14: Exchange rates and the balance of payments

Question 1

What is a freely floating exchange rate?

Answer 1

A freely floating exchange rate is one that is determined by market forces.

Question 2

What does the market graph for an economy look like with a freely floating exchange rate sysem?

Answer 2

Say you are looking at the market for US dollars you have to measure it in terms of another currency, let’s say euros. Therefore you have € per $ on the y axis, or price of $ in euros. On the x axis you have Q of $.
Then you have normal S and D curves, except they are S of $ and D for $. Where they meet is the value of the currency, this is the equilibrium exchange rate. At a higher price, more dollars would be supplied than demanded and visa versa.

Question 3

What causes the value of a currency to appreciate?

What causes the value of a currency to depreciate?

Answer 3

A currency appreciates if the demand increases or supply falls.

A currency depreciates if the supply increases or the demand falls.

Question 4

How does the appreciation of one currency affect the other? Show this with a diagram?

Answer 4

An appreciation of one currency leads to the equivalent depreciation of another.
Demand increases for the dollar so the D shifts right. More people are supplying Euros to exchange for dollars so the S of € curve shifts to the right.

Question 5

What factors lead to changes in currency demand or supply?

Answer 5

1. Foreign demand for a country’s exports
2. Domestic demand for imports
3. Relative interest rates
4. Relative inflation rates
5. Investment from abroad
6. Changes in income
7. Speculation
8. Use of foreign currency reserves

Question 6

How does foreign demand for a country’s exports change currency demand or supply?

Answer 6

Foreign demand for a country’s exports.
e.g. if there is an increase in demand for swiss watches, there is an increase in demand for swiss francs. D curve shifts to the right and the franc appreciates.

Question 7

How does domestic demand for imports change currency demand or supply?

Answer 7

Domestic demand for imports - if the US wants to import foreign-made cars, it’s supply of dollars increases as it is selling them for foreign currencies. This depreciates the dollar.

Question 8

How do relative interest rates change currency demand or supply?

Answer 8

Relative interest rates - if interest rates in one country increase relative to others, they are more attractive to investors so demand for that currency increases and D for the currency curve shifts to the right.

Question 9

How do relative inflation rates change currency demand or supply?

Answer 9

Relative inflation rates - if inflation rises relative to other countries, demand for exports fall because it becomes too expensive. Meanwhile imports for the country increase as other goods become relatively cheaper. Demand for the currency shifts left whilst supply shifts, both of which depreciate the currency.

Question 10

How does investment from abroad change currency demand or supply?

Answer 10

An increase in foreign investment from abroad appreciates the currency, ceteris peribus.

Question 11

How do changes in income change currency demand or supply?

Answer 11

If income rises, supply of the currency is larger and so it depreciated, ceteris peribus.

Question 12

How does speculation change currency demand or supply?

Answer 12

If people speculate an appreciation they will buy more of that currency which increases the demand which leads to an appreciation.

Question 13

How can exchange rate changes lead to cost-push inflation?

Answer 13

If a currency depreciates their imports are more expensive. If production within a country relies heavily on these imports, then the cost of production will increase, shifting the SRAS to the left and causing cost-push inflation.

Question 14

How can exchange rate changes lead to demand-pull inflation?

Answer 14

Exchange rates change aggregate demand by changing net exports (X - M). A currency depreciation will make imports more expensive and exports cheaper, meaning the value of X - M increases. This shifts AD to the right. If the Keynesian model is producing close to potential output, this could lead to demand pull inflation.

Question 15

How can exchange rate changes lead to changes in employment levels?

Answer 15

d

Question 16

How can exchange rate changes lead to changes in employment levels?

Answer 16

d

Question 17

How can exchange rate changes lead to changes in employment levels?

Answer 17

d

Question 18

How can exchange rate changes lead to changes in employment levels?

Answer 18

d

Question 19

How can exchange rate changes lead to changes in employment levels?

Answer 19

d

Question 20

What is a fixed exchange rate system?

Answer 20

Exchange rates are fixed by the central bank in each country and are not permitted to change in response to changes in currency supply and demand.

Question 21

Explain, using two diagrams, how a fixed exchange rate is maintained:

Answer 21

Show a foreign exchange diagram.
£ per $ on y, Q of $ on x.
S of $, D of $.
Then have another D curve to the left (less demand) called D2 for $. Have an arrow pointing from D1 to D2 and an arrow pointing from D2 to D1. Explain that the fall in demand for US exports leads to decrease in demand. Since the exchange rate is fixed the US central bank buys excess dollars, increasing the demand for dollars.
If there had been an excess demand for dollars, the central bank would sell some.

