Chapter 14 Exchange Rates and the Balance of Payment

 Explain that the value of an exchange rate in a floating system is determined by the demand for, and the
supply of, a currency.
- Exchange rate: The value of one currency expressed in terms of another, e.g. €1 = US$1.42.
- Floating exchange rate: An exchange rate system where the value of a currency is allowed to be determined
solely by the demand for, and supply of, the currency on the foreign exchange market. It is the equilibrium
exchange rate.

 Draw a diagram to show determination of exchange rates in a floating exchange rate system.
Say that we want to examine the exchange rate for Europe
o The vertical axis: Euro in terms of $
o The horizontal axis: Quantity of Euro
o And then there is the demand and the supply of Euro
o Speculate: involves buying and selling currencies in order to make a profit from changes in exchange
rates. An increase in speculation will lead to appreciation, and vice versa. n
The forces of demand and supply for the Euro are determined by:
Demand for BHD Supply of BHD
1. buy European exports of goods and services 1. Europeans to buy overseas goods and services
(and to travel in Europe) (and to travel outside Europe)
2. invest in European firms (portfolio investment 2. Europeans to invest in foreign firms
or foreign direct investment – FDI) 3. Europeans to save their money in foreign
3. save their money in European banks or other banks or other financial institutions
financial institutions 4. people who hold euro to speculate on either
4. make money by speculating on the currency. the value of the euro or the value of foreign
currencies.

 Distinguish between the depreciation and the appreciation of a currency.

 Draw diagram to show changes in the demand and supply of a currency.
- Appreciation: an increase in the value of a currency against another currency in a floating exchange rate system
- Depreciation: a decrease in the value of a currency against another currency in a floating exchange rate system
Floating exchange rate:
Advantages
1. As the exchange rate does not have to be kept at a
certain level, interest rates are free to be employed
as domestic monetary tools and can be used for
demand management policies, such a controlling
inflation.
2. In theory, the floating exchange rate should adjust
itself, in order to keep the current account
balanced. For example, if there is a current account
deficit, then the demand for the currency is low,
since export sales are relatively low, and the supply
of the currency is high, since the demand for
imports is relatively high. This should mean that the
market will adjust and that the exchange rate
should fall. Following this, export prices become
relatively more attractive, import prices relatively
less so, and so the current account balance should
right itself. (This will depend upon the Marshall-
Lerner condition being satisfied – see Chapter 27.)
3. As reserves are not used to control the value of the
currency, it is not necessary to keep high levels of
reserves of foreign currencies and gold.
Disadvantages
1. Floating exchange rates tend to create uncertainty on
international markets. Businesses trying to plan for the
future find it difficult to make accurate predictions
about what their likely costs and revenues will be.
Investment is more difficult to assess and there is no
doubt that volatile exchange rates will reduce the
levels of international investment, because it is difficult
to assess the exact level of return and risk.
2. In reality, floating exchange rates are affected by more
factors than simply demand and supply, such as
government intervention, world events like 9/11 and
speculation. This means that they do not necessarily
self-adjust in order to eliminate current account
deficits.
3. A floating exchange rate regime may worsen existing
levels of inflation. If a country has relatively high
inflation to other countries, then this will make its
exports less competitive and make imports more
expensive. The exchange rate will then fall, in order to
rectify the situation. However, this could lead to even
higher import prices of finished goods, components
and raw materials, and cost-push inflation, which may
further fuel the overall inflation rate.
Government intervention

i. Fixed exchange rates

- Fixed exchange rate: An exchange rate regime where the value of a currency
is fixed, or pegged, to the value of another currency, e.g. the Yuan has been
pegged against the US$ so that US$1 = 6.8275 CNY (China Yuan Renminbi), or
to gold.

 Method:
1. Suppose that the government of Bahrain has fixed the BD-US $
exchange rate at 2USD=1BD. Initially, there is an equilibrium in the
BD market, at point A.
2. If the currency depreciates in value (for example by a fall in demand
for Bahrain’s exports), so the demand-for-BD curve shifts from D1 to
D2.
3. Under a floating exchange rate, the exchange rate would fall to 1.5$
per 1BD. (figure 14.3.a) At the fixed exchange rate of 2$=1BD, there
is an excess supply of BD. Therefore, if the fixed exchange rate is to
be maintained, the central bank or the government must intervene.

