exchange rates and the balance of payments chapter 14

adv and disadv of managed float

-offers flexibility to pursue policies in accordance to the needs to the domestic economy-allows economies to adjust more easily to shocks offers govt the opp to prevent very sudden and large exchange rate fluctuations and makes currency speculation more difficult because speculators do not know if and when a central bank will intervene to change value of currency -cannot do enough to prevent large currency fluctuations, damaging to economies highly dependnet on exports -unsuccessful in eliminating large trade imbalances -countries can cheat by undervaluing their currencies and gaining an unfari competitive advantage

components of the current account

1) balance of trade in goods-exports of goods (sale of goods to other countries, credits) and imports of good (purchases of goods from other countries, debit)- exports - imports 2) balance of trade in services-variety of activities such as tourism, transportation-imports and exports of services balance of trade in goods and services-value of all exports minus the value of all imports-net exports of GDP 3) income-all inflows into a country of rents, interset and profits from abroad minus the outflows of rents, interests and profits 4)curent transfers- inflows due to transfers from abroads like gifts, remittances, foreign aid and pensions minus outflows of such transfers

capital account

1) capital transfers include inflows minus outflows for such things as debt forgiveness (debt is cancelled), non life-insurance claims and investment grants 2)transactions in non=produced, non-financial assets consist mainly of the puchase or use of antural resources that have not been rpdouced e.g. land - inflows of funds minus outflows of funds from these transactions capital account of the balance of payments of a country is composed of inflows minus outflows of funds for capital transfers and transactions in non-produced, non-financial assets- small compared to the current account and financial account

financial account components

1) direct investment- foreign direct investment- investments in physical capitals such as buildings usually undetaken by multinational corporations- inflows due to direct investment by foreigners minus outflows due to investment abroad 2)portfolio investment- financial investments such as stocks and bonds- inflows for the purchase of stocks and bonds minus outflows 3)reserve assets-foreign currency reserves that the central bank can buy or sell to influence the value of teh country's currency

Advantages and disadvantages of an undervalued currenct

advantages exports become less expensive to foreign buyers, imports become more expensive domestically-developing countries use it to expand their export industries, expand their economies and therefore also increase their employment levels-creates an unfair competitive advantages compared to other countries that do not undervalue their currencies "dirty float"

Advantages and disadvantageswith an overvalued currency

advantages imports become cheaper- imports of capital goods, raw materials and other inputs for manufacturing industries needed for industrilisation- developing countries disadvantages exports become more expensive-negatively affecting domestic exporters -increased imports and reduced exports lead to a worsening current account balance, resulting in payment difficulties disadvantages domestic producers who have to compete with artificially low price imports, with neg consequences for domestic employment and resource allocation

most important part of current account is

balance of trade in goods and services

in a floating exchange rate system appreciation and depreciation occur as a result of

changes in demand or supply for a currency

balance on financial account

consists of inflows minus outflows of funds for direct investment , portfolio investment and reserve assets

effect of exchange rate changes on inflation

cost push inflation-a currency depreciation makes imports more expensive, domestic producers dependent on imported fops, cops increase, SRAS curve shifts left resulting in cost push inflation currency appreciation by making imports less expensive lowers inflationary pressures demand pull inflation-currency depreciation makes exports cheaper and imports more expensive, increases net exports, increase in net exports causes a rightward shift of the AD curve in recession, an increase in AD will not cause demand pull inflation

all credits or inflows of money create a ____ and all debits create a _____

credits-foreign demand for the country's currency debits-supply of the domestic currenct

imbalance in the balance of payments

deficit in the combined current, capital and financial accounts plus errors and emissions excluding central bank intervention current account deficit + current account surplus + financial account surplus + errors and omissions

devaluation and revaluation results in

devaluation like depreciation results in cheaper exports to foreigners and more expensive imports for domestic residents, more exports and less imports revaluation like appreciation results in more expensive exports to foreigners and cheaper imports for domestic residents, fewer exports and more imports

