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BALANCE OF PAYMENTS & FOREIGN EXCHANGE RATES.
Term Paper ID:23074
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Essay Subject:
Examines relationship & factors of inflation, interest rates, alternative equilibrium models.... More...
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7 Pages / 1575 Words
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Paper Abstract:
Examines relationship & factors of inflation, interest rates, alternative equilibrium models.
Paper Introduction:
BALANCE OF PAYMENTS AND CURRENCY EXCHANGE RATES
The balance of payments for a country represents a tabulation of all credit and debit transactions between entities within that country and (1) entities in all other countries and (2) international organizations. The balance of payments is made of (a) the current account, which includes visible and invisible trade, tourism, shipping, and profits and interest earned outside of the country, and (b) the capital account, which includes the flow of investment funds, and international grants and loans.
The phrase "the balance of payments is always balanced" infers that any deficit in a country's current account is balanced in some way—a transfer out of gold assets, a transfer in of an IMF (In
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3. (Glenview,Illinois: Scott, Foresman and Company, 1993), 774-775. Macroeconomics, 6th ed. [iv]Ibid., 135-139. Under a floating exchange rate system, the international transmissionof inflation should (theoretically) be more difficult. L-R. There have been no means developedto accurately predict how long the time period will be in which creditorcountries will continue to absorb debt from a country in current accountdeficit. Conversely, a decrease in realinterest rates is expected to cause the value of a country's currency todecrease in international currency exchange markets. The LM Curve slopes upward to theright, which means that, as income increases, interest rates increase. The PPP model is based on a contention that relative rates ofinflation determine long-range exchange rate changes.[vii] In this model,it is assumed that exchange rates adjust in a way which insures that,subsequent to conversion into another currency, a currency in question willpurchase goods and services in a foreign country equivalent to that whichit could purchase in the domestic economy. Changes in foreign interest ratesare expected to draw funds away from a country's economy, and, in turn,cause the foreign currency exchange value of the country's currency todecrease. While there is likely a great deal of theoretical validity in the CABmodel, the problems lie in application. One of the problems associated with use of the PPP model is thetechnical difficulty involved in deriving acceptable estimates ofequilibrium exchange rates. Black, Foreign Exchange, 2nd ed. Theextent to which inflation would be transmitted by this mechanism woulddepend upon the magnitude of the trade in the goods for which prices wereraised. In theLM Curve, the vertical ordinal represents interest rates, and thehorizontal ordinal represents income. Generally, a country is better off to allow itscurrency to float in international currency exchange. When the international exchange value of the currency hasdiminished sufficiently, the demand for the country's exports will thenincrease; however, the decreased value of the currency will prevent atransfer of the higher prices to the importing countries (in theory). Fieleke, "Is Global Competition Making the Poor Even Poorer?"New England Economic Review (November-December 1994): 5-6. It furtherassumes that shifts in trading patterns will cause changes in the relativerates of inflation between countries, which will, in turn, maintain a long-term equilibrium in currency values. New York: McGraw-Hill Book Company, 199 .Byrns, R. [viii]Ibid., 137-146. Byrns and G. When prices areraised in one country, the demand for that country's exports will (again,in theory) diminish and, along with the diminishing demand, the demand forthat country's currency will diminish. Thus, while current account deficits will likely cause acountry's currency exchange rates to return to an equilibrium over the long-term, the long-term may turn out to be 2 -years. W. [vi]S. [ix]Ibid., 141-146. (New York:HarperCollins Publishers, 1995), 529. W. [iii]R. A change in the balance of payments in one of the linkedeconomies results in demand increases in that economy, which are,eventually, transferred to the other linked economies. ENDNOTES BIBLIOGRAPHYBlack, S. Therefore, the point at which theyintersect is the aggregate equilibrium point. "Is Global Competition Making the Poor Even Poorer?" New England Economic Review (November-December 1994): 3-16.Gordon, R. T., and Stone, G. Gordon, Macroeconomics, 6th ed. A variety of factors affect the exchange rate of a currency.[iii]There are four major types of market conditions that are expected to impactforeign currency exchange rates: (1) changes in the value of exports andimports; (2) differential rates of inflation; and (3) changes in domesticinterest rates; and (4) changes in foreign interest rates. The phrase "the balance of payments is always balanced" infers thatany deficit in a country's current account is balanced in some way-atransfer out of gold assets, a transfer in of an IMF (InternationalMonetary fund) loan, or any of a number of other balancing actions.[ii]Deficits in a country's current account tend to place pressure on theinternational exchange value of that country's currency. W. Imports andexports determine a country's balance of trade, which in turn influencesthe country's balance of payments. [ii]R. Foreign Exchange, 2nd ed. Significant among suchpreferences are political factors, and expected actions on the part ofmonetary authorities in deficit countries. Underlying this modelis the theory that countries running current account deficits over anextended period of time will eventually become debtor countries, and thatsuch deficits can persist only as long creditor countries are willing toabsorb added debt from the country in deficit. In such a situation, theCAB model becomes almost useless as tool for monetary management. Under such a fixed-rate currencyexchange rate system, the following actions were typical: 1. As a fixed-exchange rate existed, these price increases would be transmitted to theimporting countries from the exporting country which raised prices. Under a floating exchange rate system, each currency is(theoretically) permitted to find its own level of exchange, which will(again, theoretically) change from time-to-time, as economic conditionschange.