International Economics and Financial Markets

Balance of payments (BOP)

An accounting record of all monetary transactions between a country and the rest of the world. A national income statement. Typically one year statements.

Must exist a balance between income and expenditures, i.e. the sum of all incomes and expenditures must equal 0.
  • Income from exports (sales to foreigners) of goods, services or assets (financial or real). Also receipts of foreign aid, receipts of dividends on foreign bonds. Increases BOP, cash inflow, a "surplus"/"credit" item.
  • Expenditures from imports (purchases from foreigners) of goods, services or assets. Also Decreases BOP, cash outflow, a "deficit"/"debit" item.
Without balance, somebody is getting something for free.

GSA = Good, services and assets
Current account = Sale and purchases of goods and services
Capital account = Sale and purchases of assets

For balance we want:
(Income) = (Expenditures)
(Sale of GSA) = (Purchases of GSA)
(Current account) + (Capital account) = 0

Overall, BOP is very complicated, difficult and expensive to measure and calculate. Different for different types of goods:
Tangible goods - Physical goods, things you can touch. E.g. raw material. Relatively easy to measure, because of physical evidence.
Services - Difficult to measure
Assets - Difficult to measure
Electronic/internet trade - Difficult to follow electronic "trails" compared to paper/document trails.
Illegal trade - Little or no documentation.

BOP is generally just an approximation. Governments best guess. We should take the data with a big grain of salt. It can be called "more art than science", but it's still better than nothing.

BOP statements are very influencial and important in the real world. Influnces, among other things:
  • International lendings and investment decisions
  • Government policy decisions (fiscal policy, monetary policy, trade policy, exchange rate policy). Both domestic and foreign.
  • Interest rates and exchange rates
  • Inflation (actual or expected)
  • Business, risk-management, financial, marketing practices, and so on.
A big change in BOP can make big changes at many levels at an alarming speed.

Main accounts

There are two main accounts that are always included in a BOP statement: Current Account and Capital Account.
  • Current Account: Mainly exports - imports.
    • Exports (X) - imports (M). The dominant variable/main ingredience in BOP.
      • Current account = (X-M)
        • (X-M) = 0 => Balance
        • (X-M) > 0 => "surplus"
        • (X-M) < 0 => "deficit"
    • As a matter of convention, two other variables are recorded here:
      • Income payments - Dividend payments, interest payments etc.
      • Transfer payments - Gifts, foreign aid etc. Unilateral transfer payments. How can we have balance when we have transfer payments? Basically through accounting tricks.
  • Capital Account: Records asset trading, financial international transactions. Either financial assets (stock, bonds) or real assets (houses etc). In some BOP definitions, "Capital Account" only refers to real assets, while "Financial Account" is included as a third main account which separates financial assets.
    • Private capital account - Asset trade by private parties (households, private businesses). The value of purchases and sales of assets by private parties. A short-term investment in a financial asset, or a long-term investment in a real asset.
    • Public capital account ("official settlements balance") - Asset trade by public parties (government entities). The value of purchases and sales of assets by governments. Vast bulk is financial assets (not much trading in real assets), mostly currency trading. Each time a central bank buys or sells financial assets (e.g. trying to influence exhchange rate or inflation), its transactions are recorded here, even if the one being traded with is a private party. Buying or selling government bonds.
      • "Foreign exchange reserves" (FEB) - Central banks holding foreign assets. A stock measure. Measures the market value of foreign assets. One reason could be that the central bank wants to influence its exchange rate.
  • "Errors and Omissions" Account - Unexplained cash in- and outflows that cannot be tied to a particular transaction. Includes things such as illegal trade and government corruption. Compensate for errors and ommissions. If this is huge compared to the other two, it either means there's a lot of illegal trade and corruption (underground activity) or it means that the BOP is not very well calculated in the specific country. Usually high in poor countries, not necessarily because of illegal trade but because governments are incapable or unable (lack the resources) to calculate BOP correctly.

Other accounts:
"International Investment Statement" Account - A balancesheet of a country compared to the rest of the world. The value of all foreign assets and foreign liabilities held at some point of time. Records the stock of foreign assets and liabilities at a certain point of time. A complement to BOP. 


Data from IMF (2004). Another good source for BOP-data is from the specific country's central bank's web site.

Billions of US $

                Current Account        Private Capital Account        Public Capital Account
Sweden    +23.9                        -19.8                                  -4.1
Norway    +34.4                        -29.2                                   -5.2
Japan       +172.1                      -11.2                                  -160.9
USA        -665.9                        +663.1                               +2.8
U.K.        -41.9                          +42.3                                 -0.4
Switzerland +50.6                      +49                                   +1.6
Turkey    -15.5                           +19.8                                -4.3

The sum of all three columns equals 0 for each country.

Sweden 2004:
  • Current Account surplus. More export than import (a net exporter). We have a net cash inflow.
  • Private Capital Account deficit of almost 20 billion. We buy (import) more foreign assets than we sell (export) Swedish assets to foreign countries. Investment money/capital is leaving Sweden and is being invested abroad.
  • Public Capital Account deficit of 4 billions. Governments were also a net buyer of foreign assets, investing money in foreign countries.
  • We don't know if this is a good or a bad thing - we need more information.
Norway 2004:
  • Similar to Sweden, except bigger numbers.
Japan 2004:
  • Huge Current Account surplus.
  • Very small Private Capital Account deficit.
  • Huge Public Capital Account defucut. The Japanese government a massive purchaser of foreign assets. Why? Possibly to manipulate the exchange rate, in order to preserve (or increase) the size of the Current Account surplus. Cannot say for sure, need more information.
USA 2004:
  • Huge Current Account deficit. A net importer of goods and services. 
  • Huge Private Capital Account surplus. A net seller of assets.
  • The reverse of Sweden.
  • Sucking in huge amounts of goods, services and capital.
UK 2004:
  • Like USA but much smaller numbers.
Switzerland 2004:
  • Huge numbers for such a small country.
  • A very open economy, very dependant on foreign trade and investment.
Turkey 2004:
  • Typical numbers for developing countries. A moderate Current Account deficit and a moderade Private Capital Account surplus.
  • Surplus of foreign capital can be used to invest in infrastracture etc.

