Written by: Edmund Quek

CHAPTER 20 THE EXCHANGE RATE SYSTEM AND THE BALANCE OF PAYMENTS PART 2

LECTURE OUTLINE 1 1.1 1.2 1.3 1.4 1.5 2 2.1 2.2 2.3 2.4 EXCHANGE RATE SYSTEM Advantages of the fixed exchange rate system Disadvantages of the fixed exchange rate system Advantages of the flexible exchange rate system Disadvantages of the flexible exchange rate system Managed float exchange rate system BALANCE OF PAYMENTS Adverse effects of a persistent balance of payments deficit Measures to correct a persistent balance of payments deficit Adverse effects of a persistent balance of payments surplus Measures to correct a persistent balance of payments surplus

References John Sloman, Economics William A. McEachern, Economics Richard G. Lipsey and K. Alec Chrystal, Positive Economics G. F. Stanlake and Susan Grant, Introductory Economics Michael Parkin, Economics David Begg, Stanley Fischer and Rudiger Dornbusch, Economics

2011 Economics Cafe All rights reserved.

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Written by: Edmund Quek

1 1.1

EXCHANGE RATE SYSTEM Advantages of the fixed exchange rate system

Certainty Under the fixed exchange rate system, international trade and investment become less risky since profits are not affected by movements in the exchange rate. For instance, foreign investors in the economy will experience a sharp fall in their profit margins if domestic currency depreciates sharply against their home currencies. The fixed exchange rate system eliminates this source of uncertainty. Further, the fixed exchange rate system allows international traders to better plan future purchases of imports and sales of exports. Prevent competitive currency devaluations (e.g. the Bretton Woods Agreement) Some economies may attempt to increase their exports by devaluing their currencies. The problem is that when an economy devalues its currency, it may provoke a series of currency devaluations that will lead to a fall in international trade and investment. The fixed exchange rate system prevents this from happening.

1.2

Disadvantages of the fixed exchange rate system

A need for adequate foreign exchange reserves Under the fixed exchange rate system, the central bank must hold adequate foreign exchange reserves. If the central bank runs out of foreign exchange reserves, it will need to adjust the fixed exchange rate downwards. These big adjustments may sometimes be worse than frequent small changes under the flexible exchange rate system. Ineffective monetary policy Monetary policy is ineffective under the fixed exchange rate system and this means that if the central bank chooses to control the exchange rate, it cannot control interest rates. For instance, if the central bank increases the money supply to lower interest rates, hot money inflows will decrease and hot money outflows will increase which will cause the exchange rate of domestic currency to depreciate. To bring the exchange rate of domestic currency back to the initial level, there are two measures that the central bank can use. First, it can reverse the monetary policy which will make it ineffective. Second, it can intervene in the forex market to prevent domestic currency from depreciating by buying domestic currency and selling foreign currency but this will also reduce the money supply. The absence of dampening effect on inflation and unemployment When the external economic environment is strong, inflation will rise due to a rise in the prices of imported goods and services and an increase in the external demand for domestic goods and services. Under the flexible exchange rate system, the resultant appreciation of domestic currency will reduce the rise in inflation. Conversely, when the external economic environment is weak, the resultant depreciation of domestic currency will reduce the rise in unemployment. However, this dampening effect does not take place under the fixed exchange rate system.

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Written by: Edmund Quek

Undervaluation If domestic currency is pegged to a foreign currency at a rate below the long-run (average) equilibrium rate, domestic currency is said to be undervalued against the foreign currency. Under the circumstances, the central bank will continually sell domestic currency and buy the foreign currency to prevent domestic currency from appreciating. The resultant persistent increase in the money supply will lead to high inflationary pressures. Overvaluation If domestic currency is pegged to a foreign currency at a rate above the long-run (average) equilibrium rate, domestic currency is said to be overvalued against the foreign currency. Under the circumstances, the central bank will continually buy domestic currency and sell the foreign currency to prevent domestic currency from depreciating. However, in time to come, the central bank will run out of foreign exchange reserves and hence will have to start borrowing foreign currency from foreign banks which will lead to rising foreign debt. Further, if the central bank continually buys domestic currency, the money supply will fall continually which will lead to rising interest rates. The resultant falling investment expenditure and consumption expenditure will lead to falling national income and hence rising unemployment.

1.3

Advantages of the flexible exchange rate system

The advantages of the flexible exchange rate system are the disadvantages of the fixed exchange rate system.

1.4

Disadvantages of the flexible exchange rate system

The disadvantages of the flexible exchange rate system are the advantages of the fixed exchange rate system.

1.5

Managed float exchange rate system

The managed float exchange rate system is similar to the fixed exchange rate system in that the exchange rate is fixed, although within a band rather than at a specific level. Therefore, the advantages and disadvantages of the managed float exchange rate system are the same as those of the fixed exchange rate system. Nevertheless, the managed float exchange rate system is better than the fixed exchange rate system in two ways. First, the band provides flexibility for the exchange rate system to accommodate short-term fluctuations in the exchange rate of a currency. Second, the band provides some buffer in the estimation of the economys long-run (average) equilibrium exchange rate, which cannot be known precisely.

