14.2 Exchange Rates and the Balance of Payments

Exchange rates and balance of payments are crucial in international trade. They determine how currencies are valued and track a country's economic transactions with the world. Understanding these concepts helps explain global economic relationships and trade patterns.

This topic dives into exchange rate systems, factors influencing currency values, and balance of payments components. It explores how exchange rates impact trade, inflation, and economic stability, while examining policy choices countries face in managing their currencies and international transactions.

Exchange Rates and Fluctuations

Definition and Market Structure

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• Exchange rates represent the value of one currency in terms of another expressed as the price of one unit of foreign currency in domestic currency units
• Foreign exchange market operates as a global, decentralized marketplace where currencies trade 24 hours a day with major financial centers (New York, London, Tokyo) acting as hubs for transactions
• Exchange rate systems include fixed, floating, and managed float each with distinct characteristics and implications for monetary policy and economic stability
  • Fixed rates peg currency value to another currency or basket
  • Floating rates allow free market forces to determine value
  • Managed float involves some government intervention in otherwise market-determined rates

Factors Influencing Exchange Rates

• Fundamental factors impact exchange rates
  • Interest rate differentials between countries affect capital flows and currency demand
  • Inflation rate differences erode purchasing power over time
  • Political and economic stability influences investor confidence in a currency
  • Current account balances reflect trade flows affecting currency supply and demand
• Speculative factors cause short-term exchange rate fluctuations
  • Market sentiment about economic outlook
  • Expectations of future interest rate changes
  • Geopolitical events (elections, conflicts)
• Purchasing power parity theory suggests exchange rates should adjust to equalize purchasing power of different currencies in long run
  • Example: If a basket of goods costs $100 in the US and £80 in the UK, the exchange rate should theoretically be$1.25 per £1
• Interest rate parity condition links interest rates, spot exchange rates, and forward exchange rates providing framework for currency market equilibrium
  • Formula: $(1 + i_d) = (1 + i_f) * (F/S)$ where $i_d$ = domestic interest rate, $i_f$ = foreign interest rate, F = forward exchange rate, S = spot exchange rate

Balance of Payments Components

Current and Capital Accounts

• Balance of payments records all economic transactions between country residents and rest of world over specific period (typically one year)
• Current account captures trade flows and income transfers
  • Records trade in goods (physical products) and services (intangibles like tourism)
  • Primary income flows include investment income and employee compensation
  • Secondary income transfers cover remittances and foreign aid
• Capital account includes smaller set of transactions
  • Non-produced, non-financial assets (land sales to embassies)
  • Capital transfers (debt forgiveness)

Financial Account and Balance of Payments Identity

• Financial account records transactions in financial assets and liabilities between residents and non-residents
  • Direct investment involves controlling interest in foreign company (over 10% ownership)
  • Portfolio investment covers purchases of foreign stocks and bonds without controlling interest
  • Other investments include loans, currency holdings, and trade credit
• Balance of payments identity states sum of current account, capital account, and financial account balances should theoretically equal zero
  • Any discrepancies recorded as errors and omissions to balance the accounts
• Reserve assets managed by central banks play crucial role in balance of payments
  • Serve as buffer for exchange rate management
  • Provide international liquidity for country
  • Include foreign currency deposits, gold reserves, and special drawing rights (SDRs)

Implications of Persistent Imbalances

• Persistent current account deficits or surpluses significantly impact country's economic stability
  • Deficits indicate country borrowing from abroad to finance spending
    • Can lead to accumulation of external debt
    • May signal declining competitiveness in global markets
  • Surpluses suggest country saving and investing abroad
    • Can result in capital outflows and reduced domestic investment
    • May face pressure from trading partners to rebalance economy
• Long-term imbalances can affect exchange rates, interest rates, and overall economic growth
  • Example: Persistent US current account deficits contributed to dollar depreciation in early 2000s

Exchange Rate Impact on Trade

Trade Balance Effects

• Exchange rate depreciation typically improves trade competitiveness
  • Makes exports cheaper in foreign currency terms
  • Increases price of imports in domestic currency
  • Potentially improves trade balance through J-curve effect
    • Short-term worsening followed by long-term improvement as volumes adjust
• Marshall-Lerner condition determines if currency devaluation improves trade balance
  • Sum of price elasticities of demand for exports and imports must exceed one
  • Formula: $|ex| + |em| > 1$ where ex = export demand elasticity, em = import demand elasticity
• Exchange rate appreciation can lead to loss of export competitiveness
  • Makes exports more expensive in foreign markets
  • Increases import penetration as foreign goods become relatively cheaper
  • Potentially worsens trade balance if sustained over time

Broader Economic Impacts

• Exchange rate changes affect domestic inflation through pass-through effects
  • Depreciation increases cost of imported goods potentially raising overall price levels
  • Appreciation can help control inflation by reducing import prices
• Exchange rate volatility creates uncertainty for international businesses
  • Can affect investment decisions and long-term growth prospects
  • May lead to increased use of currency hedging instruments
• Impact of exchange rate changes depends on various economic factors
  • Degree of economic openness (ratio of trade to GDP)
  • Structure of imports and exports (elasticity of demand for traded goods)
  • Country's position in global value chains
• Exchange rate misalignments contribute to global imbalances
  • Affect international capital flows
  • Can lead to financial instability if sustained (Asian financial crisis 1997)

Exchange Rate Policies and Implications

Fixed vs Floating Exchange Rate Systems

• Fixed exchange rate systems provide stability but limit policy options
  • Reduce currency risk and transaction costs for international trade
  • Limit monetary policy independence as interest rates must defend the peg
  • Can lead to misalignments if fundamental economic conditions change
    • Example: Argentine peso crisis in 2001 after long-term peg to US dollar
• Floating exchange rate systems allow flexibility but increase volatility
  • Enable automatic adjustment to external economic shocks
  • Preserve monetary policy autonomy for domestic objectives
  • Can lead to higher short-term exchange rate fluctuations
    • Example: British pound volatility following Brexit vote in 2016
• Managed float systems attempt to balance benefits of fixed and floating regimes
  • Allow some market determination of rates with occasional intervention
  • Can be challenging to maintain against strong market pressures
    • Example: Chinese yuan management against US dollar

Extreme Exchange Rate Policies

• Currency boards represent extreme form of fixed exchange rate
  • Domestic currency fully backed by foreign currency reserves
  • Provides high credibility but eliminates monetary policy control
  • Example: Hong Kong's currency board system pegging to US dollar
• Dollarization involves adopting another country's currency
  • Eliminates exchange rate risk with major trading partner
  • Completely surrenders monetary policy independence
  • Example: Ecuador's adoption of US dollar in 2000

Policy Challenges and Interventions

• "Impossible trinity" or trilemma constrains policy choices
  • Countries cannot simultaneously maintain:
    1. Fixed exchange rate
    2. Free capital movement
    3. Independent monetary policy
  • Must choose two out of three policy objectives
• Central bank interventions attempt to influence currency values
  • Sterilized intervention: buy/sell foreign currency without changing money supply
  • Non-sterilized intervention: allow intervention to affect domestic money supply
  • Effectiveness often limited in long run against market forces
• Exchange rate regime choice impacts economic management
  • Affects ability to respond to economic shocks
  • Influences inflation control mechanisms
  • Determines approach to maintaining international competitiveness
  • Example: Eurozone countries facing divergent economic conditions but sharing common currency policy