loans and money

We looked at this briefly in earlier posts, but to recap it is expressed as:
S − I = Y − E = X − M
where:
S = Savings
I = Investment
Y = Income
E = Expenditure
X = Exports
M = Imports
This can actually be expanded by breaking down “savings” into public and private savings such that:
( Sp + Sg ) − I = X − M
where:
Sp = Private savings
Sg = Government savings
Here, government “dis-saving” reflects having a budget deficit. Thus, from this, we can see immediately that there is a possible link between a budget deficit and a trade deficit. If a country’s budget deficit continues to rise, this is reflected on the left-hand side of the equation by an increasingly negative value for Sg . Unless this is offset by a rise in private savings or a fall in investment, this will eventually mean that the left-hand side of the equation turns negative. Of necessity in this circumstance, the right-hand side of the equation must also be negative, which in turn means that the country has a trade deficit. Thus, a budget deficit can lead to a trade or a current account deficit. The link is not necessarily automatic. However, it should be assumed that widening budget deficits, if sustained over time, lead to widening trade and current account deficits. If we extend this, we see that at some stage widening current account deficits will become unsustainable, requiring a real exchange rate depreciation. Thus, widening budget deficits may eventually require real (and thus nominal) exchange rate depreciation.
Economists are not generally thought of as prone to high emotion. Yet, one has to say that the accounting identity is like a work of great art, hiding great intricacy and complexity behind the veneer of apparent simplicity. From this accounting identity, we can see how economies adjust to changes in fundamental conditions and therefore how exchange rates should adjust to those conditions. Again, this is probably best shown through an example.

So far in this blog, the focus has been on trying to create new exchange rate models based on capital flows to try to improve forecasting accuracy. As necessary as this is, it does not mean we abandon the traditional exchange rate models. Classical economic theory has provided the foundations for exchange rate analysis. The purpose of establishing a framework known as currency economics is to be able to combine the new with the exchange rate models and use both in a more targeted and focused way. Any major differences between this framework of currency economics and classical economics are more methodological than ideological. The traditional exchange rate models, focusing as they do on such factors as trade, productivity, prices, money supply and the current account balance, help provide the long-term exchange rate view. Capital flow-based models are considerably more helpful and accurate in terms of predicting short-term exchange rate moves.
However, these two types of exchange rate model should not necessarily be viewed as polar opposites. The very purpose of establishing a specific framework known as currency economics is to create an integrated approach to exchange rate analysis, which is capable of answering the riddles of short-, medium- and long-term exchange rate moves. The two sides do have some common ground, and it should be no surprise that this common ground is to be found in the balance of payments model — given that it focuses both on trade and capital flows. Within this, there are three specific analytical tools which should be of use to currency market practitioners in bridging the gap between short- and long-term exchange rate analysis:
The standard accounting identity for economic adjustment
The J-curve
The REER

When market conditions are perceived as stable according to the market indicators used by the index, they are of necessity optimum for investors to be in risk-seeking mode. Equally, when market conditions are unstable, this is synonymous with investor risk-aversion or avoidance. The focus for such an analytical tool has been the investor community. However, currency speculators and corporations can also use a risk appetite or instability indicator with which to trade or manage their currency risk.
Using the context of the 1997–1998 crisis period, the Instability Index seeks to measure risk appetite using leverage, credit spreads and cross-market (equity, fixed income and foreign exchange) options’ volatilities as its three benchmarks. The period of June 1997–September 1998 accelerated the focus in trying to measure risk appetite as first the Asian countries experienced currency crises one after another and then Russia devalued and defaulted in August 1998. Conceptually, everyone knew what it meant to be risk-averse, but measuring it was another matter, let alone trying to use that measurement to predict future phases of risk appetite. While investment banks needed analytical tools to track the overall risk appetite of clients across markets, particularly in times of stress, academics and policymakers also needed such a tool for the purpose of measuring just how orderly or disorderly market conditions were in order to help guide future policy responses. The Instability Index, which was formalized in 1999, is just such a guide and includes three main components:
De-leveraging — There are two parts to this. The first looks at the relationship in the currency market between the US dollar (as an equity-linked, higher yielding asset) and the likes of the Swiss franc (as a traditional safe-haven currency) and Japanese yen (as a low interest rate, funding currency). During times of market stress, the US dollar tends to lose ground against these as “leverage” or risk is cut. The second component looks at US and European bank equities as a measure of market “leverage”.
Credit spreads — In the US dollar credit markets, this tracks the spreads between BBB-rated industrial credits, emerging market Brady bonds and swaps to Treasuries, while it also tracks Euro swap spreads to Bunds. The overall reading gives a very good indicator of investor risk-tolerance.
Implied volatilities — Across the three asset classes of equities, debt and currencies, tracking three-month implied volatilities gives a good idea as to demand levels for option-related protection structures from investors. Option implied volatility tends to rise more sharply during asset market slumps than when asset prices are rising.
The advantage with the readings within this index is that they are relatively easily available and updated daily. Thus, using these three components to represent the degree of “stability” or “instability” in the market, we can have a daily indicator of risk appetite, which can in turn be used as a forecasting tool for currency markets.