pegging exchange rates

developing countries fix their currencies to the USD and float together with it pegged currency is allowed to flucutate only within a narrow range above and below a target exchange rate relative tot eh dollar or the euro, so that if the actual er hits the upper or lower limit of the range the central bank intervenes to keep it within the limits

effects of exchange rates ( appreciation and depreciation)

effects on the inflation rate cost push inflation currency depreciation-imports are more expensive-domestic producers are more dependent on imported FOPs, costs of production increase, resulting in a lefrward shift of the SRAS curve, resulting in cost push inflation currency appreciation results in lower inflationary pressures for the economy demand pull inflation exchange rate affects aggregate demand by influencing net exports- currency depreciation makes exports cheaper and imports more expensive, increases net exports, rightward shfit of the AD curve-if economy is producing at or close to potential output, inflationary pressures will result-if it is in recession, an increase in AD will not cause demand pull inflation effects on employment- currency depreciation increases net exports and therefore AD- fall in cyclical unemployment if the economy is in a recessionary gap- if at or close to potential GDP, the increase in AD may cause a temporary decrease in natural unemployment- strong demand-pull inflationary pressures currency appreciation- by reducing net exports and decrease AD will create a recessionary gap and therefore leda to cyclical unemployment if the economy begins at or close to potential output, lead to increase in cyclical unemployment if in recessionary gap effects on economic growth currency depreciation increases net exports, increasing AD, increase in RGDP- increases in real output, growth of export industries leads to increased investment spending in the domestic economy- effects on AS, causing increases in potential output-rightward shifts of LRAS or AS curves) currency appreciation may have a dampening effect on RGDP growth-by reducing net exports, makes imports cheaper, increased imports of FOPs that can be used to increase govt investment spending and therefore increase potential output effects on the current account balance balance of exports and imports of goods and services depreciation is likley to cause exports to increase- if country has an excess of imports over exports- trade deficit will become smaller over a period of time- trade surplus will become larger appreciation-imports increases, trade deficit will become larger, trade surplus decreases effects on foreign debt depreciation- lowers value of domestic currency, causes value of foreign debt to increase appreciation-value of foreign debt decreases

surplus on the capital account indicates

excess demand of the currency in the foreign exchange market

in a freely floating exchange rate system,

exchange rates are determined by market forces or the forces of demand and supply- no gov't intervention- eq exchange rate

fixed exchange rate system

exchange rates are fixed by the central bank of each country and are not permitted to change in response to changes in currency supply and demand the currency supply and demadn are made to adjust to the fixed exhange rate through the central bank and govt intervention

depreciation of a currency

fall in the value of a currency in a floating exchange rate system decrease in demand for dollars, shifts left increase in supply of rodllars, shifts right

role of foreign currency reserves in fixed vs floating

fixed- central bank intervention to maintain a fixed er requries sufficient supplies of reserves of foreign currencies-if current account deficit, reserve currencies can be sold to buy the domestic currency thus creating credits in the financial account-problems if central banks dont have enough reservers floating-no need for central banks to hold reserves since there is no need for intervention-balance is done through market forces

degree of certainty for stakeholders for fixed vs floating

fixed-high degree of certainty for firms, consumers and govt because tehy know what exchange rates will be in the future-can plan future investments domestically and abroad, exports and other activities-consumers can better plan travel abroad etc.-gvots can plan actvities involving foreign transactions speculation is limited-remove a cause of currency instability due to speculation floating-cause uncertainty as stakeholders cannot be sure what the value of currencies will be like in the future- neg effects on trade and investment flows due to inability to plan ahead large and abrupt exchange rate changes can cause problems for countries that depend heavily on exports- results in financial crises, large current account deficits currency speculation can be destabilising- if speculators expect a currency to depreciate due to large current account deficits, they can sell the currency in anticipation of its depreciation and as a result cause it to depreciate more than it otherwise would