If there is excess supply over a prolonged period of time, it is not possible to shift demand as foreign currency reserves will eventually run out. If D shifts left, supply can also be shifted left to counteract this.

Question 22

Why is an excess supply of a currency difficult to deal with? More so than excess demand?

How can the government deal with this?

Answer 22

When a currency is experiencing excess demand, the central bank can continue to sell the domestic currency and buy foreign exchange. However, when there is excess supply of a currency the central bank cannot keep buying excess, as eventually it will run out of foreign currency reserves.

Decreasing exports

Question 23

What are measures to deal with a downward pressure on a currency’s value?

Answer 23

1. Increases in interest rates
2. Borrowing from abroad
3. Efforts to limit imports
4. Imposing exchange controls

Question 24

How would increasing the interest rate help deal with a downward pressure on a currency’s value?

Answer 24

Increasing the interest rate would attract investment from other countries, as the risk is less high. This leads to higher demand, shifting the D curve back to D1.

Question 25

How would borrowing from abroad help deal with a downward pressure on a currency’s value?

Answer 25

If a country borrows from abroad its loans will come in the form of foreign exchange, increasing the demand for the currency. This leads to debt though.
e.g. when the UK borrows from France there is more demand for the pound.

Question 26

How would efforts to limit imports help deal with a downward pressure on a currency’s value?

Answer 26

Reducing imports reduces the supply of the domestic currency. In order to limit imports the government can use contractionary fiscal and monetary policies, as AD decreases, incomes lower and therefore there are fewer imports. This may lead to recession however. In addition, other countries could retaliate.

Question 27

How would imposing exchange controls help deal with a downward pressure on a currency’s value?

Answer 27

Exchange controls are restrictions imposed by the government on the quantity of foreign exchange that can be bought by domestic residents of a country. This restricts outflows of funds from the country, decreasing supply of the currency.

Question 28

What is the difference between depreciation and devaluation?

Answer 28

When a country cannot meet a fixed exchange rate they set a different exchange rate. If the value goes down, this is devaluation. If it goes it it is revaluation. These have the same effects as depreciation and appreciation of a currency, but are a result of government or central bank interference.

Question 29

What is a managed exchange rate?

Answer 29

An exchange rate in which currencies are free to float, although with periodical central bank intervention to stabilise them over the short term.

Question 30

What are pegging exchange rates?

Answer 30

Many developing countries peg their currency to the US dollar, while some transitioning countries peg it to the Euro. Their central banks allow the currency to float within a set limit of the dollar, if it hits the upper or lower limit of this the central bank intervenes.

Question 31

Advantages of pegged currencies?

Answer 31

Particularly for developing countries, it helps stabilise the currency in terms of the country they are pegging it with, for example the US dollar, preventing abrupt inflations. This facilitates trade flows between the US and these countries, as well as amongst the other developing countries pegged to the dollar.

Question 32

What is an under/overvalued currency?

Answer 32

Overvalued - a currency whose value is higher than the equilibrium value.
Undervalued - a currency whose value is lower than the equilibrium value.

Question 33

Advantages of overvalued currencies?

Disadvantages of overvalued currencies?

Answer 33

Imports become cheaper. This may be beneficial to developing countries who want to quickly increase their capital goods for industrialisation.

Exports become more expensive which negatively effects domestic suppliers. In addition, cheaper imports can hurt domestic suppliers of the good. In addition, an increase in imports and decrease in exports can worsen the current account balance.

Question 34

Advantages of undervalued currencies?

Disadvantages of undervalued currencies?

Answer 34

Exports become cheaper to foreign buyers, while imports become more expensive. Some developing countries use this as a method to increase their export industries and expand their economies, thereby decreasing unemployment levels. This gives industries an unfair competitive advantage compared to other countries that do not devalue their currencies, whose imports increase and exports decrease.

Question 35

What is the balance of payments of a country?

Answer 35

A record (usually a year) of all the transactions between the residents of a country and the residents of all other countries. It shows payments received from other countries, credits, and payments made to other countries, debits. The sum of all credits is equal to the sum of all debits.

Question 36

How is the balance of payments related to the demand and supply of a currency?

Answer 36

All credits create a foreign demand for the country’s currency and all debits create a supply of the currency.

Question 37

What accounts does the balance of payments consist of?