In conclusion, we see just two general types of BOP, because of the balance requirement (or three if including a perfect balance):
  1. Seller of goods and services. Buyer of assets. Investment money (capital) is leaving the country.
    1. E.g. Sweden
  2. Buyer of goods and services. Seller of assets. Investment money (capital) is entering the country.
    1. E.g. USA, Turkey.
    2. Typical for developing countries. Surplus of foreign capital can be used to invest in infrastracture etc.
  3. Current Account = 0 and Capital Account = 0 (no suplus)
Seller = Net exporter to ROW (Rest of the World)
Buyer = Net importer to ROW


Y = C + I + G + (X-M)
Y = Aggregate domestic income
C = Aggregate domestic consumption expenditures
I = Aggregrate domestic investment expenditures
G = Aggregrate domestic government expenditures
X = Aggregrate domestic export income
M = Aggregrate domestic import expenditures
(X-M) = "Net export income". Equals Current Account balance. Aggregate foreign expenditures on domestic goods and services (foreigners are spending money on domestic goods and services).
S = (Y-C-G) = Aggregate domestic savings. Everything that is not consumtion or government expenditures. Savings for investment purposes, either domestic or in foreign countries.

Why must the BOP balance?

Y = C + I + G + (X-M)
(Y-C-G) - I = (X-M)
From this we can see that net savings equals net exports. The national income identify in disguised form:
(S-I) = (X-M)
We see that these must balance, which is the same as BOP:
(S-I) - (X-M) = 0
(S-I) + (M-X) = 0

Looking at:
(S-I) = (X-M)
We see that:
(X-M) = Measure of current account balance. Net current account (deficit if "+", surplus if "-")
(X-M) > 0 = current account "surplus", net cash inflow
(X-M) < 0 = current account"deficit", net cash outflow
If X goes up, if initially a surplus, it gets bigger, if intitially a deficit, it gets smaller
If X goes down, if initially a surplus, it gets smaller, if intitially a deficit, it gets bigger
If M goes up, if initially a surplus, it gets smaller, if intitially a deficit, it gets bigger
If M goes down, if initially a surplus, it gets bigger, if intitially a deficit, it gets smaller

(S-I) = Measure of capital account balance. Net capital account (deficit if "+", surplus if "-")
(S-I) > 0 = Capital account "deficit", net cash outflow. If (S-I) is positive, this must mean that all savings are not invested at home. To balance, this means we must also have larger export than import (X-M) > 0
(S-I) < 0 = Capital account "surplus", net cash inflow. If (S-I) is negative, this must mean that domestic savings are not enough to cover all domestic investments. This means that we must have foreign capital used for domestic investments. To balance, this means we must also have larger import than export (X-M) < 0
If S goes up, if initially a surplus, it gets smaller. If initially a deficit, it gets larger. Same effect on (X-M).
Same effects on I.

Good or bad

Convential wisdom is that a Current Account surplus is desired, which means that Capital Account surpluses are bad. But this can be challanged economically. Can a Current Account surplus be a sign of a weak economy (rather than a strong)? It can, if we also take a look at the Capital Account.

Country A:
i) Big current account surplus (X > M)
ii) Big capital account deficit (S > I)

Possible factors:
  • (X-M) > 0
    • Strong export industries.
      • Strong corporations
      • Maybe abundant natural resources.
      • Government interviensions. Subsiding export industry, manipulating currency, mercentalism etc.
    • Weak import demand
      • Governments tell people to buy domestic
  • (S-I) > 0
    • High savings (S). Households are saving a large percentage of their income. Implies low domestic consumtion.
      • Why are consumers cutting back on their spending? This could mean that the times are bad or their expecations are - they are afraid of bad times in the future. Could mean that domestic businesses are forced to sell their goods and services outside the country (hence (X-M) > 0). Not good.
    • Low investments (I)
      • Either economic times are bad (recession) or businesses and households expect bad times and recessions in the future. Investment opportunities outside the country seems better than inside, hence low domestic investments. Not good.
In the reverse situation, you could also make the argument that a current account deficit is a sign of a strong economy.

But we cannot say for sure. We need more information to actually say if a surplus or deficit is good or bad. In particular information of the capital flows.

If we have a country that have large capital inflows (foreign capital is entering the country) = capital account surplus and a current account deficit.
Why might this capital inflow persist year after year?
Maybe the country is just a popular place for foreign capital and foreign investments. Return on investment is high, risk of investment is low.
Conventional wisdom says that current account deficits can't persist forever, but this can be challenged.

"Cost" of capital imports: 4%
"Return" on capital imports: Different scenarios, depends on what is done with capital imports:
  • If we assume that all capital is used to import consumption goods, no investment, we could have 0%. Unsustainable situation.
  • If we assume that the capital is used for more investments, we could have 4%. This is sustainable indefinitely, but with constant real wealth.
  • 6%. The bulk of capital import is used for investment purposes. This is also sustainable indefinitely, but with growing real wealth.
Like Turkey in the statistical example above. A moderate Current Account deficit and a moderade Private Capital Account surplus. Typical numbers for developing countries. Large capital inflows, maybe because of good investment opportunities. The government might like this and try to encourage this (or maybe even engineer the capital account surplus), because the capital can be used to develop the country, e.g. infrastructure (transport networks, roads, canals, ports, internet), public services (schools, hospitals), agricultural land (increase productivity), build public housing.


"Trade" flows versus "capital" flows. What drives what? Do we have a current account surplus because of the capital account deficit? Or the opposite?
What tends to move more quickly in the world today? What tends to move first? Capital flows.

The Foreign Exchange Markets

International currency markets. Networks of private banks, foreign exchange trading firms, and central banks that transacts in foreign assets (primarily currency and money) and through which private parties (households etc) and governments acquire and sell foreign currency. It is easily the largest market in the world, with trading volumes averaging €3 trillion per day (7% of worlds GDP).

Largely an electronic, over-the-counter market. Buyers and sellers contact each other directly in order to trade.

Dominated by a few large international banks, e.g. Deutche bank. 1/3rd of all currency trading takes place in London. London, New York and Tokyo, about 65% of all currency trading.


The main purpose of the foreign exchange market is provide households, businesses, and governments with foreign currency ("foreign exchange") to finance international transactions in goods, services and assets.

The market has doubled in size over the large three years. The currency traded is being used to finance international trade and investments, so because these has grown (especially investments), currency trading also has. Also speculation.

If we set aside speculators, the currency market has a "derived" demand, i.e. a demand based on the demand of a countries goods, services and assets. For example, someone wants the Swedish krona (SEK) because they want to buy Swedish goods, services or assets. Speculators on the other hand might want SEK for the currency itself, just to be able to sell it at a later date.

