International Economics: Exchange rates and balance of payments

  • Freely floating exchange rates
  • Fixed exchange rates
  • Balance of Payments
  • Balance of payments and exchange rates
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Freely Floating Exchange rates: Causes

Exchange rate: the value of one currency expressed in terms of another

Demand for foreign = Supply of domestic
Demand for domestic = Supply of foreign

  • Causes:  
    • Demand for exports increase ~ currency appreciates (D increase)
    • Demand for imports increase ~ currency depreciates (S increase)
    • Relative interest rates increase ~ Financial investment increase ~ Financial capital in currency appreciates (D increase)
    • Higher relative inflation
    • Speculation: buying and selling currencies to make profit from changes in exchange rates due to expectation. Expectation currency appreciate~currency buying~ appreciation. 
    • Use of foreign currency reserves 
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Freely Floating Exchange rates: Consequences

  • Inflation:
    • Cost push: Depreciation ~ import price of factors of production increase ~ SRAS increase. (the more inelastic, the greater the inflation) 
      If a country is importing factors of production and carrying out specialisation, it will not diversify and therefore become more and more inelastic 
    • Demand pull: Depreciation ~ import price increases & export price falls ~ AD increase 
  • Employment
  • Economic growth:
    •  Increase AD leads to economic growth 
    •  Depreciation ~ growth of export industries ~ increase invesment ~ LRAS increase
    • Appreciation ~ cost of imported factors of production decrease ~ increase invesment 
  • Current account
  • Foreign debt 
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Fixed Exchange Rates

Fixed Exchange rates: when the exchange rates are fixed by the central bank and not permitted to respond to the market mechanism. (Requires constant intervention by gov)

  • Official reserves to maintain the exchange rate:
    • Fall in demand~ depreciation -> Central bank buys currency and sells foreign reserves
    • Increase demand ~ appreciation -> CB sells currency and buys foreign reserves 
    • Persistant downward pressure (depreciation) means foreign reserves run out.  
  • Increase interest rates: Attracts financial investments -> demand for currency increases. this is a contractionary monetary policy and will affect the economy
  • Borrow from abroad: loans come in the form of foreign exchange which when converted to domestic currency will cause increase in demand for the currency.  
  • Limit imports: demand for imports fall ~ demand for foreign exchange falls (domestic supply falls)
  • Exchange controls: Restrictions imposed by the government on the quantity of foreign exchange brought back by domestic resident
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Managed & Pegged Exchange Rate

  • Managed Exchange rates: Exchange rates are for the most part free to float to their market levels over long periods of time, but CB will periodically intervene to stabilise them in ST. 
    • To prevent large and abrupt fluctuation exchange rates
    •  currency moves towards its LT equilibrium position determined by the market
  • Pegging Exchange rates: (developing countries)
    • Peg or fix your currency to the US dollar or Euro and float in relation to other currencies
    • The pegged currency is allowed to fluctuate only within the narrow range above and below a target exchange rate relative to the dollar.
    • When the actual exchange rate fluctuates to the upper or lower limit, the CB intervenes.
  • Overvalue: the value of currency is too high relative to equilibrium market exchange rate 
    • Imports are cheaper: when need cheap imports of capital goods, raw materials, other inputs for industrialisation.  
    • Exports become more expensive:  current account worsens
  • Undervalue: the value of currency is too low relative to equilibrium market exchange rate. 
    • Exports become cheaper for foreign buyers: when need to expand export industries.
    • seen as unfair competition 
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Fixed VS Freely Floating

  • Fixed 
    • + Certainty, less currency speculation
    • + Discipline: Can’t gain competitiveness through depreciation, forcing firms to be efficient 
    • - Need sufficient supplies of foreign currency reserves. May run out 
    • - No easy of adjustment. Large or persistent current account deficits require large quantities of foreign reserves or foreign borrowing. Or, use contractionary policies, trade protection, exchange control à not beneficial.
    • - Monetary policy is used to manipulate the currency, not the economy. Contractionary. 
    • - Borrowing from abroad to increase flows of funds may lead to high levels of debt
    • - Disadvantages of trade protection. (Misallocation etc.)
  •  Floating
    • - Uncertainty, more currency speculation that is destabilising
    • - May rely on depreciation of the currency to become more competitive. Worst case, may devalue in order to be more competitive (China)
    • + Adjusts automatically to excess demand and supply. à Automatic balance in the BOP. (Deficit – depreciation; surplus – appreciation)
    • + No need to adjust policies to respond to balance of payments
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Balance of Payments

