The Balance of Payments & Exchange Rates

Balance of Payments The total of all economic transactions between a nation and the rest of the world Credits- money flowing in Debits- money flowing out Includes: Current Account, Capital Account, & Financial Account Individual accounts may have surplus or deficit –Surplus- credits > debits (balance is positive) –Deficit- debits > credits (balance is negative) The sum of all three accounts will equal zero.

Exchange Rates Floating- determined by the market Fixed- set by the government Managed- Government intervenes in the market to keep the rate within acceptable values (managed float)

Determinants of Floating Exchange Rates Appreciation- value of currency increases in terms of other currencies (becomes stronger) Main Causes –Increased exports –Current Account surplus –Increased net foreign investment –Decreased inflation relative to other countries –Increased real interest rates –Political/economic stability –Speculation (expectations)

Determinants of Floating Exchange Rates Depreciation- value of currency decreases in terms of other currencies (becomes weaker) Main Causes –Increased imports –Current Account deficit –Decreased net foreign investment –Increased inflation relative to other countries –Decreased real interest rates –Political/economic instability –Speculation (expectations) –Increased deficits/ debt

Effects of Currency Appreciation Decreased Exports Imports become less expensive Less inflation Encourages investment from foreigners AD decreases, AS increases

Effects of Currency Depreciation Increased exports Imports become more expensive Increased inflation Discourages investment from foreigners AD increases, AS decreases

Fixed Exchange Rates Exchange rate is “pegged” to another currency –Devaluation- exchange rate is decreased –Revaluation- exchange rate is increased How Central bank maintains large amounts of foreign currency & buys or sells its own currency to influence supply & demand Monetary policy- higher interest rates will increase demand, lower interest rates will increase supply Exchange controls- limits on the amount of foreign currency that can be bought and sold by residents Import limits

Managed Exchange Rate A.k.a “Managed float” Government intervenes in the market to keep the rate within acceptable values Uses the same policies as a fixed rate, but to a lesser extent

Evaluation of Floating Rates Advantages  Helps to “self-correct” trade imbalances  “Shock Absorber”- helps to correct recession and inflation  Not necessary for a central bank to hold massive foreign reserves  Does not interfere with monetary policy Disadvantages  Complicates international trade  Volatility & uncertainty for investors  Macro economy can become vulnerable to currency speculators  Exchange rates cannot be used for protectionism

Evaluation of Fixed & Managed Rates Advantages  Stability  Predictability for investors  Inflation control  No speculation Disadvantages  Limits monetary policy  Need to hold foreign currency reserves  Informal markets  Overvalued currencies discourage exports  Undervalued currencies cause inflation

Currency Substitution Adopting the currency of another country Advantage –Stability Disadvantage –Loss of sovereignty