The foreign exchange markets are considered the closest examples of perfectly competitive markets in existence. Ironically, many markets are also heavily manipulated, mainly by governments (central banks).


Many different types of transactions on the foreign exchange markets, e.g.:
Spot/Cash market = The market for the immediate purchase and sale of currrency. Transactions are finished as quickly as possible, usually around two-three days from start to finish.
Forward market = The market for the future purchase and sale of currency. People want to exchange currencies at a future date, they sign a forward contract which obligates them to transact on this future date at a specific exchange rate.
Swap contracts
Future contracts
Option contracts

Exchange rates

An exchange rate is a method to calculate how much one currency is worth in terms of the other.

Bilateral exchange rate (S) = Relative price of one currency in terms of another currency. The most common, although probably most economically meaningless, way to report exchange rates. This can be expressed in two different ways:
  • Direct (price) quotation: S = (units of domestic currency) / (1 unit of foreign currency)
  • Indirect (quantity) quotation: S = (1 unit of domestic currency) / (units of foreign currency)
Direct quotation is the most commonly used. Example:
S = 9.2371 SEK / €
We can exchange 9.2371 SEK for 1 €.

A currency appreciates = Increases in value (compared to other currencies)
A currency depreciates = Decreases in value (compared to other currencies)

If we get fewer SEK per €, this means SEK "appreciates" (or the € depreciates)
If we get more SEK per €, this means SEK "depreciates" (or the € appreciates)
If S goes down, the domestic currency has depreciated

Effective exchange rates = Relative price of one currency in terms of two or more currencies. A far more useful and economically meaningful way of measuring exchange rates. Measures one currency compared to a group or "basket" of many other currencies (typically the heavy trading partners of the country in question, often the countries near geographically). Sort of an average exchange rate of many different currencies. An index, a trade-weighted average rate of exchange, with larger weight given to larger trading volume. A kind of multilateral exchange rates.

Effective exchange rates are useful because they capture the overall strength or weakness of a currency over time. A currency might over time go up against one currency but down against another, the effective rate captures the average of these changes.

IMF has a database that helps you calculate effective exchange rates.

In many economic models, it might help to think of S as a special effective exchange rate measured against all other currencies.

Sharp changes in bilateral exchange rates can depend on either domestic shocks or foreign shocks. Hard to say which.

Sharp changes in effective exchange rates can depend on either domestic shocks or shocks in group of countries(?)

Real (bilateral) exchange rate (s) = Exchange rates adjusted for relative price changes (inflation)
S = Nominal (bilateral) exchange rate
P = Domestic price level (consumer price index)
P* = Foreign price level (consumer price index)
Important that P and P* measure the same basket of goods and services (or as similar as possible).

s = S(P*/P)
Can also write: s = (SP*)/P

Because the real exchange rate depends on price levels, it can move in a different direction than the nominal exchange rates. Nominal exchange rates is therefore a poor predictor of changes in trade and investor flows between countries. The real exchange rate is a better predictor.

s = Purchasing power of foreign currency in the domestic market
1/s = Purchasing power of domestic currency in the foreign market

S = 3.446
P = 109.3
P* = 102.5
s = 3.446(102.5/109.3)
s ≈ 3.446(0.9378)
s ≈ 3.2316
We see that S > s, the real rate is lower than the nominal. Why?
Nominal exchange rate measures your ability to convert foreign currency into domestic currency. Currencies have a derived demand: you want a currency not by itself but to be able to buy foreign goods or services (unless you're a speculator). Real exchange rates measures your ability to convert foreign currency into domestic goods and services. A measure of purchasing power. The purchasing power of a foreign currency in domestic goods and services. To measure your ability to convert domestic currency into foreign goods and services, we would take 1/s.

Example 2:
If foreign price level P* rises, all else stays the same -> Real exchange rate s rises. This leads to:
  • Domestic currency loses real value
  • Purchasing power of domestic currency falls within the foreign market, because foreign prices are increasing
  • Purchasing power of foreign currency falls within the foreign market, because foreign prices are increasing
  • Both currencies lose real value in foreign markets
If foreign prices is increasing faster than domestic, real exchange rate rises

Example 3:
If domestic price level P rises, all else stays the same -> Real exchange rate s falls. This leads to:
  • Foreign currency loses real value
  • Purchasing power of foreign currency falls within the domestic market, because the domestic prices are increasing
  • Purchasing power of domestic currency falls within the domestic market, because the domestic prices are increasing
  • Both currencies lose real value in domestic markets
If domestic prices is increasing faster than foreign, real exchange rate falls

Cross rate (Scc) = A third bilateral exchange rate calculated from two bilateral exchange rate

Example of cross rate calculation:
S1 = 14.9136 SEK / £
S2 = 9.2145 SEK / €

Scc = (9.2145 SEK / €) / (14.9136 SEK / £)
Scc = 0.6183 £ / €

This was also the actual exchange rate (which it must be, or there would be room for speculation, argitage).

Most currencies are not actively traded. How do we calculate the exchange rate between two currencies if:
1) There is very little currency trading
2) The market is very inactive, not much trading

As long as both currencies are actively traded against at least one major currency, we can calculate their cross rate.
E.g. If there is active trading between SEK and € and between € and (South African) Rand, but no or very little trading between SEK and Rand. How do you calculate the exchange rate between these two smaller currencies (SEK and Rand)? You calculate the cross rate between them with € as common currency.

A cross rate could also be referred to as a "no arbitrage" rate. It's an exchange rate that excludes arbitrage.

Arbitrage = Exploiting price differences to make a profit. Speculative. E.g. buy in one market where price is low, and sell in another market where the price is higher. Buy at low price, sell at high price.
Triangular arbitrage = Exploiting price differences in three markets. E.g. three exchange rates: S1 = 1 SEK / €, S2 = 1 SEK / £ and S3 = 2 € / £. If you have 1 SEK, you go to the second market, convert it into 1 £, go to the third market and convert into 2 €, then convert back into 2 SEK. You start with 1 SEK, end up with 2 SEK. As long as there exists a price difference, it can be exploited for profit.

In the currency and asset market in general, because of many arbitrage speculators, these price differences disappear quickly. They could be said to play a social function to ensure price efficiency between different markets.

Absolute Purchasing Power Parity (PPP) Condition

P = SP*
The relation between domestic prices (P), foreign prices (P*) and the nominal exchange rate (S).