Means of government intervention in the foreign exchange market

There are two main methods.

1. By using their reserves of foreign currencies to buy, or sell, foreign currencies – if the government wishes to
increase the value of the currency, then it can use its reserves of foreign currencies to buy its own currency on the
foreign exchange market. This will increase the demand for its currency and so force up the exchange rate.

In the same way, if the government wishes to lower the value of its currency, then it simply buys foreign currencies
on the foreign exchange market, increasing its foreign currency reserves. To buy the foreign currencies, the
government uses its own currency and this increases the supply of the currency on the foreign exchange market and
so lowers its exchange rate.

2. By changing interest rates – if the government wishes to increase the value of the currency, then it may raise the
level of interest rates in the country. This will make the domestic interest rates relatively higher than those abroad
and should attract financial investment from abroad. In order to put money into the country, the investors will
have to buy the country’s currency, thus increasing the demand for it and so its exchange rate.

In the same way, if the government wishes to lower the value of the currency, then it may lower the level of interest
rates in the country. This will make the domestic interest rates relatively lower than those abroad and should make
financial investment abroad more attractive. In order to invest abroad, the investors will have to buy foreign
currencies, thus exchanging their own currency and increasing the supply of it on the financial exchange market. This
should lower its exchange rate.
Fixed exchange rate

Advantages
1. Fixed exchange should reduce uncertainty for all 1. The government is compelled to keep the exchange
economic agents in the country. Businesses will be
able to plan ahead in the knowledge that their
predicted costs and prices for international trading
agreements will not change.
2. If exchange rates are fixed, then inflation may have a
very harmful effect on the demand for exports and
imports. The government will be forced to take
measures to ensure that inflation is as low as possible,
in order to keep businesses competitive on foreign
markets. Thus, fixed exchange rates ensure sensible
government policies on inflation.
3. In theory, the existence of a fixed exchange rate
should reduce speculation in the foreign exchange
markets.
Disadvantages
rate fixed. The main way of doing this is through the
manipulation of interest rates. However, if the
exchange rate is in danger of falling, then the
government will have to raise the interest rate in
order to increase demand for the currency, but this
will have a deflationary effect on the economy,
lowering demand and increasing unemployment.
This means that domestic macroeconomic goals
(low unemployment) may have to be sacrificed.
2. In order to keep the exchange rate fixed and to instill
confidence on the foreign exchange markets, a
country with a fixed exchange rate has to maintain
high levels of foreign reserves in order to make it
clear that it is able to defend its currency by the
buying and selling of foreign currencies.

3. Setting the level of the fixed exchange rate is

not simple. There are many possible variables to take
into account and, also, these variables will change with
time. If the rate is set at the wrong level, then export
firms may find that they are not competitive in foreign
markets. If this is the case, then the exchange rate will
have to be devalued, but again, finding the exact right
level is very difficult.

4. A country that fixes its exchange rate at an artificially

low level may create international
disagreement. This is because a low exchange rate will
make that country’s exports more competitive on world
markets and may be seen as an unfair trade advantage.
This may lead to economic disputes or to retaliation.

Managed exchange rate

- Managed exchange rate: An exchange rate system where the value of the currency is allowed to float, but with
some element of interference from the government. Usually, the central bank sets an upper and lower exchange
rate value and then allows the currency to float within those limits, intervening when the exchange rate moves
beyond the limits to bring it back within them.
o Under the managed float, exchange rates are determined mainly through market forces, but with
periodic intervention by central banks aiming to smooth out abrupt fluctuations.
o Intervention takes mainly the form of buying and selling of official reserves.
o Some developing and transition economic peg (fix) their currencies to the US dollar or euro; pegged
currencies are fixed in relation to the dollar or euro, and float in relation to all other currencies.
Consequences of overvalued and undervalued currencies

Overvalued
- One that has a value that is too high relative to its
equilibrium free market value. Its exchange rate
has been set at a higher level than the equilibrium
market exchange rate.
Undervalued
- One that has a value that is too low relative to its
equilibrium free market value. Its exchange rate
has been set at a lower level than the equilibrium
market exchange rate.

