IB Economics SL14 - Exchange Rates and Balance of Payments

ECONOMICS SL EXCHANGE RATES & BALANCE OF PAYMENTS 14.1 Freely floating exchange rates EXCHANGE RATES • Constant flow of money in/out of countries because residents have transactions. • Int’l transactions use different currencies (foreign exchange). • Demand for foreign currencies generates supply of domestic currency (and vice versa). • Exchange rates relate value of one currency to another. • In a freely floating exchange rate system (abbreviated in this guide as FFERS), the market

determines the exchange rates. In a diagram, the price is expressed in terms of the other currency. CHANGES IN EXCHANGE RATES • Appreciation - increase in the value of a currency in a FFERS. • From diagram above: increase in demand for $ or decrease in supply of $ • Depreciation - decrease in value of a currency in a FFERS. • From diagram above: decrease in demand for $ or increase in supply of $

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CAUSES OF EXCHANGE RATE CHANGES* • Increase in demand for a country’s export: appreciation • Increase in country’s demand for imports: depreciation • A country’s interest rate and currency value changes in the same direction • Higher inflation in a country relative to other countries: depreciation • Increase in foreign investment: appreciation • A country’s relative income level and currency value change in opposite directions • Widespread expectation of appreciation will contribute to appreciation • Expectations of depreciation will contribute to depreciation • If the central bank buys a foreign currency: depreciation because it supplies domestic currency • If the central bank sells a foreign currency: appreciation because it demands foreign currency • CETERIS PARIBUS EXCHANGE RATE EVALUATIONS • Inflation • Cost-push: A depreciation makes imports more expensive. Production costs increases which can shift the LRAS leftwards. The more inelastic the demand of the input, the greater the inflation. Currency appreciation lowers inflationary pressures. • Demand-pull: A depreciation makes exports cheaper, increasing net exports (X–M). Whether there is an inflation will depend on where the economy is in the business cycle. • Employment • Depreciation can increase AD which can decrease cyclical unemployment and cause a temp. decrease in natural unemployment, but with inflationary pressures. • Appreciation will create a recessionary gap and cause cyclical unemployment or increase it. • Economic growth • Depreciation: Cause AD increase (short-term benefit) but with inflation. Can cause increases in potential output • Appreciation: Dampens GDP growth but may have indirect growth by making imports cheaper. • Current account balance • Depreciation: Cause imports to fall and increases exports. Can cause trade deficit to shrink. • Appreciation: Increases trade deficit. • Foreign debt • Depreciation: causes foreign currency debt value to increase • A problem faced by developing country because as their currency depreciates, they have a larger debt burden.

14.2 Government intervention FIXED EXCHANGED RATE • Fixed exchange rate system - exchange rates are “fixed” by the central bank and does not respond to supply/demand changes. Gov’t intervention is used to maintain this fixed rate.

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METHODS TO MAINTAIN FIXED RATES • Official reserves • If there is an excess supply of a currency, the central bank can sell foreign reserves to buy the excess. If there is an excess demand, the central bank can buy foreign currency. • If there is an excess supply and a downward pressure, the central bank will no longer be able to sell reserves. • When there is upward pressure, the central bank can just sell domestic currency. • Interest rates • By increasing interest rates, it will attract investments and increase the demand for the domestic currency. It may involve contractionary policy, though. • Borrowing from abroad • Loans will be converted into the domestic currency which will increase the demand, but there are borrowing costs. • Efforts to limit imports • Limiting imports can reduce supply of domestic currency. This may cause retaliation. • Exchange controls • Exchange controls - restrictions imposed on the government on the quantity of foreign exchange that can be bought by domestic residents. Restricts outflows of funds. Resource allocation. FIXED EXCHANGED RATE CHANGING • Devaluation - when the government changes the fixed rate to a lower value because it is too high to be maintained through intervention. • Revaluation - when the government fixes a currency at a higher value MANAGED EXCHANGE RATES • Managed exchange rates (managed float) combines both floating and fixed exchange rate systems, though it leans towards the “float” side. • Exchange rates usually float to their market levels, but central banks intervene to stabilize them from fluctuations. • Some developing nations peg their currency to the US dollar to float with it. Pegged currencies are fixed in relation to a currency and float in relation to other currencies. • This helps price stability for many developing nations. CONSEQUENCES • Overvalued currency - currency with value higher than equilibrium market value • Imports become cheaper - often wanted to speed up industrialization • Exports become more expensive - affects domestic exporters and worsens current account balance. • Domestic producers have to compete with low-priced imports • Undervalued currency - currency with low value relative to free market value • Exports less expensive - used to expand exports • Imports more expensive 3 EXCHANGE RATES & THE BALANCE OF PAYMENTS

• Undervalued currencies are considered “unfair” and are referred as a “dirty float.”