P = Domestic price level (or consumer price index)
P* = Foreign price level (or consumer price index)
S = Nominal exchange rate

It is the law of one price in disguised form.
Law of one price: Identical commodities should sell for identical prices in different prices, when those prices are measured in a common currency. Or in other words: "In an efficient market all identical goods must have only one price".

The reason that exchange rates change is to see that the equality holds. E.g. If only P or P* change, S must adjust as well.
If we move the terms, we can see that:
S = P/P*

If domestic prices rises -> Nominal exchange rate increases
If foreign prices rises -> Nominal exchange rate falls

If absolute PPP holds, then it must mean that real exchange rates are constant and equal to one. Nominal exchange rates change over time to ensure that real exchange rates are constant and equal to one.

If the absolute PPP condition doesn't hold, there is room for arbitrage (speculation). So this condition could also be called a "no-arbitrage" condition, because when P equals SP* there exists no arbitrage. In the real world, we can expect violations of this, e.g. transaction costs, expecations etc.

This connection between price levels and exchange rates is why shocks in the commodity markets spill over to the currency markets, and vice versa.

Absolute PPP can be seen as a long-run equilibrium condition, because in the real world it seems to hold decently in the long run but not in the short.
Nominal exchange rates are far too violatile and unstable for absolute PPP to hold. P* moves too slowly over time relative to S. Why? Because we're ignoring asset trading. In short-run term, capital and investments flows dominate the exchange rate market, but in the long-run, trade flows become more influential. We would need a P* that reflects assets as well as goods and services.

The monetary model is better at explaining long-run exchange rate movements and is a poor short-run model.

One product in the whole world: hair brush.
Domestic price of hair brush (P) = 15 SEK
Foreign price of hair brush (P*) = 1 £

Because of the Absolute Purchasing Power Parity Condition, Nominal exchange rate must be:
S = P/P* = 15 SEK / 1 £

SEK-price in Sweden: 15 SEK
£-price in UK: 1 £
SEK-price in UK: 15 SEK. Calculated by taking the £-price, multiply it with exchange rate: SP* = (15) * 1 = 15 SEK

Example 2:
Product: Shirt
Price in Sweden: 120 SEK
Price in UK: £8
What is the nominal exchange rate?

According to Absolute PPP:
P = SP*
S = P/P*
S = 120 / 8
S = 15 SEK/£

Different scenarios:
  1. What if S = 14 SEK/£? Then the £ is undervalued. There's a arbitrage opportunity (buy cheap in UK, sell expensive in SEK).
  2. What if S = 16 SEK/£? Then the £ is overvalued. There's a reverse arbitrage opportunity (buy cheap in Sweden, sell expensive in UK)
  3. What if P* = £7?
  4. What if P = 110 SEK?

Commodity arbitrage will ensure that absolute PPP holds over times. Thus, absolute PPP can be called a long-run equilibrium condition in the international commodity markets.

The real world

Why might we suspect that deviations from absolute PPP will appear when examining international price data? E.g. price differences between Spain and Italy, Italy and France, or Italy and Japan?

The law of one price fails misearably in the real world (except in a very long run). Holds better when measuring homogeneous goods and services that are freely traded, e.g. oil, while much worse for heterogenous commodities not freely traded.
  • Real barriers to trade/arbitrage exist
    • Shipping and transport costs - Significant for bulky commodities (e.g. automobiles)
    • Taxes and tariffs - Some countries tax imports, other tax exports
    • Imperfect information - Commodity prices are non-transparent. Can be very difficult to find out exact prices in different countries. "Information costs" - the cost of gathering price information. Cannot exploit an arbitrage opportunity when you do not know the exact prices right now. Creates too much risk.
    • Laws and regulations - Trade policies designed to block imports or exports, quotas, exchange controls, special commodity standards etc. Increases the costs arbitrage - to move commodities between countries.
  • Price levels difficult to measure. Price or inflation indices contain different, incomparable commodities. Even without barriers to trade, the Absolute PPP condition can fail because in the real world, P and P* are not the same. E.g. the typical Swedish household/producer doesn't use the exact same type of products as the typical Japanese household/producer (when calculating Consumer/Producer Price Index, CPI/PPI). You need to find very good and homogenous measures of the average price levels, or Absolute PPP/law of one price "fails" because we're not really measuring the same thing.
    • Non-traded commodities (e.g. services) - Services look different between countries because of things like income, culture, taste etc. Thus, average price levels of services does as well.
    • Heterogeneous commodoties (e.g. houses) - A house can be a very different thing in, for example, Sweden compared to Brazil. Thus, average price levels of houses can vary between countries because their definitions are different.
One way to calculate barriers to trade (or lack of market integration between countries and the like) is to compare the difference between law of one price/Absolute PPP and real-world numbers. The greater the differences, the higher barriers to trade.

Does electronic trade promote the law of one price, or does it make violations of it easier?

Relative Purchasing Power Parity (PPP) condition

ΔP = ΔS + ΔP*
The relation between changes in price levels (ΔP and ΔP*, also known as inflation rate) and changes in the nominal exchange rate (ΔS).

It also states that:
ΔS = ΔP - ΔP*

While Absolute PPP focuses on absolute price levels at certain points of time, Relative PPP focuses on changes in price levels. If Absolute PPP holds, then Relative PPP must hold as well. However, if Relative PPP holds, Absolute PPP doesn't necessarily hold. This makes Absolute PPP a stronger condition.

The relative condition just predicts consistency in changes, while the absolute condition also predicts consistency in exact levels. They both measure the degree of correlation between prices and exchange rates (in the long run). Long-run models, or at least "benchmark" models of perfect efficiency. They predict what would happen in a perfect world (without barriers to trade, with perfect market integration etc).

This is often expressed in inflation terms:
ΔP = The domestic rate of inflation
ΔP* = The foreign rate of inflation
ΔS = The inflation differention between the domestic and foreign country

ΔP = +1.24%
ΔP* = +8.57%

The inflation difference:
ΔS = ΔP - ΔP*
ΔS = (0.0124) - (0.0.0857)
ΔS = -0.0733
ΔS = -7.33%

This says that the nominal exchange rate will decrease with -7.33% if we see these differences in price levels.

Nominal exchange rate changes (ΔS) is driven by inflation rate differences between countries.

Reason why nominal exchange rate changes over time: To keep the real exchange rate (s) stable.
Or in other words: To preserve the purchasing power of currencies over time.

If ΔP > ΔP* then we must have ΔS > 0 to make real exchange rates (s) stay unchanged, because s = S(P*/P)
The difference between ΔP and ΔP* must be matched by ΔS.