(same as advantages and disadvantages of high exchange (same as advantages and disadvantages of low exchange
rate) rate)

The Balance of Payments:

- Balance of payments (of a country): a record of all transactions between the residents of the country and the
residents of all other countries.
- Credits: all payments received from other countries.
- Debits: all payments made to other countries.
o In the course of a year, all credits (inflows) must exactly be equal to the debits (outflows).
o In the balance of payments account of a country, all credits create a foreign demand for the country’s
currency, and the debits create a supply of the domestic currency.

The structure of the balance of payments:

Component Sub-component
a) The current account 1. Balance of trade in goods: calculated by subtracting imports of goods from exports of
- The most important goods
part for most o Current account deficit: balance has a negative value; imports greater than exports,
countries is the or credits greater than debits
balance of trade in o Current account surplus: balance has a positive value; exports greater than imports,
goods and services or debits greater than credits.
2. Balance of trade in services: calculated by subtracting imports of services from
exports of services
3. Net income: inflows of rents, interest and profits, minus outflows of such sources.
4. Current transfers: inflows due to transfers from abroad like gifts, remittances, foreign
aid, and pensions, minus all such transfers.
b) The capital accounts 1. Non-produced, non-financial assets: purchase of natural resources that have not been
- Relatively small produced (land, water, airspace)
compared to the 2. Capital transfers: debt-forgiveness, non-life insurance and investment grants
current and ∴ capital account: composed of inflows minus outflows of funds for capital transfers and
financial account transactions in non-produced, non-financial assets.
c) The financial accounts - measure of the buying and selling of assets between countries. It measures the net
change in foreign ownership of domestic assets.
1. Direct investment: investments in physical capital, e.g. buildings and factories. Usually
done by multinational companies.
2. Portfolio investment: stocks, government bonds, corporate bonds, real estate, land
3. Reserve assets: foreign currency reserves that the central bank can buy or sell to
influence the value of a country’s currency.
d) Errors and omissions o In real-life, it is very difficult to every single transaction
o However, since the sum of all credits must be equal to all debits, it is necessary for
actual accounts to include an item creating this equality.
o This is role of errors.
o E.g. when the sum of all credits is larger than debits, then this includes a debit item
to create the equality.
 The meaning of ‘balance’ in the balance of payments:

 The current account balance is equal to the sum of the capital account and financial account balances
o A current account deficit is matched by a surplus in the other three items combined
o A current account surplus is matched by a deficit in the other three items combined

Current account + (capital account + financial account + errors and omissions) = 0

How the current and financial account are interdependent

i. If there is a surplus in the current accounts, then there must be a deficit in the financial account, and vice versa
Current Account
A (+)
Export of goods and services
i. Income transfers: remittances from home i.
country nationals working abroad/ interest
earned by domestic savers abroad/ profits from
domestic companies abroad transferred home
ii. Current transfers: gifts from foreign entities to iii.
domestic entities
B (-)
Import of goods and services
i. Income transfers: remittances from foreign i.
workers at home country back to foreign ii.
country/ interest earned by foreign savers in
domestic markets/ profit from foreign iii.
companies transferred abroad
ii. Current transfers: gifts from domestic entities
to foreign entities
If A>B: surplus; if B>A: deficit
Financial Account
C (+)
Investment by foreigners in domestic assets
FDI: when foreign firms invest at least 10% in a
domestic firm. When foreign firms build
factories or acquire capital in home country.
ii. Portfolio investment
Changes in official reserves of foreign exchange:
a current account deficit leads to a decrease in
official reserves, and positive in financial
account.
D (-)
Investment by domestic entities in foreign assets
FDI: when domestic firms invest abroad
Portfolio investment: domestic investments
in stock and bonds abroad
Changes in official reserves of foreign
exchange: a current account surplus leads to
an increase in official reserved and negative
in financial accounts
If C>D: surplus; if D>C: deficit

N.B.
1) If A>B (c.a. surplus) then D>C (f.a. deficit)
2) If B>A (c.a deficit) then C>D (f.a surplus)
- If there is a current account deficit, there must be a financial account surplus, which provides it with the foreign
exchange it needs to pay for the excess of imports over exports.
- The surplus on the financial account may have arised from investments in physical or financial capital, including
loans from foreigners.
- It therefore follows that a deficit in the current account is matched by a surplus in the financial account.