14.4 The balance of payments BALANCE OF PAYMENTS • The balance of payments is a record of all transactions between the residents of a country and the residents of other countries. • Credits - payments for other countries; debits - payments to other countries; deficit - more debits than credits (negative balance); surplus - more credits than debits (positive balance) • Credits create a foreign demand of a country’s currency, and debits create a supply of the currency. • The IB follows a certain format for the balance of payments: Current Account 1 Exports of goods 2 Imports of goods

Balance of trade in goods - subtract imports from exports.

Balance of trade in goods (1+2) 3 Exports of services

Same as above, but with services.

4 Imports of services Balance of trade in services (3+4) Balance of trade in goods and services (1+2+3+4) Also called trade balance or balance of trade; value of total exports minus imports. The most important part of the current account. 5 Income

Inflows of interest, rents, and wages into a country minus outflows. Income flowing into a country is credit; and income flowing out of a country is debit.

6 Current transfers

Inflow of transfers such as gifts, foreign aid, and pensions minus outflows

Balance on current account (1+2+3+4+5+6) Capital Account 7 Capital transfers

Inflows minus outflows of things like debt forgiveness, insurance claims, ad investment grants

8 Transactions in non-produced/financial assets

Purchase of non-produced assets, such as mineral rights, fishing rights, airspace, etc. 4 EXCHANGE RATES & THE BALANCE OF PAYMENTS

Balance on capital account (7+8) Financial Account 9 Direct investment

Investment in physical capital undertaken by multinational corporations. (Also known as foreign direct investment)

10 Portfolio investment

Financial investments (stocks and bonds). Borrowing from foreign lenders appears as credits

11 Reserve assets

Foreign currency reserves that the central bank can buy/sell to affect country’s currency.

Balance on financial account (9+10+11) 12 Errors and omissions

Transactions are hard to record precisely. Since credits should equal debits, the error and omissions balances it out.

Balance (1+...+12) • The sum of everything is zero; the credits balance the debits. • current account + (capital account + financial account + errors/omissions) = 0 CURRENT ACCOUNT AND FINANCIAL ACCOUNT • If imports > exports, there is a deficit in the trade balance, which makes it likely for there to be a current account deficit. • If there is a current account deficit, there is a financial account surplus, which provides it with the exchange needed to pay for the excess imports. • A current account surplus means a country consumes less, the country has more foreign exchange that is used to buy assets and other stuff which results in a financial account deficit. IMBALANCE • A balance of payments deficit/surplus means there is a deficit/surplus in the combined balance of payments excluding central bank intervention. In a deficit, the central bank can buy up excess currency to balance the payments.

14.5 The balance of payments and exchange rates BALANCING DEFICITS WITH SURPLUSES (FREELY FLOATING) • If there is a deficit/surplus in the current account, market forces create a/n downward/upward pressure on the exchange rate. The exchange rates automatically create a balance. BALANCING DEFICITS WITH SURPLUSES (MANAGED FLOAT) • The central bank of a country buys and sells currencies to balance the balance of payments. 5 EXCHANGE RATES & THE BALANCE OF PAYMENTS

BALANCING DEFICITS WITH SURPLUSES (FIXED) • Policies that fix the exchange rate maintain the balance of payments. COMPARING AND CONTRASTING EXCHANGE RATE SYSTEMS Fixed exchange rates

Floating exchange rates

Degree of certainty for stakeholders

High degree of certainty. People can plan more. International trade favored - easy to calculate exchange rates.

Higher uncertainty. Stakeholders unsure of future value. Abrupt changes can cause serious problems and crises. Currency speculation destabilizing.

Role of foreign currency reserves

Maintain fixed exchange rate. Sell reserves if deficit. Problem when not enough reserves.

Not necessary. No need for intervention. Market force does it.

Ease of adjustment

No easy methods. Hard to handle large shocks or large deficits.

Automatic adjustment. Appreciation and depreciation eliminates surpluses and deficits.

Flexibility offered to policy-makers

No flexibility. To maintain fixed rate, government needs to pursue specific policies.

Greater flexibility. Domestic policies don’t have to respond to BoP problems.

EVALUATION: MANAGED FLOAT • Supporters: Offers flexibility to pursue policies that the economy needs. Also allows government to prevent large fluctuations. • Critics: Not good enough to deal with large fluctuations; not successful in eliminating trade imbalances; allows dirty floats

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