Forward currency markets

In opposite to spot currency markets (where transactions happen immediately), in forward currency markets, people want to exchange currencies at a future date. They sign a forward contract which obligates them to transact on this future date at a specific exchange rate. 

Spot market - Trade with immediate effect
Forward market - Trade with future effect (e.g. 1 month or 1 year in the future)

The use of forward markets it to eliminate foreign exchange risk, i.e. the risk that the nominal exchange rate will change (ΔS changes). This could cause problems for both international traders, investors and governments, such as:
  • Capitlal losses.
    • The value of foreign assets (A) held by the business falls. A capital loss on the asset-side.
    • The value of foreign liabilities (L) increases.
  • Cash-flow problems. Liquidity problems.
    • Foreign income/revenue (I) falls
    • Foreign expenditues (E) increases.

Example of forward contract to eliminate the risk of that foreign expenditues (E) increases:

A Swedish pharmaceutical company (e.g. Astra Zeneca) contracts in Nov 2010 to buy £3 million worth of chemicals from a British chemical company for delivery in May 2011. Payment upon delivery.

There is a risk because of the late delivery/payment rate, because the payment is fixed in £. The SEK price can change depending on the nominal exchange rate.

Current spot exchange rate: 15.000 SEK/£
SEK contract price: £3 million x 15.000 SEK/£ = 45 million SEK

If at May 2010 the exchange rate increases (SEK appreciates against the £) by a certain percent, the SEK contract price increases with the same percent. The Swedish company will make a loss because they will have to buy the chemicals at a higher real price than expected.

If at May 2010 the exchange rate decreases, the SEK contract price decreases. The Swedish company will make a profit because they can buy the chemicals at a lower real price than expected.

The risk is that the exchange rate will increase and the company will make a loss.

How can Astra Zeneca reduce/eliminate this risk?
  1. Pre-pay. Pay the £3 million today (through the spot market for foreign exchange). However, this could lead to lost income (opportunity cost) because you lose the ability to invest these money until it they would originally be paid.
  2. Money-market hedge. Exchange the money into £ today, but wait until the specific date to pay. This means you can still invest the money (in the UK).
  3. Sign only SEK-denominated purchase contracts. However, this doesn't eliminate the risk, but transfers it to the British company, because it's now dependant on the £ exchange rate. The British company might demand pre-payment or compensation.
  4. Sign a forward contract in the forward exchange market ("hedge" with a forward contract, i.e. reduce or eliminate the risk)

Hedge/hedging - Reducing or eliminating a risk

The forward exchange market is the market for contracts ensuring the future delivery of a currency at a specific date and at a specific exchange rate.

If the company decides to go for option 4:
Astra Zeneca would take a "long" position in the £ by acquiring a 6-month forward buy contract in November 2010 to eliminate foreign exchange risk. The other party will have a "short" position.

Positions in forwards contracts:
"Long" position = Future buy position
"Short" position = Future sell position

It will want to sign this forward contract

Current 6-month forward exchange rate: 15.450 SEK/£.
This is the "6-month" forward rate, compared to the 15.000 SEK/£ that is the current spot rate. The rate is decided by the demand and supply conditions, which makes it different from, say a "1-month" forward rate or a "1-year" forward rate. They could have an either lower or higher rate depending on the demand. In this case, clearly the 6-month forward rate is higher than the current spot rate, but this is not always the case. Forward rates could be less than the spot rate, depending on demand and future expectations.
SEK contract price: £3 million x 15.450 SEK/£ = 46.35 million SEK.

Now, we see that even if the spot exchange rate changes (increases or decreases) in May 2011, and the SEK contract price using the current spot exchange rate increases or decreases, Astra Zeneca would always pay 46.35 million SEK. This means they could both avoid a loss (the risk) or lose a profit

What kind of a forward contract does AZ want?
Type of forward contract that Astra Zenica want to acquire:
Reason - AZ buys a second contract (the forward exchange contract) to "hedge" the first contract
Time - It would want the "maturity" of the forward contract to be May 2011, so it would synchronize with the first contract.
Amount - If it want to eliminate all of the risk, it would write it on exactly £3 million. Or it might want to eliminate half of the risk, and would only write half of the sum, and so on.
Transaction price - It want a fixed transaction price (F), e.g. the exchange rate = F (in this case 15.45 SEK/£). How is F determined? F is bigger than S (nominal exchange rate) which must mean that there's a high demand for it. In general, a forward rate is an expected future spot rate. So this is their best guess of future spot rates. They expect the SEK will depreciate with 3% in the next 6 months.
Buy from who - There are major Swedish banks providing these services (e.g. SEB) or an insurance company. Let's assume they call SEB and SEB agrees to be the counter-party in this contract. What would SEB gain from this? It could profit if it believes its premium is over-valued, but AZ doesn't know (because of asymmetric information), and SEB is signing the contract to exploit an ignorant party. If we do assume it's fair exchange rate, SEB might simply be doing it out of good-will (for good contact with a big company). Or SEB might also have signed another forward contract, which could complement this contract. It's common practice that dealers of forward contracts try to maintain a balance, so that the contracts hedge each other. SEB might also want to increase their risk (speculate), to try to make money. SEB receivs SEK and pay in pounds, both fixed sums, so it hopes that the SEK will appreciate (go up in value). This would make them be able to convert the SEK into more pounds than the fixed pay sum, which would make them a profit.

What will happen on May 2011:
  1. AZ receives the chemicals from British Exporter
  2. AZ pays SEB 46.35 million SEK to SEB and receives acquires £3 million in return
  3. AZ pays British Exporter the £3 million.
AZ never trades in the spot market, only in the forward market. However, there's a cost because the forward price is higher than the current spot rate. Is it worth it? Hard to say, depends on many factors, such as how unstable the exchange rate is expected to be. But if AZ doesn't want to guess and is risk averse (wants to avoid risk) then this is preferred.

 AZ is "shorting" the pound with British Exporter and goes "long" on the pound with SEB. Offsetting positions, which is the essence of "hedging".

In this case, prepayment would cost 45 million SEK (plus lost "opportunity costs" such as investing the money), while forward hedging would cost 46.35 million SEK. This means that the cost of forward hedge is 1.35 million SEK (3% higher) than prepayment, which might be worth it to eliminate the risk. This can be referred to as a 3% forward premium. The price they pay to stabilize its foreign expenditures

Forward premium = When F > S
Forward discount = When F < S

Forward premium/discount on the foreign currency (%-terms) = (F-S) / S
Important and widely-used concepts by economists.