Illustrating using PPC:

i. Trade deficit: means imports are greater than exports. This means that a country is producing more than its
maximum potential, and therefore the production point is outside the PPC.
ii. Trade surplus: exports are greater than imports. This means that a country is producing within its usual
potential, and therefore the production point is within the PPC.
Balancing deficits with surpluses under free floating exchange rates:

 Under a free-floating exchange rate, when there is a deficit in the current account, market forces create a
downward pressure on the currency exchange rate.
◊ If there is an increase in the demand for imports from a foreign country, this leads to an increase in the
supply of a currency into the foreign exchange market, and a rightward shift from S1 to S2.
◊ Therefore, at the equilibrium, there is a surplus in the supply of currency.
◊ The country therefore has a current account deficit, corresponding to excess debits in their balance of
payments.
 When there is a surplus in the current account, market forces create an upward pressure on the currency
exchange rate.
◊ This is because in equilibrium, the sum of credits is equal to the sum of debits in the country’s balance of
payments. In other words, the quantity of the currency demanded is equal to the quantity of the
currency supplied, and there is a balance in the balance of payments.
◊ If there is an increase in the demand for a currency, this creates a rightward shift from D1 to D2. So at
the initial equilibrium, there is an excess demand for the currency equal to the distance between A and
B.
◊ The country now has surplus on its current account, and since nothing has changed in the remaining
accounts, it has excess credits in its balance of payments. An imbalance has therefore been created.
◊ This causes the currency to appreciate and the imports to increase and the exports to decrease unyil the
current account surplus in eliminated.
 As result, exchange rate changes automatically eliminate current account deficits and surpluses and create a
balance in the balance of payments.
 In a managed exchange rate system, the balance of payments is made to balance by a combination of central
bank buying and selling of currencies, and market forces.
 In a fixed exchange rate, the balance of payments is made to balance by policies that keep the exchange rate
fixed.

Consequences of current and financial account surpluses

- If the current account is in surplus, there may be other consequences.

 The country can have a deficit on capital account by building up reserves or purchasing assets abroad.
 The surplus usually leads to an appreciation of the currency, which makes imports cheaper, reducing
inflation, but exports more expensive, leading to unemployment.
 There may be increased protectionism from other countries.

A financial account surplus may have two consequences.

1) If it is based upon the purchasing of assets for ownership, it is usually a positive thing and allows a current
account deficit.
2) If it is based upon high levels of borrowing from abroad, it is usually a bad thing in response to a current account
deficit.

Methods of correcting a persistent current account deficit

i. Expenditure-switching policies: These are any policies designed to attempt to switch the expenditure of
domestic consumers away from imports towards domestically produced goods. Here are some examples.
1) Government could introduce policies to depreciate or devalue the value of the currency, and thus make imports
more expensive, reducing demand for them. (Success depends on the price elasticity of demand (PED) for
imports.)
 2) Protectionist measures, such as tariffs, quotas, embargoes and legal restraints could be used, but these
measures may lead to retaliation and may be against WTO agreements. They also encourage domestic
producers to be inefficient.

ii. Expenditure-reducing policies

These are policies designed to attempt to reduce overall expenditure in the economy, thus shifting aggregate demand to
the left, and reducing the demand for all goods and services, including imports. Deflationary demand-side policies are
used (fiscal and/or monetary).

However, although import expenditure may be reduced, the policy is also likely to lead to a fall in domestic employment
and eventual recession! This is probably too big a cost to pay for external balance.

Economic Integration
A trading bloc is groups of countries that join together in some form of agreement in order to increase trade between
themselves and/or to gain economic benefits from co-operation on some level.
The stages of economic integration are:
1) A preferential trading area (PTA) is a trading bloc that gives preferential access to certain products from certain
countries.
2) A free trade area is an agreement made between countries, where the countries agree to trade freely amongst
themselves, but are able to trade with countries outside of the free trade area in whatever way they wish, e.g.
NAFTA.
3) A customs union is an agreement made between countries, where the countries agree to trade freely amongst
themselves, and they also agree to adopt common external barriers against any country attempting to import
into the customs union e.g. EU.
4) A common market is a customs union with common policies on product regulation, and free movement of
goods, services, capital and labour, e.g. EU.
5) An economic and monetary union is a common market with a common currency, e.g. the Eurozone.
6) Complete economic integration This would be the final stage of economic integration, at which point the
individual countries involved would have no control of economic policy, full monetary union, and complete
harmonisation of fiscal policy.