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Exchange Rate And Balance Of Payments Pdf

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To maintain a fixed exchange rate, the central bank will need to automatically intervene in the private foreign exchange Forex by buying or selling domestic currency in exchange for the foreign reserve currency. Subsequently, if excess demand for foreign currency in some periods is balanced with excess supply in other periods, then falling reserves in some periods when dollars are bought on the Forex will be offset with rising reserves in other periods when dollars are sold in the Forex and a central bank will be able to maintain the fixed exchange rate. Problems arise, though, if a country begins to run out of foreign reserves.

Balance-of-Payments Accounting and the Foreign-Exchange Market

The balance of payments also known as balance of international payments and abbreviated B. These financial transactions are made by individuals, firms and government bodies to compare receipts and payments arising out of trade of goods and services. The balance of payments consists of two components: the current account and the capital account.

The current account reflects a country's net income, while the capital account reflects the net change in ownership of national assets. Until the early 19th century, international trade was heavily regulated and accounted for a relatively small portion compared with national output.

In the Middle Ages, European trade was typically regulated at municipal level in the interests of security for local industry and for established merchants. Beginning in the 16th century, mercantilism became the dominant economic theory influencing European rulers. Local trade regulations were replaced by national rules aiming to harness the countries' economic output.

The prevailing orthodoxy of the mercantilist age was the now discredited notion that the accumulation of foreign exchange or, at that time, precious metals, made countries wealthier, and so countries favored exporting their own goods to run balance of payments surpluses. Economic growth remained at low levels in the mercantilist era; average global per capita income is not considered to have significantly risen in the whole years leading up to , and is estimated to have increased on average by less than 0.

In the essays Of Money and Of the Balance of Trade , Hume argued that the accumulation of precious metals would create monetary inflation without any real effect on interest rates. It is the foundation of what is known in modern economic studies as the quantity theory of money , the neutrality of money and the consideration of interest rates not as a monetary phenomenon, but a real one.

Adam Smith built on this foundation. He accused mercantilists of being anti-free trade and confusing money with wealth. David Ricardo based his arguments on Say's Law , developing the theory of comparative advantage , which remains the dominant theory of growth and trade in modern economics. After victory in the Napoleonic wars Great Britain began promoting free trade, unilaterally reducing her trade tariffs.

Hoarding of gold was no longer encouraged, and in fact Britain exported more capital as a percentage of her national income than any other creditor nation has since. According to historian Carroll Quigley , Great Britain could afford to act benevolently [6] in the 19th century due to the advantages of her geographical location, its naval power and economic ascendancy as the first nation to enjoy an industrial revolution.

Though Current Account controls were still widely used in fact all industrial nations apart from Great Britain and the Netherlands actually increased their tariffs and quotas in the decades leading up to , though this was motivated more by a desire to protect "infant industries" than to encourage a trade surplus [4] , capital controls were largely absent, and people were generally free to cross international borders without requiring passports. A gold standard enjoyed wide international participation especially from , further contributing to close economic integration between nations.

BoP crises began to occur, though less frequently than was to be the case for the remainder of the 20th century. From to , there were approximately [9] 8 BoP crises and 8 twin crises — a twin crisis being a BoP crisis that coincides with a banking crisis.

The favorable economic conditions that had prevailed up until were shattered by the first world war, and efforts to re-establish them in the s were not successful. Several countries rejoined the gold standard around But surplus countries didn't "play by the rules", [4] [10] sterilising gold inflows to a much greater degree than had been the case in the pre-war period.

Deficit nations such as Great Britain found it harder to adjust by deflation as workers were more enfranchised and unions in particular were able to resist downwards pressure on wages. During the Great Depression most countries abandoned the gold standard, but imbalances remained an issue and international trade declined sharply. There was a return to mercantilist type "beggar thy neighbour" policies, with countries competitively devaluing their exchange rates, thus effectively competing to export unemployment.

There were approximately 16 BoP crises and 15 twin crises and a comparatively very high level of banking crises. Following World War II, the Bretton Woods institutions the International Monetary Fund and World Bank were set up to support an international monetary system designed to encourage free trade while also offering states options to correct imbalances without having to deflate their economies.

Fixed but flexible exchange rates were established, with the system anchored by the dollar which alone remained convertible into gold. The Bretton Woods system ushered in a period of high global growth, known as the Golden Age of Capitalism , however it came under pressure due to the inability or unwillingness of governments to maintain effective capital controls [11] and due to instabilities related to the central role of the dollar.

Imbalances caused gold to flow out of the US and a loss of confidence in the United States ability to supply gold for all future claims by dollar holders resulted in escalating demands to convert dollars, ultimately causing the US to end the convertibility of the dollar into gold, thus ending the Bretton Woods system. The Bretton Woods system came to an end between and There were attempts to repair the system of fixed exchanged rates over the next few years, but these were soon abandoned, as were determined efforts for the U.

Part of the reason was displacement of the previous dominant economic paradigm — Keynesianism — by the Washington Consensus, with economists and economics writers such as Murray Rothbard and Milton Friedman [12] arguing that there was no great need to be concerned about BoP issues.

In the immediate aftermath of the Bretton Woods collapse, countries generally tried to retain some control over their exchange rate by independently managing it, or by intervening in the foreign exchange market as part of a regional bloc, such as the Snake which formed in From the mids however, and especially in the s and early s, many other countries followed the US in liberalizing controls on both their capital and current accounts, in adopting a somewhat relaxed attitude to their balance of payments and in allowing the value of their currency to float relatively freely with exchange rates determined mostly by the market.