This focuses on SEK/ £, e.g. a  £-denominated contract. These can be reversed to analyze the rates relative to the SEK rather than the pound. Requires 1/F and 1/S. If we do this we would instead have a forward discount based on a SEK-denominated contract.

If roles were reversed, and the first contract was SEK-denominated (AZ pays British Exports 45 million SEK at delivery date) the risk would be transferred to British Exports. They are afraid of the same as AZ was: a possible depreciation in the value of the SEK, and would have to sign a forward contract with for example a British bank to be able to convert the 45 million SEK into the final £3, although in the above scenario there would be a cost of the future contract, so they would only get around  £2.91 million in the end. They pay a price to stabilize its foreign income.


While hedgers try to decrease risk, speculators attempt to increase the risk exposure to make profit. To be successful, speculators must be very good at predicting the future.

Suppose that an individual trader (speculator) in the forward market expects that the pound will depreciate relative to the SEK over the next 6 months. How can the trader profit if her expectations are correct?

Current spot exchange rate (Nov 2010): 15.000 SEK/£.
SEB expectations, i.e. current 6-month forward exchange rate (May 2011): 15.450 SEK/£
She (the speculator) believes that there'll be a depreciation of SEK in May 2011: 14.825 SEK/£

How can she profit?
She believes the SEK is overvalued. To profit from overvalued currencies, she must be a seller. So she takes a "short" position in the pound.

Let's assume that the forward contract size is: £1 million
Our speculator decides to trade with a single contract:
  1. Nov 2010: Acquire a single 6-month forward sell contract on the pound. The contract allows her to: Receive 15.450 million SEK in May 2011 for £1.
  2. May 2011: Go to the spot market, exchange 15.450 million SEK for £1.042 million
  3. May 2011: Pay £1 to counterparty and receive 15.45 million SEK in return
Result: In the end, she earns a £0.042 million net profit (roughly an 8% annualized return on her "investment")

However, if there are many traders that believe the same thing, the following steps will occur:
  1. The supply of the pound in the forward market will rise, that is an increased numbers of sellers
  2. As a result, the 6-month forward exchange rate for the pount will fall
  3. In the end, the forward exchange rate for the pound will represent the aggregate market prediction/forecast for the future spot exchange rate of the pound, based on all available information. The forward rate will reflect the average forecast of the future spot rate.

Example 2:
Let's assume that Astra Zeneca (AZ) is an investor who wants to invest surplus capital. They can choose between two different investments with the same maturity:
  1. One investment at home - 6-month Swedish government bonds
  2. An investment in a foreign country (the UK) - 6-month Brittish government bonds
Let's assume that these are identical investments: They both expose AZ to the same risk, and they're both essentially risk-free (no default risk). The only difference is that one is a domestic bond and the other is foreign - one has to be paid in SEK and one in pounds.

R = Interest rate on Swedish bonds
R* = Interest rate on British bonds
F = Forward exchange rate (SEK/£), in this case 6-month forward rate
S = Spot exchange rate (SEK/£)
St = Expected future spot exchange rate (SEK/£)

In reverse, this means that:
1+R = SEK return on S

Let's calculate investment returns per SEK invested.
1 SEK invested:
  • "Guaranteed" SEK-return on Swedish bonds: (1+R)
  • £-return on British bonds.
    • We first have to convert the SEK into £, this requires us to know how many pound 1 SEK gives us, i.e. £/SEK. This is NOT given by S, because it gives SEK/£, so we have to convert it to its reverse form by doing: 1/S
    • The £-return then becomes: (1/S)(1+R*)
  • If AZ choses not to hedge, the unhedged SEK-return on British bonds 6 months later:
    • Have to convert back to SEK after 6 months so have to guess the future spot exchange rate (St).
    • Then we get: (1/S)(1+R*)(St)
    • This is uncertain because we don't know St for sure.
  • "Guaranteed" SEK-return on Brittish bonds. By using a forward contract, we can remove the risk by using forward contracts, and will instead receive a hedged SEK-return on British bonds after 6 months:
    • Instead of expected exchange rate (St) we uses a fixed forward exchange rate (F) given by the forward contract. No need to guess, it's guranteed:
    • (1/S)(1+R*)(F)

Similar to law of one price, we see that, in equilibrium, identical assets should offer identical rates of return, when the rates of return are measured in a common policy, so "guaranteed" SEK-return should be the same for Swedish bonds and Brittish bonds.

If not, identical assets will sell for different prices in different markets. We have room for a type of arbitrage.

In equilbrium:
1+R = (1/S)(1+R*)(F/S)
We can rewrite the last parenthesis:
(F/S) = (S+F-S)/S = (S/S) + (F-S)/S = 1 + (F-S)/S

From this we can create an approximation:
1+R = (1+R*)(1+(F-S)/S)
R-R* ≈ (F-S)/S
This is the so called: Covered Interest Parity Condition (CIPC)

It says that, in equilbrium:
Interest differential between the domestic and foreign country = The forward premium disount of the foreign currency(?)

It holds if identical assets offers identical rates of return when the rates of return are measured in a common policy.

What does CIPC imply?
  • If (F-S) > 0 (If there is a forward premium on the foreign currency), then R > R*
  • If (F-S) < 0 (If there is a forward discount on the foreign currency), then R < R*
  • If (F-S) = 0 (If there is no forward premium/discount on the foreign currency), then R = R*

In equilibrium, Swedish bonds must pay an interest rate that equals (1) the interest rate on British bonds plus (2) the forward premium on the pound.

If you're making a foreign investment, you're not just making one investment, you're making two. You invest in a foreign asset that will offer a rate of return, but you also invest in a foreign currency, which will also offer a rate of return.

R ≈ R* + (F-S)/S
R ≈ (return on the foreign asset) + (return on the foreign currency)

  1. If R > R* + (F-S)/S, then the total return on domestic investment is greater, and it's only interesting to invest domestically
  2. If R < R* + (F-S)/S, domestic companies will invest in the foreign assets
  3. If R = R* + (F-S)/S, then the domestic company is indifferent between domestic or foreign assets

If, for 4-month government bond:
R = 4.35%
R* = 5.75%
S = 15.000 SEK/pound
What must be true in equilibtrium according to covered interest parity?

