The Concepts and Theories of International Economics Explained by Miltiades Chacholiades: Focus on Chapter 25
International Economics by Miltiades Chacholiades
International economics is a fascinating and complex field of study that deals with the interactions between countries in terms of trade, finance, and development. It examines how different economies affect each other through the flows of goods, services, money, and people across borders. It also explores how policies and institutions shape these flows and their impacts on welfare, growth, and stability.
International Economics Miltiades Chacholiades 25.pdfl
One of the most influential books on international economics is International Economics by Miltiades Chacholiades, a Greek economist who taught at several universities in the US and Europe. His book, first published in 1978, provides a comprehensive and rigorous analysis of the theories and empirical evidence on various topics in international economics, such as trade theory, trade policy, balance of payments, exchange rates, international monetary systems, and economic integration.
In this article, we will focus on one of the chapters of his book, chapter 25, which deals with the balance of payments and foreign exchange markets. We will explain what these concepts mean, why they are important, and how they are related to each other. We will also discuss some of the models and hypotheses that Chacholiades uses to explain the behavior and determinants of these variables.
Chapter 25: The Balance of Payments and Foreign Exchange Markets
What is the balance of payments?
The balance of payments is a record of all the transactions between a country and the rest of the world during a given period of time, usually a year or a quarter. It shows how much a country earns from its exports and spends on its imports, how much it borrows from or lends to other countries, and how much it changes its holdings of foreign assets and liabilities.
The balance of payments is divided into three main accounts: the current account, the capital account, and the official reserves account. Each account measures a different type of transaction and has a different impact on the country's economic performance and position.
What are the components of the balance of payments?
Current account
The current account records the transactions that involve goods, services, income, and transfers. It includes:
The trade balance, which is the difference between exports and imports of goods.
The services balance, which is the difference between exports and imports of services, such as transportation, tourism, insurance, and royalties.
The income balance, which is the difference between income received from abroad and income paid to abroad, such as interest, dividends, and wages.
The transfers balance, which is the difference between transfers received from abroad and transfers paid to abroad, such as remittances, foreign aid, and pensions.
The current account balance is the sum of these four balances. It measures the net flow of goods, services, income, and transfers between a country and the rest of the world. A positive current account balance means that the country has a surplus, meaning that it earns more than it spends. A negative current account balance means that the country has a deficit, meaning that it spends more than it earns.
Capital account
The capital account records the transactions that involve financial assets and liabilities. It includes:
The direct investment balance, which is the difference between direct investment inflows and outflows. Direct investment refers to the acquisition or disposal of a lasting interest in a foreign enterprise, such as ownership or control.
The portfolio investment balance, which is the difference between portfolio investment inflows and outflows. Portfolio investment refers to the purchase or sale of foreign securities, such as stocks and bonds.
The other investment balance, which is the difference between other investment inflows and outflows. Other investment refers to the lending or borrowing of foreign currency, such as loans, deposits, and trade credits.
The capital account balance is the sum of these three balances. It measures the net flow of financial assets and liabilities between a country and the rest of the world. A positive capital account balance means that the country has a surplus, meaning that it receives more capital than it sends. A negative capital account balance means that the country has a deficit, meaning that it sends more capital than it receives.
Official reserves account
The official reserves account records the transactions that involve official reserves. Official reserves are the foreign assets that are held by the central bank or the government to intervene in the foreign exchange market or to meet international obligations. They include:
Foreign currency reserves, such as US dollars, euros, or yen.
Gold reserves, which are valued at a fixed price in US dollars.
Special drawing rights (SDRs), which are international reserve assets created by the International Monetary Fund (IMF).
Reserve position in the IMF, which is the amount of SDRs that a country can draw from the IMF.
The official reserves account balance is the difference between official reserves increases and decreases. It measures the net change in official reserves between a country and the rest of the world. A positive official reserves account balance means that the country has increased its official reserves. A negative official reserves account balance means that the country has decreased its official reserves.
What are the determinants of the balance of payments?
The balance of payments is influenced by various factors that affect the demand for and supply of foreign currency in a country. These factors can be grouped into three categories: national income and expenditure, relative prices and exchange rates, and trade policies and capital controls.
National income and expenditure
National income and expenditure refer to the level and composition of aggregate demand in a country. They affect the balance of payments through their impact on imports and exports. For example:
A higher national income implies a higher demand for goods and services, both domestic and foreign. This increases imports and worsens the current account balance.
A higher national expenditure implies a higher spending on goods and services, both domestic and foreign. This also increases imports and worsens the current account balance.
A higher share of consumption in national expenditure implies a higher preference for consumer goods over capital goods. This may increase imports of consumer goods and worsen the current account balance.
