Exchange rates and BoP Flashcards
Fixed
Gov has target- central peg
max and min
intervention if outside the zone
keeps large currency reserves
Free floating
£UK,$ US
value of a currency determined by the laws of supply and demand
no government intervention
Positives of a free floating ER
automatic correction of a balance of payment deficit/ surplus
no need to tie up public resources into large currency reserves
less risk of currency becoming over/under valued
Drawbacks of free floating ER
more volatile- higher uncertainty for firms, lower business confidence ( combated by derivatives)
may contribute to cost push inflation if higher R of inflation- reduced D for £, WIDEC, higher import prices
Positives of a fixed exchange rate
less volatile, higher confidence for firms
helps combat cost-push inflation prevents large devaluation of currency
Drawbacks of fixed ER
Requires large amounts of reserves, tying up public resources that could be more productively used elsewhere
conflicts with the objectives, less freedom to use IR to manage AD and inflation if must tie into ER objectives
J-curve
Initially a devaluation in a currency may worse the current account position on BOP
as, PED inelastic so % increase in Q on exports like smaller than % fall in price
whilst % decrease in q imported like smaller than % increase in price
so overall value of exports falls whilst imports rise
tied up in contracts, takes time to react find other suppliers
long term
PED more elastic so will improve WIDEC
Marshal-lerner condition
for a currency depreciation to lead to an improvement in the currency account position,
the PED for imports + exports must be > 1
What makes up the capital account?
transfer of ownership of fixed assets
sale/ transfer of property rights
What makes up the financial account?
change of ownership of financial assets between domestic and foreign owners
FDI- purchasing assets, setting up production
portfolio investment- bonds, shares
Hot money flows into and out of banks
What makes up the current account?
balance in trade of goods
balance in trade of services
net primary income ( interest, profits, dividend generated from assets abroad)
net secondary income
Causes of current account deficit (cyclical)
cyclical- short term or
down turn in key export markets
high consumer demand, EG, inflation higher relative
over-valuation of currency
Policies to correct a current account deficit- expenditure reducing
expenditure reducing
raise interest rate
raise tax
Self correcting current account deficit
if export prices not competitive reduce demand for them reduced demand for £ weakening £ WIDEC imports deeper, exports cheaper LT reduce value of imported products and increase value exported
Causes of a current account deficit (structural)
structural-long term underlying issues
low international competitiveness
low productivity
low investment
slow rate of technological change, dynamic efficiency
