Net External Wealth and Real Exchange Rate - Essay Example

? Net External Wealth and Real Exchange Rate Introduction In the contemporary business world, most of the economies in the world follow free market principles. It has been realized over time that a single nation is not capable enough to generate all the required goods and services efficiently. Owing to the competitive advantage, countries have less reluctantly opened up their economies in the global market. Globalization, liberalization and privatisation are the terms used as modern jargons in the contemporary business world. Over time, the global economy has rapidly progressed with the benefits of international trade. However it should not be ignored that with rising amount of benefits, the level of complexities in the state of business affairs in a nation have also increased with the emergence and progress of international trade. A country in the modern world faces a lot of imbalances and problems in its economy. This essay will emphasize on the debatable issue of the relationship between a country’s net external wealth and real exchange rate (Lane and Milesi-Ferretti, 2006). Concepts The net external wealth of a nation relates to the balance of payment conditions of the country. The net foreign asset of a nation is the difference of the value of the asset owned by the nation from the rest of the world and the value of the asset of the country owned by the foreign countries in the world. Net Foreign Asset (NFA) = Foreign asset value (owned by the nation) – Domestic asset value (owned by the foreign countries). Thus this concept explains indebtedness that is borne by different countries. Thus a lower value of NFA is always better for a nation than a higher value of NFA. If a nation in an open economic system takes a loan from a foreign country owing to an impending deficit in its current account, then its NFA falls by the exact amount of the loan taken by the nation (Barney, 1991). Exchange rate in between two nations defines the rate at which the currency of one nation will be exchanged by the currency of another country. It can also be termed as the value of the currency of a nation in terms of the value of currency of another nation. An exchange rate can be a real exchange rate or a nominal exchange rate. The changes in the exchange rates of a nation largely influence the values of its foreign assets and liabilities. If the value of currency of a nation appreciates, then the value of its indebtedness in terms of foreign assets falls. This helps to improve the nations NFA situations and vice versa (Williamson, 2008). The nominal exchange rate (e) explains the amount of home currency (units) that can be purchased with a given unit of a foreign currency. Thus a rise in e refers to the depreciation or devaluation of the currency of a nation. On the other hand, the fall in e refers to the appreciation or evaluation of the currency of a nation. Real exchange rate is defined as the simple ratio of the price level (Pd) of the domestic currency and the price value of the foreign currency (Pf ). The real exchange rate of a nation (Q) = Pd/e*Pf , It refers to the amount of goods and services of a domestic country that can be purchased by a unit of money of a foreign nation (CNB, 2013). When analysts assess the changes in the exchange rates in the international trade, they rely more on the real exchange rate than nominal exchange rate. A real appreciation refers to a rise in the real exchange rate while a nominal appreciation refers to a decrease in the nominal exchange rate (Feenstra and Taylor, 2008). Relationship between Net Foreign Asset and Real Exchange Rate The relationship existing between the net foreign assets of a country and the real exchange rate has been a debatable issue of concern since 1920. If a steady state open economy model is considered, then the following relations can be established: tb = -r*b (1) (States that a steady trade deficit can exist in a nation = net investment income on net foreign asset position). rer = -Otb + ?X (2) (States that if the other factors in the economy (X) are given, then the larger and steady state trade surplus will make the real exchange rate more depreciated). Where tb = trade balance GDP (gross domestic product) ratio. r= rate of return on external liabilities and assets b= stock of net foreign assets which is at a ratio of real GDP. rer = the rate of CPI (consumer price index) based at the value of real exchange rate. X = other factors that influence the real exchange rate. Solving equation 1 and 2 one would get: rer = -r*b + ?X ? ?? + ?X. (3) (States that the real exchange rate is directly proportional to the net foreign asset position of a nation if all the other factors are taken as given). This positive relation between the real exchange rate and the level of net foreign asset position was supposed in the long term perspective. That stated that if the indebtedness of a country rises, then the real exchange rate of the nation would also rise. The discussion