Answer 37

The current account, the capital account and the financial account.

Question 38

What components are used to calculate the current account?

Answer 38

1. Balance of trade in goods (exports of goods - imports of goods)
2. Balance of trade in services (exports of services - imports of services)
3. Income (inflows - outflows)
4. Current transfers (transfers from abroad - transfers to abroad)

Question 39

How do you calculate income in the current account?

Answer 39

All the inflows of rent, wages, interest and profit minus all the outflows of rent, wages, interest and profit.

Question 40

How do you calculate current transfers?

Answer 40

All the inflows from transfers from abroad such as gifts, foreign aid, pensions minus all the outflows of such transfers to other countries.

Question 41

What components are used to calculate the capital account?

Answer 41

1. Capital transfers (e.g. debt forgiveness)
2. Non-produced, non-financial assets - when countries buy or use natural resources that have not been used yet such as minerals that have not been mined.

Question 42

What components are used to calculate the financial account?

Answer 42

1. Foreign direct investment - e.g. investments in physical capital like buildings often undertaken by MNCs.
2. Portfolio investment - financial investments. This includes borrowing from foreign lenders and loans to foreign governments. Borrowing is credit, loans are debit.
3. Reserve assets - foreign currency reserves the central bank buys and sells to influence the value of the country’s economy.

Question 43

What are net errors and omissions?

Answer 43

In the real world it is difficult to record every economic transaction. Therefore often debits do not equal credits. If credits are greater than debits, the net errors and omissions will include a debit item equal to the discrepancy.

Question 44

What is the meaning of ‘balance’ in balance of payments?

Answer 44

The current account balance is equal to the sum of the capital account and financial account balances (and errors and omissions)

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

Question 45

Show the difference between a trade deficit and trade surplus on the PPC?

Answer 45

Trade deficit shows a point of consumption beyond the PPC. Trade surplus shows within the PPC (probably not on).

Question 46

Why is there a balance of payments?

Answer 46

A current account deficit means a country consumes more than it produces, which it pays for through a financial account surplus as borrowing counts as a credit. Part of the income generated from a sale of extra output (exports) corresponds to a financial account deficit.

Question 47

How can there be a balance of payments surplus/deficit if it is balanced?

Answer 47

These refer to the sum of the current, capital and financial accounts excluding central bank intervention, which is the reserve assets.

Question 48

Why does a surplus/deficit in the current account of the balance of payments result in a downward pressure of the exchange rate in a floating exchange rate system?

What does this mean?

Answer 48

If there is a deficit in the current account of country A, country A is importing more than they are exporting from country B. This means supply of county A’s currency shifts to the right and demand for country B’s currency shifting to the right. Therefore the currency of country A depreciates and country B’s appreciates.

The depreciation causes imports to decrease (as they are more expensive) and exports to increase (as they are cheaper for other countries) until the current account deficit is fixed.

Question 49

How is a balance of payments balanced through government intervention:

Answer 49

With managed exchange rates the central bank stops the currency from appreciating or depreciating by buying and selling dollars. Therefore the reserve assets equal the sum of any deficit.
With fixed exchange rates - central banks cannot keep selling and buying dollars so they come out with other ways to balance it such as increasing interest rates to increase foreign investment.

Question 50

Why is balance of payments so closely related to exchange rates?
What does this indicate?O

Answer 50

Everything recorded in the balance of payments determines the supply and demand for a currency. This means that a balance in the balance of payments indicates that there is a balance between supply and demand of a currency.

Question 51

Factors you can use to evaluate fixed vs floating exchange rate systems:

Answer 51

1. Degree of certainty for stake holders
2. The role of foreign currency reserves
3. Ease of adjustment
4. Flexibility offered to policy makers

Question 52

How does degree of certainty for stake holders change with a fixed vs floating exchange rate system?

Answer 52

Fixed is more certain for stakeholders.
Firms are more likely to invest, tourism may be stable as consumers can plan travel better, governments can plan foreign transactions. Also speculation is limited (except people can speculate that a government will devalue/revalue the currency)
Opposite from above. In addition large and abrupt exchange rate changes can cause serious problems for countries that depend heavily on exports.

Question 53

How do foreign currency reserves change with a fixed vs floating exchange rate system?

Answer 53

A fixed exchange rate requires sufficient supplies of reserves and foreign currencies. Central banks may not have enough reserves to carry out necessary interventions.
The balance of payments with a floating exchange rate occurs entirely through market forces. There is no need for intervention.

