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Last classes: human capital

Relationship between education, health and

income

Human capital approach

Inequalities in education and health outcomes

Performance of education and health systems

Conditional Cash Transfers

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Class material

Class Fri 1 Nov (postponed from Wed 30 Oct)

T&S Ch13: p. 638-649

Mankiw et al, 4thCanadian edition, p. 278-283

(electronic copy posted on course website)

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Learning objective

What is the balance of payments (BoP)?

4ECO 2117 Classes 20-21

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Balance of payments (BoP)

The BoP summarizes a countrys financialtransactions with the outside world

i.e. transactions related to trade, foreign investment,

foreign aid, remittances, foreign loans

It consists of three accounts:

1. current account

2. capital account

3. cash account Inflows enter as positive (credit / receipt)

Outflows enter as negative (debit / payment)


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Understand balance of payments (BoP)

Current account+ exports, - imports (= also called trade balance)+ investment income, - debt service payments, + netremittances & transfers

Capital account+ foreign private investment, + foreign loans,- amortization, - foreign assets, - resident capital outflow

Cash or international reserve account+ foreign currency in cash, + gold, + deposits with IMF


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A Hypothetical BoP Table for a Developing Nation(Attention: big typo mistake in Table 13.3 in new edition!!!)


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Learning objective

What is an exchange rate and what drives

exchange rate movements?


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Nominal exchange rate

An exchange rate is a price

Nominal exchange rate The rate at which a person can trade the currencyof

one country for that of another

Example: 80 Yen for 1 Dollar

Appreciation When 1 $ gives you moreof the foreign currency

i.e. from 80 to 90 Yen

Depreciation When 1 $ gives you lessof the foreign currency

i.e. from 80 to 70 Yen

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Real exchange rate

Real exchange rate:

The rate at which a person can trade a good / serviceofone country for that of another

Example: 0.5 kilo Russian wheat for 1 kilo Cad. wheat

Real exchange rate =(nominal exchange rate * domestic price)/foreign price

The real exchange rate a key determinant of how mucha country imports / exports

In the above example Canadian wheat is 50% cheaper thanRussian wheat. Buyers will thus prefer to buy Canadianwheat which is good for Canadian exports.(assuming equal quality of wheat)

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What determines exchange rates?

Theory of purchasing power parity Law of one price: a good must sell for the same price

everywhere (due to arbitrage: i.e. profit by buying wherecheap & reselling where more expensive)

This law also applies to currencies: a currency must havethe same purchasing power in every country

Consequence: The nominal exchange rate thus reflects differences price

levels between two countries

Changes in domestic prices thus lead to changes in thenominal exchange rate (everything else equal)

Prices, and thus the exchange rate, also depends onmoney supply (monetary policy) & money demand

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Hyperinflation in Germany

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What determines exchange rates?

The theory of purchasing power parityexplains long termchanges in nominal andreal exchange rates quite well

But short termdeviations between real andnominal exchange rates are quite common,due to:

Non-tradables & imperfect substitutes

Governments exchange rate policies(to be explained in trade theme)

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Learning objective

Why are current and capital account deficits a

problem and how can they be reduced?


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Table 13.4 Before and After the 1980s Debt Crisis:

Current Account Balances and Capital Account Net financial Transfers of

Developing Countries, 1978-1990 (billions of dollars)


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Payment deficits are a problem (i)

When current and capital accounts are both in deficitonly the cash account remains:

International reserves are like bank accounts; they can beused to pay bills

But, if reserves are not replenished, they will sooner orlater be depleted

A BoP crisis arises when a country does not have anyfunds to pay its international bills (= liquidity

problem) Consequence: the rest of the world will not want to do

business with the country


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Payment deficits are a problem (ii)

A BoP crisis is a symptom

Generally, the underlying problem is that thecountrys economy and economic policies are(perceived as) not sustainable in the long term

Exports too expensive, too large budget deficits, too highdebt, too high inflation, unattractive investment climateetc.

In other words: the underlying problem is oftenstructural

Long term solutions are only available throughsubstantial changes in economy and policy


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Alternative ways of reducing & financing

current & capital account deficits(and more on this in next classes )

Borrow from abroad

but: borrowing means debt, which means interest paymentsand amortizations

Devalue official exchange rate this stimulates exports and discourages imports

Encourage foreign investment

Restrictive fiscal and monetary policies

Structural adjustment Stabilization policies

Special drawing rights (SDRs)

provide short term relief for BoP problems


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In sum

An open economy is a country that has economic relationswith other countries (= most countries)

Balance of payments & exchange rates are key concepts tounderstand when analyzing open economies

Too high current and capital account deficits can lead to abalance of payments crisis, which often kick starts a bigeconomic recession

A crisis is only a symptom of a underlying structural problemsin the domestic economy and the way its managed

The remaining course themes will focus on economic relationsbetween countries (international trade & finance) and whatthis means for developing countries economies

Documents

7. Open Economy(1)