will include the concept of trade balance in a nation that explains the difference in the value of exports and imports of a nation measured in monetary terms of the currency of that country. By making empirical analysis on the basis of the above model, it has been stated by the analysts that the trade balance in nation is negatively related to the real exchange rate (Kharroubi, 2011). In Keynesian view, when a nation faces a rise in the net foreign asset position, it actually faces a rise in the indebtedness. In order to adjust the impending loss of insolvency, the country tries to achieve trade surpluses on its balance of payment accounts. A surplus in the trade means a rise in the level of exports or a fall in the level of imports. A surplus in the trade balance can only be achieved if the nation depreciates its real exchange rate value. Because depreciation in the real exchange rate means a fall in the level of the currency value of the country. A fall in the value of currency in a nation implies that the value of exports of the country to the other parts of the world would be cheaper and hence it would increase. On the other hand, when the real value of the currency of a nation would fall it would imply a poor purchasing power parity condition of the nation, this would make the imports more expensive and hence it would fall. Thus, according to the Keynesian view, it can be stated that the relationship between NFA and real exchange rate of a nation is negative. As stated above, a rise in the indebtedness or NFA of a nation implies a fall or depreciation of the real exchange rate. Mussa (1984) in his simple model also emphasized a positive relationship between a nations NFA and terms of business trade (Kang and Paper, 2007). However, the debatable issue of concern is the sensitivity of the real exchange rate and the trade balances in the economy. It has been found that post-globalization, the expansion of business activities have largely facilitated the changes in the trade which balances it and have made it highly sensitive to the exchange rate fluctuations. But the greater amount of global supply chains in the economy has made this relation less sensitive. In reality, the effect differs in nation to nation basis. It has been found that in U.S., trade deficit is largely caused due to the impending changes in the real exchange rates in the country. On the other hand, the changes in the real exchange rates in China have not helped in reducing the level of the country’s trade surplus. Now it is a matter of concern to realize the cause factor among the two (Feenstra and Taylor, 2008). In reality, after globalization it has been noticed that the positive returns achieved by the creditors in the economies in the long run from foreign investments have helped them to improve the situation of trade balance in the country. This in turn has helped the nations to achieve the appreciated real exchange rate value. If the monetary authority in a nation abides this norm, then it is obvious that a rise in the level of NFA would facilitate an appreciation of the real exchange rate in future. Thus, this view largely goes against the Keynesian concept that indicates a negative relationship between the real exchange rate and NFA. Conclusion The traditional belief that the real exchange rate and NFA is inversely related is no longer feasible in the modern era, after the occurrence of globalization. A country in its economy can now always afford to encourage foreign direct investment and augment the level of its NFA. This is due to the fact that though the extent real exchange rate or currency value of the country would fall in the short run, the positive returns from the investments in the long run would substantially help the nation improve its real exchange rate. Therefore post-globalization, real exchange rate is assumed to have a positive relationship with NFA (Lane and Milesi-Ferretti, 2002). Reference List Barney, J. B., 1991. Firm resources and sustained competitive advantage. Journal of Management, 17 (1), p. 99-120. CNB, 2013. What is the nominal and real exchange rate? [online] Available at [Assessed 25 October]. Feenstra, R. C. and Taylor, A. M., 2008. International Economics. 1st Ed. London: Worth Publishers. Kang, J. S. and Paper, J. M., 2007. Consumption and Real Exchange Ratesin an Economy with Private Information. [pdf] Missouri. Available at [Assessed 25 October]. Kharroubi, E., 2011. The Trade Balance and the Real Exchange Rate. [pdf] BIS. Available at [Assessed 25 October]. Lane, P. R. and Milesi-Ferretti, G. M., 2002. External wealth, the trade balance, and the real exchange rate. European Economic Review, 46, p. 1049 – 1071. Lane, P. R. and Milesi-Ferretti, G. M., 2006. Exchange Rates and External Adjustment: Does Financial Globalization Matter? The Institute for International Integration Studies Paper Series, 129. Williamson, O. E., 2008. Transaction-cost economics: the governance of contractual relations. Journal of Law and Economics, 22, p. 233-61. Read More