Question 54

How does ease of adjustment change with a fixed vs floating exchange rate system?

Answer 54

There are no easy methods under fixed exchange rates to correct imbalances in the balance of payments. External shocks (such as a sudden increase in the price of oil) cannot be handled easily. Persistent current account deficits require large quantities of foreign currency reserves or access to foreign borrowing. If these are not readily available, the country must resort to contractionary policies, trade protection or exchange controls. If it persists further, the country may have to devalue its currency.
With floating exchange rates a current account deficit is balanced by depreciation, and a surplus by appreciation.

Question 55

How does flexibility offered to policy makers change with a fixed vs floating exchange rate system?

Answer 55

Fixed exchange rates make it hard for policy makers to implement contractionary or expansionary policies as they will effect the exchange rate.
With a floating exchange rate domestic economic policy does not need to respond to balance of payments problems and can be carried out in accordance with domestic priorities. The government can pursue expansionary policies in a recession and the exchange rate will correct itself by appreciating.

Question 56

Key disadvantages of fixed exchange rates:

when does it have the opposite effect

Answer 56

1. interest rates increase foreign investments but have contractionary effects in the domestic economy because of loans.
2. Borrowing from abroad increases inflows but extensive borrowing may lead to high levels of debt.
3. Contractionary fiscal and monetary policies to limit imports may create a recession and unemployment in the domestic industry.
4. Trade protection to limit imports results in increased inefficiency in production and increased domestic and global misallocation of resources.
5. Exchange controls limit currency outflows but result in major resources misallocation.

Question 57

Explain how increasing the interest rate can have adverse effects?

Answer 57

Increasing the interest rate leads to foreign investment, increasing D for currency and appreciating the currency. However, this leads to more domestic saving, decreasing AD which may lead to a recession.

Question 58

Evaluate the managed float (managed exchange rates):

Answer 58

For:
• Flexibility to pursue policies according to the needs of the domestic economy.
•This allows economies to respond to supply shocks.
•Whilst allowing governments the opportunity to prevent sudden and large exchange rate fluctuations.
Against:
•Critics argue it cannot do enough to prevent large currency fluctuations, which is damaging to countries highly dependent on exports.
• It allows countries to cheat by undervaluing their currencies and gaining unfair competitive advantage (the dirty float).

Question 59

Consequences of persistent current account deficits financed by loans:

Answer 59

1. Higher interest rates may be needed to attract foreign financial investment, leading to recession.
2. High indebtedness
3. Depreciating the exchange rate - currency becomes vulnerable to speculative attacks as people do not want to hold currency they suspect is going to fall in value so they sell their currency, increasing the supply for the currency and decreasing the demand, both of which depreciate it further.
4. Poor international credit ratings - this makes it receive more loans in the future. The country may be forced to increase its interest rates if it can no longer receive loans.
5. Painful demand management policies
6. Cost of paying interest on loans may increase the debt
7. Fewer imports of needed capital goods.
8. Possibility of lower economic growth - if a country is in debt and constantly trying to pay this back then it is difficult for economic growth to occur. In addition without necessary capital goods production may decrease.
9. Lower standard of living in the future - at some point consumption will be less than production.

Question 60

What conditions must be true such that borrowing leads to economic growth:

Answer 60

1. The current account deficit remains relatively small and does not get out of hand by excessive borrowing.
2. Borrowed funds are used to finance imports of capital goods and other inputs needed in production, rather than consumer goods imports.
3. Some production is geared towards export industries so that exports increase, making increased export earnings possible, which helps pay back loans and interest, and finance more capital goods and imports.

Question 61

Consequences of persistent current account deficits financed by the sale of domestic assets:

Answer 61

1. Higher interest rates may be needed to attract foreign financial investment, leading to recession.
2. High indebtedness - less ownership is in the domestic economy.
3. Depreciating the exchange rate - currency becomes vulnerable to speculative attacks as people do not want to hold currency they suspect is going to fall in value so they sell their currency, increasing the supply for the currency and decreasing the demand, both of which depreciate it further.
4. Poor international credit ratings and loss of confidence in the currency and economy.
5. Painful demand management policies
6. Lower standard of living in the future - if countries want to regain possession of their domestic assets in the future they will need to consume less than they produce.

Question 62

What are expenditure reducing policies? Evaluate them.

