.

2. Impossible Trinity: Fixed exchange rate system, capital liberalization, and autonomous monetary policy cannot coexist.

Managed Floating (Dirty Floating): A hybrid system.

Advantages: Automatic resolution of current account imbalances, allows for autonomous monetary policy.

Disadvantages: Uncertainty makes foreign exchange rate forecasting difficult, hindering long-term planning.

Floating: Determined by the foreign exchange market.

Ch 35: Philips Curve

Friedman: The Phillips curve is downward sloping because the Short-Run Aggregate Supply (SRAS) curve is upward sloping.

Misery Index: Inflation Rate + Unemployment Rate

Natural Rate Hypothesis

Disinflation: Fall in the inflation rate.

Deflation: Fall in the Price Level (PL).

Sacrifice Ratio: The percentage decrease in Real GDP for each 1% reduction in inflation.

Rational Expectations Theory:

• Adaptive Expectations Hypothesis
• Rational Expectations:

1. People have rational expectations.
2. The government is credible.
3. Government policy is fully anticipated.

Policy Ineffectiveness Theorem: Advocates of Rational Expectations argue that the Long-Run Phillips Curve (LRPC) and the Short-Run Phillips Curve (SRPC) are both vertical.