[MUSIC] The balance of money flows between economies determines the rate at which their currencies are traded. What are the macroeconomic factors that drive the balance of payments? In this segment, we study how international trade and finance determines the flow of funds between markets. Payments flow across economies for two basic reasons. Number one, the current level of international trade and number two, international financial investment. Current trade flows are measured by the current account. International financial flows are measured by the capital and financial account. The net flow of a foreign currency into an economy is referred to as the balance of payments. The exchange rate is an important factor that determines market flows of currency into and out of the economy. In this segment we will construct a theoretical model which will depict the connection between the exchange rate and the balance of payments. >> After viewing this segment, you should be able to one, calculate the balance of payments using national income accounts. Two, construct the balance of payments model of exchange rates. Two kinds of traders meet in foreign exchange markets. Traders selling foreign currency meet traders selling domestic currency. We look at currency flows. Traders with foreign currency that want to buy domestic currency are foreign currency inflows. Traders with domestic currency that want to buy foreign currency are currency outflows. The balance of currency inflows and outflows from the private sector determine the supply and demand pressures in foreign exchange market. What are the economic transactions underlying these currency flows? First, consider the motivations behind currency inflows. Why might traders bring foreign dollars to buy domestic currency? We divide currency flows into two categories, those for current purposes and those for investment purposes. Current flows are primarily accounted for by exports. Foreign traders will acquire domestic currency to purchase domestic goods. In addition, domestic residents may earn income in foreign currency on their investments or other sources which they bring home through forex markets. Together, these combine to represent current income. Financial inflows include corporate direct investment, foreign investment, and domestic stocks and bonds, lending from foreign banks, and other flows. We can also see the reverse motivation for currency outflows. Current payments are primarily the foreign currency needed to purchase imports. Traders will bring domestic currency to the forex market to acquire these foreign dollars. In addition, interest payments made to foreign investors are similar, are also accounted for as current payments. These will requires flows to the forex market. Finally, when domestic firms, individuals or banks invest in foreign economies they will need to trade domestic currency for foreign. Deconstructing flows into these categories will help us think about their effects. We construct a measure of imbalances in the foreign exchange market called the balance of payments. This is the gap between the foreign currency coming into the market and the domestic currency trying to get out of the market. The difference is the net balance of payments, the net foreign currency entering into the market. Another name for the balance of payments is the official account. The final participant in the foreign exchange market is the central bank. When the balance of payments is positive, this is an indicator that the central bank is purchasing the excess inflow as a foreign currency. When the balance of payments is negative, this indicates that the central bank is selling some of its inventory of foreign reserves to meet the excess demand. To put these flows into perspective, we can see the currency flows in and out of Indonesia in recent years on a net and gross basis. We see that the gross currency flows into and out of Indonesia tend to have range between $100 billion US and $250 billion US. The net balance of payments is smaller. We can think of the foreign exchange market in terms of some commonly used macroeconomic indicators. For example, the current account, which is often used to indicate the trade balance, is officially measured as the current income less current payments. Current income is income from exports plus interest income on international assets. Current payments are for imports or interest paid to international investors. Another more familiar way of writing the current account is as net exports, meaning exports minus imports, plus net interest income, interest income, net of payments. The capital and financial account is a measure of changes in the country's international investment position. This is measured as financial inflows minus financial outflows. The sum of current income and financial inflows is currency inflows. The sum of current payments and financial outflows is currency outflows. So just as the balance of payments is currency inflows minus currency outflows, it is also the current account plus the capital and financial account. Consider balance of payments data for Indonesia in 2017. The current account is a current income at $210 billion US minus current payments at 227.3 billion. This is a current account of negative 17.3 billion. The capital & financial account has financial inflows of $47.9 billion US minus financial outflows of 19 billion. Net financial inflows is 28.9 billion. The sum of negative 17.3 plus positive 28.9 is a balance of payments of 11.6 billion. From the currency market perspective, currency inflows, or current income plus financial inflows, are 210 plus $47.9 billion US, equaling a total of $257.9 billion US. Currency outflows are current payments plus financial outflows equaling 227.3 plus 19 billion, or $246.3 billion US in total. Currency inflows minus outflows can then be calculated as 257.9 minus 246.3, which equals a balance of payments of $11.6 billion US. The current account plus the capital financial account or currency inflows minus outflows are both two ways of calculating the same number, the balance of payments. The balance of payments model will be a simple supply and demand model of the foreign exchange market. The object being sold will be US dollars. We will represent supply as the amount of US dollars that traders will be bring to the market to obtain domestic currency, which we call currency inflows. The demand in the market will be how much foreign dollars traders want to buy with domestic currency. Let's draw a picture of the currency market. We conjecture that traders with foreign currency will want to buy more of it when the exchange rate is low. The reasoning is that when foreign dollars are cheap then imported goods and foreign assets are more attractive. Conceptually, we represent this relationship as a schedule for currency outflows that would be negatively related to the exchange rate. We can think of this as equivalent to a demand curve for foreign currency. By the same token, we conjecture that traders seeing to sell foreign currency will want to sell more of it when the exchange rate is high. The reasoning is that when foreign dollars are more expensive, the domestic currency will be relatively cheap and domestic goods and assets will be more attractive. Conceptually, we represent this relationship as a schedule for currency inflows that will be positively related to the exchange rate. We can think of this as equivalent to a supply curve for foreign currency. If we think of currency inflows and outflows simultaneously, then there must be an exchange rate where outflows exactly match inflows. We can use this level, the exchange rate, which we call the equilibrium rate, as a benchmark. The equilibrium exchange rate is a concept that cannot be directly measured, but is useful as a benchmark. When the exchange rate is above the equilibrium, then we call the exchange rate undervalued. When the spot exchange rate is too high relative to the benchmark, the value of domestic currency will be low relative to foreign dollars. And currency outflows will be more attractive than inflows. When the exchange rate is lower than the equilibrium, we call it overvalued. By definition, when the spot exchange rate is lower relative to the equilibrium, the price of foreign dollars is low. This means that currency outflows are more attractive than inflows. The equilibrium is a useful benchmark when we think about what it means for the balance of payments. Consider if the exchange rate is undervalued, say at a level S1. If the spot exchange rate is weaker than equilibrium, then currency inflows are greater than currency outflows, and the balance of payments is positive. Undervalued currencies are associated with balance of payments surpluses, By considering overvalued exchange rate, such as S2. If the exchange rate is strong, then currency outflows are less than currency inflows and the balance of payments is negative. Overvalued currencies are associated with balance of payments deficits. After viewing this segment, you should be able to one, calculate the balance of payments using national income accounts. Two, construct the balance of payments model of exchange rates. >> Let's summarize by answering the key question. What are the factors that drive the balance of payments? Traders seeking foreign dollars meet traders seeking domestic currency in foreign exchange markets. Foreign dollars are sought to buy imported goods or to engage in international investment. Traders might seek domestic currency in turn to purchase exports or intvest in the domestic economy. The level of the exchange rate should impact all of these flows. When foreign currency is relatively expensive, fewer foreign dollars will be sought at the expense of foreign currency will make imports and foreign assets less attractive. When domestic currency's relatively expensive, they will likewise be fewer traders seeking to acquire domestic currency. The net balance of foreign currency in the forex market can be in surplus when the exchange rate is weak, the balance of payments in deficit when the value of the domestic currency is strong. In the next segment, we'll consider how the clearing of payments deficits and surpluses will determine market base exchange rates.