ease of adjustment in fixed vs floating

fixed-no easy methods to correct imbalances in the balance of payments-external shocks such as sudden oil price increase leading to current account deficits for all oil imports, cannot be handles quickly and easily- large q of foreign currency reserves is required if large or persisitent current account deficits are around country must resort to contractionary policies, trade protection or exchange controls if no reserves or if not devaluate its currency floating-ability to adjust automatically to excess demand or supply of the domestic currency, automatically rbingign about a balance in the balance of payments-deficit is eliminated through currency depreciation, surplus through appreciation- easy adjustment to external shocks

flexibility offered to policy makers fixed vs floating

fixed-no flexibility to policy makers-maintaining the er at a fixed level forces the govt and central bank to pursue a range of policies that come with certain disadv interest rates increase financial investments but have contractionary effects in the domestic economy, borrowing from abroad increases inflows of funds but extensive borrowing can lead to high levels of debt, contractionary fiscal and monetary policies to limit imports may create a recession and unemployment in the domestic economy, trade protection to limit imports results in inefficiency in production, increased domestic and global misallocation of resources and may result in retaliation, exchange controls limit currency outflows but result in major resource reallocation floating- offers greater flexibility to policy makers-domestic policy has independence but can have undesirable effects in the foreign sector of the economy

causes of changes in exchange rates

foreign demand for a country's exports- as demand for a country's exports increases, its currency appreciates-demand curve shifts right domestic demand for imports-as a country's imports increases, sell local currency in the foreign exchange rate market its currency depreciates-supply curve shifts right relative interest rate changes-financial capital are funds used to make financial investments- if a country's interest rate increases, the value of its currency increases-if interest rates increase, attracts investors, demand for that country's currency increases, demadn curve shifts to right relative rates of inflation-higher inflation in a country relative to the other countries leads to currency depreciation-sweden inflation, demand for exports falls, imports from other countries with lower inflation rates increase , fall in Swedish exports causes demand for Swedish currency decreases, increase in imports causes supply of kronor to increase investment from abroad-foreign direct investment (investment by multinational corporations) and financial investments-increase in foreign invesmtnet from abroad results in currency appreciation, affects demand for that country's currency shifts right changes in income-a country's level of income relative to other countries increases, they demand more imports, supply of that currency increases, suppl shifts right, value of its currency decreases speculation-involves buying and selling currencies in order to make a profit from changes in exchange rates-based on expectations of future exchange rate changes-widespread expectation that a currency will appreciate leads to currency buying that contributes to appreciation use of foreign currency reserves-if a central bank buys a foreign currency, it must sell teh domestic currency in the foreign exchange market, supply shifts to the right, currency depreciates

devaluation of currency and revaluation

if currency has a higher value than can be maintained through interventin, govt may change the fixed rate to a new and lower value-devaluation revaluation-of currency has a lower value than can be maintained through intervention, govt may set a higher value

why the current account and financial account are interdependent

if imports are greater than exports, deficit in its trade balance, important ocmponent of the current account, likely to have a current account deficit must be a financial account surplus which provides it with the foreign exchange it needs to pay for the excess of imports over exports-surplus on financial account can be due to invetments in physical capital by foreigners deficit in the current account is matched by a surplus in the financial account surplus in the current account is matched by a deficit in the financial account

deficit

in an account occurs whenever a balance has a neg value, meaning thar debits are larger than credits

surplus

in an account occurs whenever a blance has a positive value; credits are larger than debits

managed exchange rates

in between the two extremes of fixed exchange rates and floating exchange rates-central banks periodically intervene to stabilize them over the short term-but are for the most part free to float to their market levels central bank intervenes to prevent large and abrupt fluctuations in exchange rates which disrupt the orderly flow of international trade and create uncertainties

appreciation of a currency

increase in the value of a currency relative to the other in a floating exchange rate system increase in demand for dollars, D shifts right decrease in supply of dollars, spply curve shifts left

