Written by: Edmund Quek

CHAPTER 14 THE EXCHANGE RATE SYSTEM AND THE BALANCE OF PAYMENTS PART 1

LECTURE OUTLINE 1 1.1 1.2 1.3 1.4 2 2.1 2.2 2.3 2.4 3 3.1 3.2 EXCHANGE RATE SYSTEM Flexible/floating exchange rate system Determinants of the demand and the supply of a currency Fixed exchange rate system Managed float exchange rate system BALANCE OF PAYMENTS Current account Capital and financial account Total currency flow Net errors and omissions TOTAL CURRENCY FLOW AND EXCHANGE RATE SYSTEM Balance of payments equilibrium under the flexible exchange rate system Balance of payments disequilibrium under the fixed exchange rate system

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

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1 1.1

EXCHANGE RATE SYSTEM Flexible/floating exchange rate system

The exchange rate of a currency is the rate at which the currency can be exchanged for another currency. Under the flexible exchange rate system, also known as the floating exchange rate system, the exchange rate of a currency is determined by the market forces of demand and supply. Therefore, the flexible exchange rate system does not involve any central bank intervention in the foreign exchange market. Most of the large economies in the world operate under the flexible exchange rate system. Under the flexible exchange rate system, an increase in the demand for a currency will lead to a rise in the exchange rate (i.e. an appreciation of the currency).

In the above diagram, an increase in the demand for a currency (D$) from D$0 to D$1 leads to a rise in the exchange rate (E) from E0 to E1. The demand for a currency may rise due to several factors such as an increase in exports and capital inflows. The converse is also true. Under the flexible exchange rate system, an increase in the supply of a currency will lead to a fall in the exchange rate (i.e. a depreciation of the currency).

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In the above diagram, an increase in the supply of a currency (S$) from S$0 to S$1 leads to a fall in the exchange rate (E) from E0 to E1. The supply of a currency may rise due to several factors such as an increase in imports and capital outflows. The converse is also true.

1.2

Determinants of the demand and the supply of a currency

Generally, foreigners demand a currency and the residents in the economy supply the currency in the forex market. The demand for a currency is directly related to money inflows. The demand for a currency may rise due to an increase in exports, inward income remittances, inward current transfers, inward capital transfers or inward foreign investments. The converse is also true. The supply of a currency is directly related to money outflows. The supply of a currency may rise due to an increase in imports, outward income remittances, outward current transfers, outward capital transfers or outward foreign investments. The converse is also true.

1.3

Fixed exchange rate system

Under the fixed exchange rate system, a currency is pegged to a foreign currency at a particular rate. Therefore, the fixed exchange rate system involves central bank intervention in the foreign exchange market. The fixed exchange rate system is not commonly used.

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Under the flexible exchange rate system, an increase in the demand for a currency will lead to a rise in the exchange rate. However, under the fixed exchange rate system, the central bank will intervene in the foreign exchange market by selling the currency and buying foreign currency to keep the exchange rate unchanged.

In the above diagram, an increase in the demand for a currency (D$) from D$0 to DS$1 followed by an increase in the supply (S$) from S$0 to S$1 leaves the exchange rate (E) unchanged at E0. Under the flexible exchange rate system, an increase in the supply of a currency will lead to a fall in the exchange rate. However, under the fixed exchange rate system, the central bank will intervene in the foreign exchange market by buying the currency and selling foreign currency to keep the exchange rate unchanged.

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In the above diagram, an increase in the supply of a currency (S$) from S$0 to S$1 followed by an increase in the demand (D$) from D$0 to D$1 leaves the exchange rate (E) unchanged at E0. 1.4 Managed float exchange rate system

Under the managed float exchange rate system, a currency is pegged to a foreign currency within a policy band set by the central bank. As long as the exchange rate of the currency falls within the policy band, the central bank will not intervene in the foreign exchange market, unless there are wide fluctuations. Most of the small economies in the world, including Singapore, operate under the managed float exchange rate system. Suppose that the demand for a currency under the managed float exchange increases. If the increase is small, although the exchange rate will rise, if it still falls within the policy band, the central bank will not intervene in the foreign exchange market. However, if the increase is large, the exchange rate is likely to breach the policy band. If this happens, the central bank will intervene in the foreign exchange market by selling the currency and buying foreign currency.