  • Balance of Payments: the record of all transactions between the residents of the country and the residents of all other countries. sum of credits = sum of debits. 
    • - Credit: inflow of money into the country - create foreign demand for currency 
    • - Debit: outflow of money from the country - create a supply of currency 
    • -  the deficit = excess supply of the currency; a surplus = excess demand. 
  • Current Account:  Balance of trade in goods, balance of trade in services, income (wages, rent, interests, profits) and current transfers (gifts, foreign aid, pensions).  
  • Capital Account: Capital transfers (flows of debt forgiveness, non-life insurance claims, investment grants), Transactions in non-produced, non-financial assets (purchase in natural resources) 
  • Financial Account: FDI (investment in physical capital usually undertaken by multinational corporations), Portfolio investment (stock and bonds), reserve assets (foreign reserves
  • Errors and omissions
  • - 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. (investments in physical or financial capital by foreigners (including loans))
  • - If there is a current account surplus, the country is accumulating foreign exchange (as it earns more foreign exchange from exports than it pays out to buy imports), which can be used to buy assets abroad.
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Consequence of Persistent Current Account Deficits

Financed by loans:

  • Higher interest rates to attract foreign financial investments, leading to recession. 
  • High indebtedness
  • Depreciating exchange rate due to deficit. (Imported inflation, speculative attacks)
  • Poor international credit ratings (may raise interest rates)
  • Demand management policies (contractionary)
  • Cost of paying interest on loans 
  • Fewer imports of needed capital goods (interest payments use up FE earnings)  
  • Possibility of lower economic growth
  • Lower standard of living in the future
    • PRO: Borrowing can lead to economic growth 

Financed by sales of domestic assets: (increased purchases of land, factories, stocks, etc)

  • The ability of a country to go on indefinitely financing its current account deficit by selling off its assets depends very much on the confidence that foreign investors have in the domestic economy and currency. A belief of depreciation -> unwilling to invest
  • Also, most of the above. 

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Correcting persistent current account deficits

  • Expenditure reducing policies (reduction in AD):
    •  Contractionary fiscal policy-> lower AD -> lower import demand. (also lower inflation, which may make domestic good more competitive-> increase exports) CON: recession. Contractionary monetary policy=higher interest rates=appreciation
  • Expenditure-switching policies:
    • Trade protection: switch consumption away from imports to domestic goods. CON: Higher import prices, lower domestic consumption, inefficiency, domestic misallocation of resources, retaliation. 
    • Depreciation: allowing the currency to depreciate= export competitiveness increase CON: higher import prices -> imported inflation.
    • Undervalue: expand export industries, expand economy, increase employment. CON: dirty float -> risk retaliation. Imported inflation. 
  • Supply-side policies to increase competitiveness: 
    •  Lower cost of production for firms by shifting the SRAS and LRAS curve to the right
    •  lower rates of inflation -> increase exports
    •  increase productivity in order to increase export. 
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Marshall Lerner Condition and J-curve

Considering whether a depreciation reduces the size of the trade deficit. What matters is the changes in the value of exports and imports, not the quantity of imports and exports. 

  • IMPROVE: PEDm + PEDx > 1 
  • WORSEN: PEDm + PEDx < 1
  • Even if PEDm <1 and PEDx<1, if sum is >1 there will be an improvement
  • Depreciatin leads to a change in the price of exports only when expressed as FE.
    (price of exports remains the same for domestic consumers)
    Since domestic price stays the same, export revenue increases.
    with PEDm >1 : fall in import expenditure
    with PEDm <1 : rise in import expenditure -> consider the sum. 


  •  depreciation -> PEDm and PEDx <1 (due to time lags)
  •  consumers and producers adjust to changes in prices PEDm and PEDx increase  
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Consequence of Persistent Current Account Surplus

  • Low domestic consumption
  • Insufficient domestic investment: 
    • the financial account deficit means funds are leaving the country, resulting in a risk of insufficient domestic investment, limiting economic growth. 
  • Appreciation of domestic currency
  • Reduced export competitiveness due to appreciation of the currency. 
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