A higher share of investment in national expenditure implies a higher demand for capital goods. This may increase imports of capital goods or exports of domestic savings, depending on whether domestic or foreign capital goods are used. This may worsen or improve the current account balance.
A higher share of government spending in national expenditure implies a higher fiscal deficit. This may increase imports of goods and services or exports of domestic savings, depending on how the deficit is financed. This may worsen or improve the current account balance.
Relative prices and exchange rates
Relative prices and exchange rates refer to the price levels and currency values in a country compared to other countries. They affect the balance of payments through their impact on competitiveness and purchasing power. For example:
A higher domestic price level implies a higher cost of production and a lower profitability for domestic producers. This reduces exports and worsens the current account balance.
and a higher profitability for foreign producers. This increases imports and worsens the current account balance.
A higher domestic exchange rate implies a higher value of the domestic currency relative to foreign currencies. This makes domestic goods more expensive and foreign goods cheaper in terms of foreign currency. This reduces exports and increases imports, worsening the current account balance.
A lower foreign exchange rate implies a lower value of the foreign currency relative to the domestic currency. This makes foreign goods more expensive and domestic goods cheaper in terms of foreign currency. This increases exports and reduces imports, improving the current account balance.
Trade policies and capital controls
Trade policies and capital controls refer to the measures that a country adopts to regulate or restrict the flows of goods, services, and capital across its borders. They affect the balance of payments through their impact on incentives and barriers. For example:
A higher tariff implies a higher tax on imports. This increases the price of imported goods and reduces the demand for them. This reduces imports and improves the current account balance.
A lower subsidy implies a lower support for exports. This reduces the price of exported goods and reduces the supply of them. This reduces exports and worsens the current account balance.
A higher quota implies a lower limit on imports. This restricts the quantity of imported goods and increases their price. This reduces imports and improves the current account balance.
A lower quota implies a higher limit on exports. This allows more quantity of exported goods and reduces their price. This increases exports and improves the current account balance.
A tighter capital control implies a higher restriction on capital flows. This reduces the availability of foreign currency and increases its price. This reduces capital inflows and outflows, improving or worsening the capital account balance depending on which is larger.
A looser capital control implies a lower restriction on capital flows. This increases the availability of foreign currency and reduces its price. This increases capital inflows and outflows, worsening or improving the capital account balance depending on which is larger.
What are foreign exchange markets?
Foreign exchange markets are markets where different currencies are traded for each other. They facilitate international transactions by allowing agents to exchange one currency for another at an agreed price, called the exchange rate. They also enable agents to hedge against exchange rate risk by locking in a future exchange rate, called the forward rate.
Foreign exchange markets are decentralized and operate 24 hours a day, seven days a week, through a network of banks, brokers, dealers, and traders around the world. They are divided into two segments: the spot market and the forward market. The spot market deals with transactions that are settled within two business days, while the forward market deals with transactions that are settled at a future date.
What are the functions of foreign exchange markets?
Foreign exchange markets perform three main functions: transfer of purchasing power, provision of credit, and minimization of exchange risk.
Transfer of purchasing power
The transfer of purchasing power is the primary function of foreign exchange markets. It enables agents to buy goods, services, or assets from other countries using their own currency or another currency that is acceptable to both parties. For example:
An American tourist who wants to visit France needs to exchange US dollars for euros to pay for accommodation, food, and transportation in France.
A French company that wants to import machinery from Japan needs to exchange euros for yen to pay for the equipment, shipping, and insurance from Japan.
A Japanese investor who wants to buy shares in an American company needs to exchange yen for US dollars to pay for the stock, brokerage fees, and taxes in America.
Provision of credit
The provision of credit is a secondary function of foreign exchange markets. It enables agents to borrow or lend foreign currency to finance their international transactions or investments. For example:
An American importer who wants to buy goods from China can obtain a short-term loan in US dollars from a bank or a supplier to pay for the goods now and repay later when they are sold.
A Chinese exporter who wants to sell goods to America can offer a credit term in US dollars to a buyer or a bank to receive payment later when the goods are delivered.
An American investor who wants to buy bonds in Germany can borrow euros from a bank or a broker to pay for the bonds now and repay later when they mature or are sold.
Minimization of exchange risk
The minimization of exchange risk is a tertiary function of foreign exchange markets. It enables agents to reduce or eliminate the uncertainty and volatility of exchange rates that may affect their profits or losses from their international transactions or investments. For example:
An American exporter who expects to receive euros from a German buyer in three months can enter into a forward contract with a bank or a dealer to sell euros for US dollars at a fixed rate in three months, regardless of the spot rate at that time.