In the above diagram, a small increase in the demand for a currency (D$) from D$0 to D$1 leads to a rise in the exchange rate (E) from E0 to E1. Since E1 still falls within the policy band, the central bank will not intervene in the foreign exchange market. However, a large increase in the demand for the currency (D$) from D$0 to D$2 leads to a rise in the exchange rate (E) from E0 to E2. Since E2 is higher than the policy band, the central bank will intervene in the foreign exchange market by selling the currency and buying foreign currency.

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The exchange rate of a currency under the managed float exchange rate system is not necessarily pegged to a single currency. Instead, it may be pegged to a trade-weighted basket of currencies of the economys major trading partners and competitors. A case in point is Singapore. Further, the policy band is not necessarily kept constant. In some economies such as Singapore, the central bank will raise the policy band to reduce inflation when it predicts a strong external economic environment.

BALANCE OF PAYMENTS

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. The balance of payments is made up of the current account and the capital and financial account.

2.1

Current account

The current account records flows of goods, services, incomes and current transfers. The current account balance is the sum of four balances: the goods balance, the services balance, the income balance and net current transfers. Goods balance The goods balance, also known as the balance on goods, the balance on trade in goods, the balance of visible trade, the balance of merchandise trade or the visible balance, is computed by subtracting imports of goods from exports of goods. The goods balance is positive when exports of goods exceed imports of goods and vice versa. Services balance The services balance, also known as the balance on services or the balance on trade in services, is computed by subtracting imports of services from exports of services. The services balance is positive when exports of services exceed imports of services and vice versa. Income balance The income balance, also known as the balance on income, is computed by subtracting outward income remittances from inward income remittances. Income refers to wages, rent, interest and profits. The income balance is positive when inward income remittances exceed outward income remittances and vice versa. Net current transfers Net current transfers, also known as net unilateral transfers or net unilateral current transfers, are computed by subtracting outward current transfers from inward current transfers. Currents transfers are government contributions to and receipts from other economies and international transfers of money by private individuals and firms. Net

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current transfers are positive when inward current transfers exceed outward current transfers and vice versa. Note: In the balance of payments, money inflows are recorded as credits and are entered with a positive sign, and money outflows are recorded as debits and are entered with a negative sign. The sum of the goods balance and the services balance is commonly referred to as the balance on goods or services, the balance of trade or simply the trade balance. The sum of the services balance, the income balance and net current transfers is commonly referred to as the invisible balance.

2.2

Capital and financial account

The capital and financial account is made of the capital account and the financial account. The capital account records capital transfers such as the transfers of funds by migrants, development aid funds, etc. It also includes the acquisition and disposal of non-produced, non-financial assets such as land, patents, copyrights, franchises, etc. The financial account records changes in the holdings of shares, government securities, corporate bonds, bank deposits, loans, reserve assets held by the central bank, etc. The financial account is comprised of direct investment, portfolio investment, other investment and reserve assets. Direct investment Direct investment refers to investment made with the objective of obtaining a lasting interest in an organisation and exercising a significant degree of influence in its management. This is defined as ownership of at least 10% of an organisations ordinary share (also known as voting share or common share). Portfolio investment Portfolio investment refers to investment in paper assets such as shares (less than 10% of voting share), government securities, corporate bonds, etc. Other investment Other investment consists of loans and bank deposits. Reserve assets Reserve assets are the central banks holdings of monetary gold, foreign exchange reserves, Special Drawing Rights (SDRs) and reserves with the International Monetary Fund (IMF).

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By design, the sum of the current account balance and the capital and financial account balance is always equal to zero regardless of the exchange rate system (this will be explained in section 3).