[ix] It is important to note that countries do not, in allsituations, permit their currencies to find their own level of exchangeeven if such countries have agreed to a flexible exchange system.. This model also assumes that exchange rates will fluctuate withrespect to relative rates of price inflation between countries. Without such estimates, meaningful assessmentsof exchange rate level may not be made. T. The relationship of the money supply to rates of inflation and realinterest rates may be explained through the IS-LM Equilibrium Model.[iv]The IS Curve shows the various combinations of national income and interestrates for which leakages will be equated with injections. Such factors distortanticipated interactions of macroeconomic factors affecting currencyexchange rates. The LM Curve shows the combinations of interest rates and incomelevels that are consistent with equilibrium in the monetary sector. Lastly,the problems associated with the use of the PPP model may be traced to themodel's inability to account for factors other than inflation, which alsoaffect currency exchange rates. L-R. As the demand for the currencydiminishes, the international exchange value of the currency will alsodiminish. Economics Today: The Micro View, 8th ed. When the willingness toabsorb added debt ends, the exchange value of the deficit country'scurrency will be decline. An increase in real interest rates (nominal interest ratesadjusted for inflation) in a country's economy is expected to attractforeign capital, which, in turn, will cause the value of the country'scurrency to increase in foreign exchange. Thus, it is reasoned that only those currencyexchange rates that will maintain a country's current account in balanceare sustainable over the long-term. (New York: HarperCollinsPublishers, 1995), 429-438. These difficulties stem from (1)the use of different measures in inflation in various countries, and (2)the selection of a base periods for analysis in various countries. Stone, Economics, 5th ed. [vii]Gordon, 435-439. BALANCE OF PAYMENTS AND CURRENCY EXCHANGE RATES The balance of payments for a country represents a tabulation of allcredit and debit transactions between entities within that country and (1)entities in all other countries and (2) international organizations.[i]The balance of payments is made of (a) the current account, which includesvisible and invisible trade, tourism, shipping, and profits and interestearned outside of the country, and (b) the capital account, which includesthe flow of investment funds, and international grants and loans. Thisdemand-pull inflation is typically exacerbated by the multiplier effectthrough the several connected economies. Miller. Glenview, Illinois: Scott, Foresman and Company, 1993.Fieleke, N. S. The major problem withit is that is simply has been unable to adequately explain currencyexchange rate changes over the long-term and in a wide variety ofenvironments. 2. New York: HarperCollins Publishers, 1995.Miller, R. When foreigncurrency exchange rates are free to fluctuate, the market value of anation's currency will appreciate and depreciate in response to changingmarket conditions. An increase in the price of internationally traded goodswould, in turn, result in an increase in import prices. Economics, 5th ed. A variety of models to explain and predict exchange rates have beendeveloped.[v] Two of the more significant of these approaches are (1) thecurrent account balance (CAB) model and (2) the purchasing power parity(PPP) model. (New York: McGraw-Hill BookCompany, 199 ), 131-132. If the value of a country's exports increases relative to the value ofits imports, the value of the country's currency is (other things beingequal) expected to increase in the foreign currency exchange markets.Alternatively, of the value of imports increases relative to the value ofexports, the value of the currency is expected to decrease. W. Thetwo curves work counter to one another. The PPP model has, however, been used successfully in morelimited applications. [v]N. S. One major reason for the failure of the CAB model to accuratelypredict the time required for a return to equilibrium values is that itfails to account for asset holding preferences. In the IS Curve,the vertical ordinal represents interest rates, and the horizontal ordinalrepresents income. The PPP model has a strong theoretical appeal. New York: HarperCollins Publishers, 1995.----------------------- [i]R. The CAB model relies on surpluses and deficits in a country'sinternational current account balance (one of the two major components ofthe balance of payments) as the primary variable in the determination ofcurrency exchange rates.[vi] This model is based on an assumption that anequilibrium currency exchange rate will maintain a balance in a country'scurrent account, after allowing for short-term fluctuations resulting fromthe effects of business cycles and trade barriers. The industrial countries have employed two general types ofinternational monetary rate change systems since the end of the SecondWorld War-fixed-rate systems and flexible-rate systems.[viii] A fixed-rateexchange system is one in which different countries have agreed upon therates at which their various currencies will be exchanged in internationaltrading, or one in which one country has a fixed-exchange rate for its owncurrency which it is prepared to defend. It is quite possible that the price increases would cause areduction in the amount of goods traded, thus, moderating the impact of anyinternational transmission of inflation. J. Economics Today: The Micro View, 8th ed. Flexible currency exchange rates mean that the exchange rates are freeto fluctuate in response to supply and demand factors. J. The IS Curve slopes downward to the right, which meansthat, as income increases, interest rates decrease. Other factors remaining unchanged, if the inflation rate in country"A" is greater than that in country "B," the value of country "A's"currency is expected to decrease relative to country "B's" currency, andvice versa. Changes in foreign interest rates affect the foreign exchange value ofa country's currency in a manner exactly the opposite of the effect causedby changes in domestic interest rates. An increase in the nominal goods and service balancegenerates an increase in aggregate money demand for domestic output.
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