International Trade and Finance
Equilibrium and Disequilibrium in the Balance of Payment key definition
Week Two (A) Equilibrium and Disequilibrium in the Balance of Payment and Risk of International Trade
Equilibrium and Disequilibrium in the Balance of Payment Balance of Payment represent balance in current account, capital account will always be equal if receipt and payment are equal. If receipt and payment are equal, we could say Balance of Payment is in equilibrium state in international trade. If there any surplus or deficit is know as disequilibrium in international trade.
Equilibrium and Disequilibrium in the Balance of Payment the emphasis in this class is in the export and import domain in the current account. Firstly, we need to review some basic concepts in the foreign exchange
Equilibrium: The state in which market supply and demand balance each other and, as a result, prices become stable. In other words The equilibrium price is the price at which the supply of goods matches demand.
Equilibrium and Disequilibrium in the Balance of Payment A causes of the disequilibrium in the balance of payment is - Price fluctuation - Huge development and investment programs in the developing economic - A vast increase in the domestic production of foodstuffs, raw material, substitute good. Etc. - International borrowing and investment
Equilibrium and Disequilibrium in the Balance of Payment Nominal Exchange Rate: The rate at which a person can trade the currency of one country for the currency of another. For Example: if you go to bank, you might see a posted exchange rate of 80 yen per dollar. If you give the bank one U.S dollar, it will give you 80 Japanese yen
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Equilibrium and Disequilibrium in the Balance of Payment Appreciation: an increase in the value of a currency as measured by the amount of foreign currency it can buy. For Example: a dollar buys more foreign currency, that change is called an appreciation of the dollar.
Equilibrium and Disequilibrium in the Balance of Payment At times you may have heard the media report that the dollar is either “strong” or “weak.” These descriptions usually refer to recent changes in the nominal exchange rate. When a currency appreciates, it is said to strengthen, because it can then buy more foreign currency. Similarly, when a currency depreciates, it is said to weaken.
Equilibrium and Disequilibrium in the Balance of Payment Real and nominal exchange rates are closely related. To see how, consider an example. Suppose that a bushel of American rice sells for $100, and a bushel of Japanese rice sells for 16,000 yen. What is the real exchange rate between American and Japanese rice? (Assume nominal exchange rate is one dollar=80 yen)
Equilibrium and Disequilibrium in the Balance of Payment Depreciation: a decrease in the value of a currency as measured by the amount of foreign currency it can buy. For example: a dollar buys less foreign currency, that change is called a depreciation of the dollar.
Equilibrium and Disequilibrium in the Balance of Payment • Real Exchange Rate The rate at which a person can trade the goods and services of one country for the goods and services of another. Real Exchange Rate = Nominal Exchange Rate * Domestic Price Foreign price
Equilibrium and Disequilibrium in the Balance of Payment The solution: Real exchange rate= Nominal exchange rate * domestic price foreign price
= 80*100 16,000 = 1/2
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Equilibrium and Disequilibrium in the Balance of Payment
Equilibrium and Disequilibrium in the Balance of Payment
Why does the real exchange rate matter? A country’s real exchange rate is a key determinant of its net export of goods and services. A depreciation in the U.S real exchange rate means that U.S goods have become cheaper relative to foreign goods. This change encourages consumers both at home and abroad to buy more U.S goods and fewer goods from other countries. As a result, U.S export rise, and import fall. Conversely, an appreciation in the U.S real exchange rate means that U.S goods have become more expensive compared to foreign goods so U.S. net export fall.
The real exchange rate is a key determinant of how much a country exports and imports Now let denote p = price index in domestic country. P* = price index in the foreign country. e = nominal exchange rate Real exchange rate = (e*p) / p*
Equilibrium and Disequilibrium in the Balance of Payment
Equilibrium and Disequilibrium in the Balance of Payment
a nominal exchange rate appreciation of domestic country lead to real exchange rate appreciation, and the country’s export decrease. The balance of payment of the country will be deficit.
an increase in foreign prices result in real exchange rate depreciation, the country’s export increase, and import decrease. The balance of payment of the country will be surplus.
an increase in domestic prices result in real exchange rate appreciation, and the country’s export decrease. The balance of payment of the country will be deficit.
Equilibrium and Disequilibrium in the Balance of Payment Measure to correct the Disequilibrium - Trade measure - Monetary measure - Current devaluation - Money contraction - Exchange control - Encouragement to foreign investment - Incentive to foreign tourist
Risk of International Trade • • • • • • • • • • •
The risks that exist in international trade can be divided into two major groups: Economic risks Risk of insolvency of the buyer, Risk of protracted default - the failure of the buyer to pay the amount due within six months after the due date, and Risk of non-acceptance Surrendering economic sovereignty Political risks Risk of cancellation or non-renewal of export or import licenses War risks Risk of expropriation or confiscation of the importer's company Risk of the imposition of an import ban after the shipment of the goods Transfer risk - imposition of exchange controls by the importer's country or foreign currency shortages Surrendering political sovereignty
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