Answer 62

Expenditure reducing policies reduce aggregate demand through contractionary and fiscal policy. This decreases the amount available to spend on imports and can lead to a lower rate of inflation which can increase exports which in turn reduces current account deficits.
However, they may lead to a recession in the domestic economy. In addition the effectiveness of contractionary policy is questionable as higher interest rates reduce domestic aggregate demand but increase foreign investment which decrease demand for the currency which appreciates it, increasing imports and decreasing exports, reducing the effect.

Question 63

What are expenditure switching policies?

Answer 63

Policies intended to switch consumption away from imported goods and towards domestically produced goods.

1. Trade protection
2. Depreciation
3. Depreciation and managed changes in exchange rates

Question 64

Evaluate the use of trade protection to combat current account deficit:

Answer 64

They are effective as they directly decrease imports and improved domestic production, yet they lead to higher domestic prices and lower domestic consumption, inefficiency and global misallocation of resources. It also may lead to retaliatory trade barriers.

Question 65

Evaluate the use of depreciation to combat current account deficit:

Answer 65

A country that has a persistent current account deficit is likely to face a strong downward pressure on its value. The government may allow the currency to depreciate in which case it encourages exports and discourages imports, improving the current account deficit.
This may have negative effects on the domestic economy as higher import prices often result in domestic inflation. Firms may also lead to higher costs of production if imported capital goods are required. This may lead to higher prices which is a type of cost push inflation, shifting the LRAS to the left which can have recessionary effects, even leading to stagflation.

Question 66

Evaluate the use of depreciation to combat current account deficit: (more intentional, not determined by forces)

Answer 66

The central bank may wish to encourage depreciation, i.e. at a rate that it would not occur in a floating exchange rate system. This could be by selling their foreign currency reserves of that currency, increasing supply. This is considered as undervaluing the currency and is considered a ‘dirty float’ as it provides unfair competitive advantage and increases imports, leaving foreign producers worse off.
In addition higher import prices may lead to inflationary pressures.

Question 67

Evaluate the use of supply side policies to increase competitiveness as a method to combat current account deficit:

Answer 67

Supply side policies aim to lower costs of production for firms by shifting the LRAS and SRAS curves to the right, which can result in lower rates of inflation. These policies include increasing competition, tax reforms and decreasing wage price stickiness. Over a long period of time lower inflation may increase exports, thereby addressing the problem of current account deficit.
Countries can also use interventionist policies such as support for training, education, healthcare and investment into research and development.
They generally take a long time to come into effect.

Question 68

What does the Marshall-Lerner condition state?

Answer 68

The higher the PEDs of exports and imports, the smaller the devaluation or depreciation needed to obtain trade balance improvements.

MATH: If PEDm + PEDx > 1 (elastic), devaluation/depreciation will make a trade deficit smaller.
If PEDm + PEDx < 1, devaluation/depreciation will make a trade deficit larger.
This is because if it is inelastic people will continue to buy imports despite a depreciation which means the balance remains unchanged, or even worsened.

Question 69

What is the J-curve effect? How would you show this on a graph?

Answer 69

A devaluing or depreciating country may see a worsening in the trade balance in the period immediately following the depreciation of its currency, but eventually it will begin to improve, provided the Marshall-Lerner condition holds.

Graph:
Balance of trade on y (X-m), time on x
All values greater than 0 indicate a trade surplus.
At 0, X=m. If a country is in a trade deficit, shown by a short horizontal line below 0, and depreciation occurs, the trade deficit will initially worsen, causing the line to curve down, but eventually it will improve, causing the curve to go up and past 0 indicating a surplus.

Question 70

Why is the J curve shaped like that?

Answer 70

Because of the Marshall Lerner condition. In the period directly after depreciation price elasticities of demand for exports and imports are very low, as people do not have time to look for substitutes. The Marshall Lerner condition is not satisfied as PEDm + PEDx < 1, so the trade deficit worsens. As time passes, PED for exports and imports increases, so trade balance begins to improve.

Question 71

Consequences of persistent current account surpluses?

Answer 71

1. Low domestic consumption - may mean lower standards of living compared to a county which has a current account deficit or balances current account.
2. Insufficient domestic investment - funds are leaving the country due to a financial account deficit (which occurs to balance the current account deficit).
3. Appreciation of the domestic currency - demand for currency increases, leading to appreciation, leading to decreased exports and increased imports, which may decrease the effect of the surplus and have a dampening effect on the economy.
4. Reduced export competitiveness - as domestic currency appreciates it makes it harder for domestic firms to compete with foreign producers.