In equilibrium, F = 14.790 SEK/pound (a 1.4% forward discount must exist on the pound)

Basis point = 1/100th of a percentage point
1 bp = 0.01%

Annual interest rates:
R = 3.45%
R* = 3.85%
S = 9.19 SEK/€
F* ≈ 9.1869 SEK/€

F* is the "no-arbitrage" 1-month forward rate. The equilibrium forward rate.
Example: (F* < S) meaning we have forward discount on €

Let's assume that:
F = 9.17 SEK/€ meaning we have a "big" forward discount on €. Room for arbitrage.

R-R* > (F-S)/S

In the foreign market, the € is undervalued. So you want to be a buyer.
Overall strategy:
1) Buy € in forward market
2) Sell € in spot market

Actual transactions:
  1. Borrow € in foreign country and sell today at spot market rate S to convert into SEK ("short-sell")
  2. Buy € back in future at forward rate F ("long")
Effects: S will decrease (because everyone is dumping € in the spot market), F will increase (because everyone is buying € in the forward market). This goes on until the covered interest parity condition holds, i.e. until the prices adjust to eliminate the arbitrage opportunities.
Effective rates:
R = 0.2875%
R* + (F-S)/S = (0.3208%) + (-0.2176%) = 0.1032%

  1. Borrow at "low" foreign rate (0.1032%)
  2. Invest at "high" Swedish rate (0.2875%)
    1. "Spread": 0.1843%
    2. Profits: (€€ borrowing) x ("spread")
    3. In efficient capital markets then expected profits is zero: E(π) = 0
    4. However, in this case we can make a profit. E.g. we borrow €500 million and make profit of €921,000. So markets are not efficient, in this case the inefficiency lies in F.
    5. Potential complications:
      1. Transaction costs: Taxes etc.
      2. Borrowing constraints: Not everyone can borrow as much money as they want. Generally only for the big players.
      3. Possible investment losses: This is short-term markets so the default risk is low
      4. Time-value of money: Not a factor, because we're not putting our own money at play, just borrowing money from others.

In detail:
  1. Borrow € at R* for 1 month
  2. Convert € into SEK at S
  3. Invest SEK at R for 1 month
  4. Sign forward contract to sell SEK at F (long position in €)
  5. Convert SEK into € at F (using forward contract)

Now, let's assume the reverse:
F = 9.20 SEK/€
Forward premium on €
CIPC: R-R* < (F-S)/S

Overall strategy:
  1. Buy € in spot market
  2. Sell € in forward market
Actual transactions:
  1. Buy € today at S ("long" position)
  2. Sell € in future at F ("show" position)
Spot rate S increases, forward rate F falls until the arbitrage possibility disappears, e.g. until R-R* = (F-S)/S (or approximately, because in practice, transactions costs etc might make exact equality impossible).

In the real world, these numbers are unrealistic, because forward rates shouldn't be this different from spot rates. Yet, very minor differences can still create great opportunities for the big players that have a lot of money to invest.

If F = 9.20 SEK/€ then we know that:
R = 0.2875%
R* + (F-S)/S = (0.3208%) + (0.1088%) = 0.4296%

So our arbitrage strategy is to:
  1. Borrow SEK at R for 1 month
  2. Convert SEK into € at S
  3. Invest € at R* for 1 month
  4. Sign forward contract to sell € at F (short position in €)
  5. Use the forward contract to convert € into SEK at F
Net Arbitrage Profits:
If borrow 50 million SEK -> Profit 71,050 SEK
If borrow 4 billion SEK -> Profit 5.7 million SEK

  • We are ignoring transaction costs, taxes etc. Are the arbitrage profits greater than the transaction costs?
    • Yes: S will increase, F will fall until they reaches the level of the transaction costs
    • No: CIRC violated. There's an arbitrage opportunity but it cannot be exploited because of transaction costs.
  • Do barriers to capital movements exist? E.g. capital controls, exchange controls, restrictions on foreign investments. Some countries restrict capital inflow and outflow. Could also violate CIRC.
  • Default risk? There could be an arbitrage opportunity, but it's too risky to exploit. E.g. large investment risks, counterparty risk of the forward contract is too high.
  • If there's no active spot market or forward market for a specific currency, there will be no arbitrage, and such differences will stay.

Monetary model

Monetary approaches to balance-of-payments and exchange rate determination.

"Open-Market" operations (OMO)

Open market operation is the means of implementing monetary policy by which a central bank controls the short term interest rate and the supply of base money in an economy, and thus indirectly the total money supply.

  1. Central banks either buy or sell bonds at the bond market (with bond traders). Pumping more money or withdrawing money from the bond market.
  2. This increases or reduces the money supply.
  3. This increase of decrease short-term interest rate
  4. This can either stimulate or slow down the economy, e.g. monetary policy

Usually central banks only focus on the short-term government bond market. Why not other markets, such as stock market or the property market? Because it would influence the market too much and cause chaos. Other markets are not deep enough to be able to handle such large short-term investments. Hard to find such a large volume of buyers or sellers in other markets in short term, and is probably going to take longer than 72 hours.
Bond markets on the other hand have very large volumes, so central banks can generally buy or sell large volumes without notibly influensing the market. The market can absorb exchanges of this size easily without creating chaos (e.g. influence prices).

How about the currency market? This is usually at least as large as the bond market. Central banks would buy or sell foreign currency (FER) at the currency market. This would give similar effect on the money supply (Ms). However, this would also influence the exchange rate which is an unwanted effect and might end up hurting the economy rather than helping the economy.

MB = Monetary base. "High-powered money" - money tha created money. Can be defined in two ways:
1) The sum of domestic assets (DC) plus foreign assets (FER) held by the domestic central bank
The sum of the domestic securities and loans held by a central bank (domestic credit, DC, the value of all domestic assets held by the domestic central bank) plus the foreign securities and deposits ("foreign exchange reserves", FER) held by the central bank.

Another definition
2) The sum of currency circulation (C) plus the total reserve deposits of the private banking system held by the central bank (TR).
MB = C + TR

The relationship between the monetary base (MB) and the money stock (M) can be most simply defined as:
M = m * MB
m = money multiplier (= 1 / (required reserve ratio))
Required reserve ratio = A part of the deposit money that private banks receive that must be held in liquid form, set by the central bank. This is too avoid banking panics and bank runs, if people feel that they cannot withdraw their money. In most countries around 5-10%.

If the required reserve ratio is 0.05, then m = 20. If central bank increases MB by 20 million SEK, it will increase M by 400 million SEK. This process occurs through a process called "multiple-deposit expansion/contraction". Thus, by manipulating the assets and liabilities in its balance sheet, a central bankcan control the domestic money stock.