with a trade surplus country consumes

inside its ppc

a current account surplus means that a country consumes

less than it produces and part of the income generated from the sale of extra output produced corresponds to a financial account deficit

under freely floating exchange rates

market forces cause the exchange rate to change

under freely floating exchange rates when there is a deficit in teh current account

market forces create a downward pressure on the currency exchange rate

under freely floating exchange rates when there is a surplus in the current account

market forces create an upward pressure on the currency exchange rate-exchange rate changes automatically eliinate current account deficits and surpluses, and create a balance in the balance of payments

a current account deficit means that a country consumes

more than it produces and it pays for extra output consumed through a financial account surplus

current account is

of the balance of payments is the sum of the balance of trade in goods, balance of trade in services, infome inflows minus income outflows, current transfer inflows minus outlflows

with a trade deficit country consumes

outside its ppc

overvalued currency, undervalued currenc

overvalued currency-one that has a value that is too high relative to its eq free market value-exchange rate has been set at a higher level than the eq market exchange rate undervalued currency-one whose value is too low relative to its eq free market value- exchange rate is low realtive to the one the market would have determined

in a fixed exchange rate system the balance of payments is made to balanc eby

policies that keep the exchange rate fixed- increase interset rates to increase credits in financial account decrease the debits- limit imports through contractionary fiscal and monetary polcies or trade protection or exchange controls, impose exchang eocntrols

objective of central bank intervention in er and what forms it takes

prevent large and abrupt fluctuations in exchange rates that could arise if currencies were left entirely to free market forces-large and abrupt exchange rate changes disrupt the orderly flow of international trade and create uncertainties that undermine investment and economic activity mechanisms-buying and selling of currencies by the central bank, influencing currency demand and supply-change interest rates

balance of payments

record usually for a year of all transactions between the residents of a country and the residents of all other countries its role it to show all payments received from other countries called credits and all payments made to other countries called debits in the course of a year all inflows of payments (credits) must exactly equal the outflows of payments (debits) involves imports and exports, travel, investments in stocks and bonds, investments by multinational companies, buying propoerty, sending or receving gifts etc. anything that gives rise to a flow of money across international boundaries

main reason for pegging exchange rates

stabilises the exchange rate of the pegged currency in relation to the currency to which it is pegged, preventing abrupt or strong fluctuations-developing countries that peg their currencies to the USD experience exchange rate stability- facilitates trade flows with the US as well as between the countries with pegged currencies

errors and omissions

statistics trick- if sum of credits larger than the sum of debits, includes a debit item to create the equality

deficit on current account means

there is an excess supply of the currency in the foreign exchange market

in a managed exchange rate system the balance of payments is made to balance

to balance by a combination of central bank buying aand selling of currencies and market forces

under the managed float, exchange rates are determined

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- intervention takes the form of the buying and selling of official reserves

intervention to maintain fixed exchange rates

using official reserves-excess supply of boples, sells some of its foreign currency reserves to buy excess boples- shifts demand for doples to right increases in interest rates-attracts financial investments from other counntries-higher demand for the foreign currency, shifting the demand for boples to right- involves contractionary monetary policy which may lead to a recession in the domestic economy borrowing from abroad-if country borrows from abroad, loans will come in the form of foreign exchange- when converted into boples, causes an increase in the demand for boples and hence a rightward shift in the demand curve efforts to limit imports-reduces supply of domestic currency causes a leftward shift in teh currency supply curve- 1) can use contractionary fiscal and monetary policies to lower AD, incomes and therefore result in fewer imports or trade protection trade policies-lowers quantity of imports-2) trade protection trade policies-lowers quantity of imports that can enter the country-however can lead to recession while trade protection comes with numerous disadvantages such as possibility of retaliation by trading partners, lower exports imposing exchange controls-restrictions imposed by the govt on the quantity of foreign exchange tat can be bought by domestic residents of a country-restricts outflows of funds from teh country for investments abroad etc. -can cause serious resource misallocation

exchange rate

value of one currency to another