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2 2.1

BALANCE OF PAYMENTS Adverse effects of a persistent balance of payments deficit

The balance of payments is a record of all the transactions between the residents of the economy and the rest of the world over a period of time. In other words, the balance of payments records all the money flows between the economy and the rest of the world. A balance of payments deficit occurs when money outflows exceed money inflows. Flexible exchange rate system Under the flexible exchange rate system, a persistent balance of payments deficit may lead to high imported inflation, high cost-push inflation, lower national income and higher unemployment. When money outflows persistently exceed money inflows, the supply of domestic currency persistently exceeds the demand and this leads to a persistent downward pressure on the exchange rate. Under the flexible exchange rate system, this will cause domestic currency to depreciate persistently. A persistent depreciation of domestic currency will lead to rising prices of imported goods and services, which include both consumer and intermediate goods, which may lead to high imported inflation. Further, the rising prices of imported intermediate goods may lead to high cost-push inflation which may make domestic goods and services relatively more expensive than foreign goods and services. If this happens, the resultant decrease in net exports will worsen the balance of payments which may become a vicious cycle. A persistent depreciation of domestic currency may induce people to sell it in anticipation of further falls in the exchange rate. If this happens, the resultant currency instability may lead to a fall in foreign direct investments. Aggregate demand is the total demand for the goods and services produced in the economy over a period of time and is comprised of consumption expenditure, investment expenditure, government expenditure on goods and services and net exports. When investment expenditure falls, aggregate demand will fall which will lead to larger decrease in national income due to the reverse multiplier effect. Further, since national income is equal to national output, the decrease in national income will lead to a fall in the demand for labour in the economy resulting in a rise in unemployment, assuming the size of the labour force remains the same. Fixed exchange rate system Under the fixed exchange rate system, a persistent balance of payments deficit may lead to rising foreign debt, lower national income and higher unemployment. Under the fixed exchange rate system, when money outflows persistently exceed money inflows, the central bank will continually intervene in the foreign exchange market to eliminate the persistent downward pressure on the exchange rate of domestic currency. In other words, the central bank will continually buy domestic currency and sell foreign currency to prevent domestic currency from depreciating. However, in time to come, the central bank will run out of foreign exchange reserves and hence will have to start borrowing foreign currency from foreign banks which will lead to rising foreign debt. Further, if the central bank continually buys domestic currency, the money supply will fall continually which will lead to rising interest rates. The resultant falling investment expenditure and

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consumption expenditure will lead to falling aggregate demand resulting in falling national income and hence rising unemployment. A non-persistent BOP deficit will not cause problems in the economy and may be desirable. If a BOP deficit is due to an increase in imports of capital goods, the production capacity in the economy will increase which will lead to a rise in economic growth. If a BOP deficit is due to an increase in imports of consumer goods, the amount of goods and services available for consumption will increase which will lead to a rise in the standard of living. If aggregate demand and hence the general price level is rising rapidly, a BOP deficit which occurs due to a decrease in net exports may cool down the overheating economy. If a BOP deficit is due to an increase in capital outflows such as hot money outflows or outward foreign direct investments, the resultant increase in inward income remittances in the form of interest and profit in the long run will lead to an improvement in the BOP. It is undesirable for the economy to have a persistent current account deficit even if it is matched by a persistent capital and financial account (excluding the change in reserve assets) surplus. A capital and financial account (excluding the change in reserve assets) surplus will lead to more outward remittances of interest and profit. Therefore, the current account deficit will increase and it will eventually exceed the capital and financial account (excluding the change in reserve assets) surplus resulting in a balance of payments deficit. 2.2 Measures to correct a persistent balance of payments deficit

The measures to correct a persistent balance of payments deficit are often classified into expenditure-switching policies and expenditure-reducing policies. Devaluation (Expenditure-switching policy) The central bank can devalue domestic currency to correct a persistent BOP deficit, assuming the economy operates under the fixed exchange rate system. A depreciation of domestic currency will lead to an increase in net exports and hence an improvement in the BOP. However, if the Marshall-Lerner condition does not hold, which may happen in the short run, a devaluation of domestic currency will lead to a deterioration in the BOP. Further, a weaker domestic currency will lead to a rise in the prices of imported goods and services, which include both consumer and intermediate goods, which may lead to high imported inflation. The rise in the prices of imported intermediate goods may also lead to high cost-push inflation which may render devaluation an ineffective measure for correcting a persistent BOP deficit. Protectionism (Expenditure-switching policy) The government can use protectionist measures to correct a persistent BOP deficit. Protectionist measures include tariffs, import quotas, subsidies, etc. For instance, tariffs are taxes imposed on imports and they can be increased to push up the price of imports to decrease the quantity demanded. When this happens, import expenditure will decrease which will lead to an improvement in the BOP. However, the immediate cost of increasing tariffs is higher prices for consumers. In addition, protectionism reduces competition for domestic firms which may foster inefficiency.