Current Account Balance Capital and Financial Account Balance 0

2.3 Total currency flow

Although the balance of payments is always equal to zero, it is not always in equilibrium. Whether the balance of payments is in equilibrium depends on the total currency flow. The total currency flow is the sum of the current account balance and the capital and financial account balance (excluding the change in reserve assets). When the total currency flow is positive, the balance of payments is in surplus and that occurs when money inflows exceed money outflows. When the total currency flow is negative, the balance of payments is in deficit and that occurs when money outflows exceed money inflows. Economists refer to these as balance of payments disequilibria. When the total currency flow is zero, the balance of payments is in equilibrium and that occurs when money inflows are equal to money outflows. Economists refer to this as a balance of payments equilibrium. Under the flexible exchange rate system, the balance of payments is in equilibrium. Under the fixed exchange rate system, the balance of payments is in disequilibrium, unless by chance.

2.4

Net errors and omissions

Errors and omissions, also known as balancing item or statistical discrepancy, are bound to occur as the data for the current account and the capital and financial account are obtained from diverse sources. Since net errors and omissions always occur, the sum of the current account balance and the capital and financial account balance is not equal to zero. Rather, it is the sum of the current account balance, the capital and financial account balance and net errors and omissions that is equal to zero.

Current Account Balance Capital and Financial Account Balance Net Errors and Omissions 0
Due to the same reason, the total currency flow is not the sum of the current account balance and the capital and financial account balance (excluding the change in reserve assets). Rather, it is the sum of the current account balance, the capital and financial account balance (excluding the change in reserve assets) and net errors and omissions.

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3 3.1

TOTAL CURRENCY FLOW AND EXCHANGE RATE SYSTEM Balance of payments equilibrium under the flexible exchange rate system

Under the flexible exchange rate system, the balance of payments is in equilibrium (i.e. the total currency flow is equal to zero) because any balance of payments disequilibrium will be automatically corrected through an adjustment of the exchange rate. A balance of payments deficit occurs when money outflows exceed money inflows. In other words, the total currency flow is negative. When this happens, the supply of domestic currency will exceed the demand which will lead to a downward pressure on the exchange rate. Under the flexible exchange rate system, the resultant depreciation of domestic currency will lead to an increase in net exports which will correct the balance of payments deficit. A balance of payments surplus occurs when money inflows exceed money outflows. In other words, the total currency flow is positive. When this happens, the demand for domestic currency will exceed the supply which will lead to an upward pressure on the exchange rate. Under the flexible exchange rate system, the resultant appreciation of domestic currency will lead to a decrease in net exports which will correct the balance of payments surplus. Since the total currency flow is equal to zero and these is no change in the reserve assets held by the central bank, the sum of the current account balance, the capital and financial account balance and net errors and omissions is equal to zero.

3.2

Balance of payments disequilibrium under the fixed exchange rate system

Under the fixed exchange rate system, the balance of payments is in disequilibrium (i.e. the total currency flow is not equal to zero) because any balance of payments disequilibrium will not be automatically corrected through an adjustment of the exchange rate. A balance of payments deficit occurs when money outflows exceed money inflows. In other words, the total currency flow is negative. When this happens, the supply of domestic currency will exceed the demand which will lead to a downward pressure on the exchange rate. Under the fixed exchange rate system, the central bank will intervene in the foreign exchange rate by buying domestic currency and selling foreign currency to prevent domestic currency from depreciating. Therefore, net exports will not rise and the balance of payments will remain in deficit. Although the total currency flow is negative, it is matched by a decrease in the reserve assets (recorded with a positive sign) held by the central bank. Therefore, the sum of the current account balance, the capital and financial account balance and net errors and omissions is equal to zero.

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A balance of payments surplus occurs when money inflows exceed money outflows. In other words, the total currency flow is positive. When this happens, the demand for domestic currency will exceed the supply which will lead to an upward pressure on the exchange rate. Under the fixed exchange rate system, the central bank will intervene in the foreign exchange rate by selling domestic currency and buying foreign currency to prevent domestic currency from appreciating. Therefore, net exports will not fall and the balance of payments will remain in surplus. Although the total currency flow is positive, it is matched by an increase in the reserve assets (recorded with a negative sign) held by the central bank. Therefore, the sum of the current account balance, the capital and financial account balance and net errors and omissions is equal to zero.

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