Why do central banks and finance ministries intervene in the foreign exchange rate markets? Might want to manipulate exchange rates, or smooth out their path, i.e. stabilize exchange rates (reduce exchange rate volatility). Or fix the rate against a specific currency. However, as we said before, this can also influence the money supply. 

Governments usually hold foreign exchange reserves to fund interventions, some quite huge.
Swedish Riksbank: €35 billion
European Central Bank: €400 billion
US Federal Reserve: $64
Bank of China: €1.8 trillion
However, not that huge numbers, because at the foreign exchange markets, the average daily turnover is about €3 trillion.


Exercise 1

In Jan 1999 the spot exchange rate for the EUR was 0.9 EUR/$. The EUR price level was 105.3 and USD price level was 108.
In July 2000 the rate is 1.08 EUR/$. The EUR price level was ? and USD price level was ?.

a) In nominal terms did the euro appreciate or depreciate against the dollar? What was the rate of appreciation or depreciation?
(b) Calculate the January 1999 real exchange rate for the euro. Calculate the July 2000 real exchange rate for the euro.
(c) Based on your answers in (b), in real terms did the euro appreciate or depreciate against the dollar? What was the rate of appreciation or depreciation?
(d) Based upon the information in question (1), and according to absolute purchasing power parity (PPP) was the euro overvalued or undervalued relative to the dollar in July 2000? By what percent?
(e) Based upon the information in question (1), and according to relative PPP, what is the predicted value for the euro for July 2000?
(f) According to your answer in (e), was the euro overvalued or undervalued relative to the dollar in July 2000? By what percent?

Answer a:
Important: In this excercise, the exchange rate is given by EUR (€) per $. To calculate percentage change with focus on the EUR, we must have EUR in the denominator, i.e. $/€. So we much reverse the rate:

Jan 1999: 1/S = 1/0.9 = 1.1111 $/€
July 2000: 1/S = 1/1.08 = 0.9259 $/€

How do we calculate the rate of change? We want to calculate the percantage change, so we do:
(0.9259 - 1.1111) / 1.1111 = -0.167

This means that the EUR weakened (depreciated) by -16.7% against the $.
1 USD gives us more EUR 

Answer b:
Jan 1999:
We know the formula to calculate real exchange rate:
s = S(P*/P)
s = Real exchange rate
S = Nominal exchange rate
P = Domestic price level
P* = Foreign price level

Now, which is the domestic price level? Becuase we're calculating $/€ we use the nominal rate we got in the previous answer. Because we assume direct quotation, the domestic country must the $ and the foreign the EUR. So the foreign price level P* is 105.3 and domestic price level P = 108

S = (1.1111)(105.3/108)
S = 1.0833 $/€

Can do the same for July 2000:
S = 0.8891 $/€

Why not write it in €/$ just like the nominal exchange rate?

Answer c)
Use same method as in a)
Should give 17.9% depreciation of € against $

Answer d)

We know that the Absolute PPP is given by:
P = SP*
Which gives us:
S = P/P*
S = 113.3 / 108.8 = 1.0414 $/€

Absolute PPP gives us what the nominal rate should have been in theory: 1.0414 $/€
However, in reality it was only 0.9259 $/€
So we can conclude that the € is undervalued against the $.

EUR is undervalued in the actual market relative to theoretical absolute PPP value by:
(0.9259 - 1.0414) / 1.0414 = -11.1%
The percentage derivation of actual rate compared to theoretical rate is -11.1%

Answer e)
Relative PPP condition states that:
ΔP = ΔS + ΔP*
From this we can get:
ΔS = ΔP - ΔP*

ΔP = (113.3 - 108.0) / 108.0 = 0.0491 (4.91%)
ΔP* = (108.8 - 105.3) / 105.3 = 0.0332 (3.32%)
This gives us the inflation rates for both countries and explains why the real value of the EUR was lower than its nominal value.

We can now calculate:
ΔS = ΔP - ΔP*
ΔS = 0.0491 - 0.0332 = 0.0159
According to relative PPP the EUR should have gone up by 1.59%. To get the actual rate, we take the Jan rate and multiply it with the percent increase:
(1.1111) * (1.0159) = 1.1288 $/€

Answer f)
The relative PPP states that we should have 1.1288 $/€.
But in reality it was: 0.9259 $/€
The EUR is undervalued against the $ because you get fewer € for one $.
You can calculate the exact percentage:
(0.9259 - 1.1288) / 1.1288 = -0.18
The real exchange rate was 18% lower than Relative PPP.

It's no surprise that the theoretical PPP condition doesn't equal reality. See section about the PPP conditions.

Exercise 2

Asset-Based Models of Balance of Payments and Exchange-Rate Determination

1. Write out an equation representing the monetary approach to balance-of-payments and exchange-rate determination. Suppose that domestic credit equals 1,000 million SEK, foreign exchange reserves equal 80 million SEK, the money multiplier is 2, the fraction of nominal income that individuals desire to hold as cash is 20%, the foreign price level is 1.2, and the spot exchange value of the domestic currency is 2.
(a) What is the money stock of the domestic economy?
(b) What is the level of real income of the domestic economy?

2. Using the information in question (1), suppose that the domestic monetary authorities increase domestic credit by 10 million SEK through an open-market purchase of securities.
(a) Under a fixed exchange-rate regime, what is the effect of this open-market transaction on the nation’s balance of payments?
(b) Under a flexible exchange-rate regime, all other things constant, what is the new exchange value of the kroner? Is this an appreciation or depreciation?

3. Illustrate the spot exchange market for the domestic currency using the supply and demand framework. Explain and illustrate the effect of a central bank open-market sale of bonds on the exchange value of the domestic currency.

Answer 1:
The equation representing the monetary approach to balance-of-payments and exchange-rate determination is given by:
m(DC+FER) = kSP*y
m = Money multiplier
DC = Domestic credit
FER = Foreign exchange reserves
S = Nominal exchange rate
y = Real income
The left side is the money supply

We already know the variables, so can simply calculate the money supply.
m = 2
DC = 1,000
FER = 80
m(DC+FER) = 2(1,000 + 80) = 2160 million SEK

k = 0.2
S = 1/2 = 0.5
P* = 1.2
m(DC+FER) = kSP*y
We replace the values we have:
2160 = 0.2 * 0.5 * 1.2 * y
y = 18000 million SEK

Answer 2)
DC increases.
This should give us:
S* = 0.5046

Current account balance increases by ...