A German importer who expects to pay US dollars to an American supplier in six months can enter into a forward contract with a bank or a dealer to buy US dollars for euros at a fixed rate in six months, regardless of the spot rate at that time.
An American investor who holds shares in a British company can enter into a swap contract with a bank or a broker to exchange the dividends in pounds for US dollars at a predetermined rate, regardless of the spot rate at that time.
What are the types of foreign exchange transactions?
Foreign exchange transactions can be classified into three types: spot transactions, forward transactions, and swap transactions.
Spot transactions
A spot transaction is a transaction that involves the exchange of two currencies at the prevailing market rate, called the spot rate, and is settled within two business days. For example:
An American tourist who wants to buy euros for US dollars at the airport kiosk is engaging in a spot transaction.
A French company who wants to sell yen for euros at the bank branch is engaging in a spot transaction.
A Japanese investor who wants to buy US dollars for yen at the online platform is engaging in a spot transaction.
Forward transactions
A forward transaction is a transaction that involves the exchange of two currencies at a predetermined rate, called the forward rate, and is settled at a future date. For example:
An American exporter who wants to sell euros for US dollars in three months at a fixed rate is engaging in a forward transaction.
A German importer who wants to buy US dollars for euros in six months at a fixed rate is engaging in a forward transaction.
An American investor who wants to buy pounds for US dollars in one year at a fixed rate is engaging in a forward transaction.
Swap transactions
A swap transaction is a combination of two transactions that involve the exchange of two currencies at two different dates, one in the present and one in the future. For example:
An American exporter who wants to sell euros for US dollars now and buy them back in three months at a fixed rate is engaging in a swap transaction.
A German importer who wants to buy US dollars for euros now and sell them back in six months at a fixed rate is engaging in a swap transaction.
An American investor who wants to buy pounds for US dollars now and sell them back in one year at a fixed rate is engaging in a swap transaction.
What are the theories of exchange rate determination?
Exchange rate determination is the process of explaining how the market forces of demand and supply determine the equilibrium exchange rate between two currencies. There are several theories that attempt to explain this process, such as the purchasing power parity theory, the interest rate parity theory, and the asset market approach.
Purchasing power parity theory
The purchasing power parity theory is based on the law of one price, which states that identical goods should have identical prices across countries when expressed in a common currency. This implies that the exchange rate between two currencies should reflect their relative purchasing power, or their ability to buy goods and services. For example:
If one euro can buy 10 loaves of bread in France and one US dollar can buy 5 loaves of bread in America, then the purchasing power parity exchange rate should be 1 euro = 2 US dollars.
If one euro can buy 20 liters of gasoline in France and one US dollar can buy 10 liters of gasoline in America, then the purchasing power parity exchange rate should be 1 euro = 2 US dollars.
If one euro can buy 100 units of electricity in France and one US dollar can buy 50 units of electricity in America, then the purchasing power parity exchange rate should be 1 euro = 2 US dollars.
The purchasing power parity theory predicts that changes in the price levels of two countries will lead to changes in their exchange rates. For example:
is higher in France than in America, then the price level in France will rise faster than the price level in America. This will reduce the purchasing power of the euro and increase the purchasing power of the US dollar. This will cause the euro to depreciate and the US dollar to appreciate.
If inflation is lower in France than in America, then the price level in France will rise slower than the price level in America. This will increase the purchasing power of the euro and reduce the purchasing power of the US dollar. This will cause the euro to appreciate and the US dollar to depreciate.
The purchasing power parity theory assumes that there are no barriers to trade, no transaction costs, and no differences in preferences, quality, and availability of goods and services across countries. These assumptions are often violated in reality, which limits the applicability and accuracy of the theory.
Interest rate parity theory
The interest rate parity theory is based on the arbitrage condition, which states that identical assets should have identical returns across countries when expressed in a common currency. This implies that the exchange rate between two currencies should reflect their relative interest rates, or their cost of borrowing or lending. For example:
If the interest rate on a one-year bond is 5% in France and 3% in America, then the interest rate parity exchange rate should be 1 euro = 1.0204 US dollars.
If the interest rate on a one-year bond is 10% in France and 8% in America, then the interest rate parity exchange rate should be 1 euro = 1.0185 US dollars.
If the interest rate on a one-year bond is 15% in France and 13% in America, then the interest rate parity exchange rate should be 1 euro = 1.0176 US dollars.
The interest rate parity theory predicts that changes in the interest rates of two countries will lead to changes in their exchange rates. For example:
If the interest rate increases in France and decreases in America, then the return on holding euros will in