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Devaluation and protectionism are subject to several common limitations. First, if the root cause of a persistent BOP deficit is high production cost or low product quality, devaluation and protectionism will not solve the underlying problem. Second, if the economys trading partners retaliate, the fall in import expenditure may be offset by a fall in export revenue, leaving the BOP unchanged. Third, even in the absence of retaliation, export revenue may also fall if protectionism leads to a fall in the national income and hence the imports of the economys trading partners. Contractionary demand-side policies (Expenditure-reducing and expenditure-switching policies) The government can use contractionary demand-side policies to correct a persistent BOP deficit. The government can decrease aggregate demand by decreasing expenditure on goods and services, increasing direct taxes, decreasing transfer payments or decreasing the money supply to raise interest rates. A decrease in aggregate demand will lead to a larger decrease in national income due to the reverse multiplier effect. When national income falls, imports will fall which will lead to an improvement in the BOP. A decrease in aggregate demand will also lead to a fall in the general price level which may make domestic goods and services relatively cheaper than foreign goods and services resulting in an increase in net exports. If this happens, assuming the demand for exports is price elastic, the BOP will improve. However, contractionary demand-side policies will lead to a fall in the standard of living and a rise in unemployment. Further, the effect of a fall in national income on the BOP may be small if the marginal propensity to import is small. Contractionary demand-side policies are also subject to limitations such as inflexibility of government expenditure and taxation and the effectiveness time lag. Supply-side policies (Expenditure-switching policy) The government can use supply-side policies to correct a persistent BOP deficit. The government can use education and training and research and development to increase aggregate supply. An increase in aggregate supply will lead to a fall in the general price level which may lead to an increase in net exports. If this happens, assuming the demand for exports is price elastic, the BOP will improve. However, an increase in aggregate supply will lead to an increase in national income and hence imports which will cause the BOP to deteriorate. Further, supply-side policies are subject to the limitation of a long effectiveness time lag. Note: The classification of expenditure-switching policies and expenditure-reducing polices is not important for the examination.

2.3

Adverse effects of a persistent balance of payments surplus

Lower standard of living A persistent balance of payments surplus usually occurs due to imports being persistently lower than exports. If the surplus had been used to purchase imports, the amount of goods and services available for consumption and hence the standard of living would have been higher.

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Retaliation A persistent balance of payments surplus would probably mean that the economys trading partners are experiencing persistent balance of payments deficits. If this happens, it will simply be a matter of time that the deficit economies use protectionist measures to correct their persistent balance of payments deficits which will reduce the exports of the economy. Persistent appreciation of domestic currency and hence falling export competitiveness Under the flexible exchange rate system, a persistent balance of payments surplus will lead to a persistent appreciation of domestic currency and hence falling export competitiveness. Persistent increase in the money supply and hence high inflationary pressures Under the fixed exchange rate system, a persistent balance of payments surplus will require the central bank to continually sell domestic currency and buy foreign currency. However, this will lead to a persistent increase in the money supply and hence high inflationary pressures.

2.4

Measures to correct a persistent balance of payments surplus

The measures to correct a persistent balance of payments surplus are often classified into expenditure- switching policies and expenditure-increasing policies. Revaluation (Expenditure-switching policy) The central bank can revalue domestic currency to correct a persistent BOP surplus, assuming the economy operates under the fixed exchange rate system. An appreciation of domestic currency will lead to a decrease in net exports and hence a deterioration in the BOP. However, if the Marshall-Lerner condition does not hold, which may happen in the short run, a devaluation of domestic currency will lead to a deterioration in the BOP. Reverse protectionism (Expenditure-switching policy) The government can remove or reduce protectionist measures to correct a persistent BOP surplus. For instance, the government can reduce tariffs to decrease the price of imports to increase the quantity demanded. When this happens, import expenditure will increase which will lead to a deterioration in the BOP. However, reducing tariffs may lead to a decline in some of the industries in the economy. Expansionary demand-side policies (Expenditure- reducing and expenditure-switching policies) The government can use expansionary demand-side policies to correct a persistent BOP surplus. The government can increase aggregate demand by increasing expenditure on goods and services, decreasing direct taxes, increasing transfer payments or increasing the money supply to raise interest rates. An increase in aggregate demand will lead to a larger increase in national income due to the multiplier effect. When national income rises, imports will rise which will lead to a deterioration in the BOP. An increase in aggregate demand will also lead to a rise in the general price level which may make domestic goods and services relatively more expensive than foreign goods and services resulting in a

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decrease in net exports. If this happens, assuming the demand for exports is price elastic, the BOP will deteriorate. However, the effect of a rise in national income on the BOP may be small if the marginal propensity to import is small. Further, expansionary demand-side policies are also subject to limitations such as inflexibility of government expenditure and taxation and the effectiveness time lag.

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