Developing countries who chose to allow the market to determine their exchange rates would often develop sizable current account deficits, financed by capital account inflows such as loans and investments, [14] though this often ended in crises when investors lost confidence.

Typically but not always the panic among foreign creditors and investors that preceded the crises in this period was usually triggered by concerns over excess borrowing by the private sector, rather than by a government deficit. For advanced economies, there were 30 BoP crises and 6 banking crises. A turning point was the Asian BoP Crisis , where unsympathetic responses by western powers caused policy makers in emerging economies to re-assess the wisdom of relying on the free market; by the developing world as a whole stopped running current account deficits [17] while the U.

The resulting state of affairs has been referred to as Bretton Woods II. Usually, a rising trade surplus leads to a rising value of the currency. A rising currency would make exports more expensive, imports less so, and push the trade surplus towards balance. China circumvents the process by intervening in exchange markets and keeping the value of the yuan depressed. In the early to mids, many free market economists and policy makers such as U.

While several emerging economies had intervening to boost their reserves and assist their exporters from the late s, they only began running a net current account surplus after This was mirrored in the faster growth for the US current account deficit from the same year, with surpluses, deficits and the associated buildup of reserves by the surplus countries reaching record levels by the early s and growing year by year.

Some economists such as Kenneth Rogoff and Maurice Obstfeld began warning that the record imbalances would soon need to be addressed from as early as , joined by Nouriel Roubini in , but it was not until about that their concerns began to be accepted by the majority of economists.

Under a fixed exchange rate system, the central bank accommodates those flows by buying up any net inflow of funds into the country or by providing foreign currency funds to the foreign exchange market to match any international outflow of funds, thus preventing the funds flows from affecting the exchange rate between the country's currency and other currencies. Then the net change per year in the central bank's foreign exchange reserves is sometimes called the balance of payments surplus or deficit.

Alternatives to a fixed exchange rate system include a managed float where some changes of exchange rates are allowed, or at the other extreme a purely floating exchange rate also known as a purely flexible exchange rate. With a pure float the central bank does not intervene at all to protect or devalue its currency , allowing the rate to be set by the market , the central bank's foreign exchange reserves do not change, and the balance of payments is always zero.

The current account shows the net amount of a country's income if it is in surplus, or spending if it is in deficit. It is the sum of the balance of trade net earnings on exports minus payments for imports , factor income earnings on foreign investments minus payments made to foreign investors and unilateral transfers.

These items include transfers of goods and services or financial assets between the home country and the rest of the world. Private transfer payments refer to gifts made by individuals and nongovernmental institutions to foreigners.

Governmental transfers refer to gifts or grants made by one government to foreign residents or foreign governments. When investment income and unilateral transfers are combined with the balance on goods and services, we arrive at the current account balance. The capital account records the net change in ownership of foreign assets.

It includes the reserve account the foreign exchange market operations of a nation's central bank , along with loans and investments between the country and the rest of world but not the future interest payments and dividends that the loans and investments yield; those are earnings and will be recorded in the current account.

If a country purchases more foreign assets for cash than the assets it sells for cash to other countries, the capital account is said to be negative or in deficit. The term "capital account" is also used in the narrower sense that excludes central bank foreign exchange market operations: Sometimes the reserve account is classified as "below the line" and so not reported as part of the capital account.

Expressed with the broader meaning for the capital account , the BoP identity states that any current account surplus will be balanced by a capital account deficit of equal size — or alternatively a current account deficit will be balanced by a corresponding capital account surplus:. The balancing item , which may be positive or negative, is simply an amount that accounts for any statistical errors and assures that the current and capital accounts sum to zero.

By the principles of double entry accounting , an entry in the current account gives rise to an entry in the capital account, and in aggregate the two accounts automatically balance. A balance isn't always reflected in reported figures for the current and capital accounts, which might, for example, report a surplus for both accounts, but when this happens it always means something has been missed — most commonly, the operations of the country's central bank — and what has been missed is recorded in the statistical discrepancy term the balancing item.

An actual balance sheet will typically have numerous sub headings under the principal divisions. For example, entries under Current account might include:. Especially in older balance sheets, a common division was between visible and invisible entries.

Visible trade recorded imports and exports of physical goods entries for trade in physical goods excluding services is now often called the merchandise balance. Invisible trade would record international buying and selling of services, and sometimes would be grouped with transfer and factor income as invisible earnings. The term "balance of payments surplus" or deficit — a deficit is simply a negative surplus refers to the sum of the surpluses in the current account and the narrowly defined capital account excluding changes in central bank reserves.

Denoting the balance of payments surplus as BoP surplus, the relevant identity is. The balance of payments takes into account payments for a country's exports and imports of goods , services , financial capital , and financial transfers.

The balance of payments accounts keep systematic records of all the economic transactions visible and non-visible of a country with all other countries in the given time period. In the BoP accounts, all the receipts from abroad are recorded as credit and all the payments to abroad are debits.

Since the accounts are maintained by double entry bookkeeping, they show the balance of payments accounts are always balanced.

Sources of funds for a nation, such as exports or the receipts of loans and investments , are recorded as positive or surplus items. Uses of funds, such as for imports or to invest in foreign countries, are recorded as negative or deficit items. When all components of the BoP accounts are included they must sum to zero with no overall surplus or deficit.

For example, if a country is importing more than it exports, its trade balance will be in deficit, but the shortfall will have to be counterbalanced in other ways — such as by funds earned from its foreign investments, by running down currency reserves or by receiving loans from other countries. While the overall BoP accounts will always balance when all types of payments are included, imbalances are possible on individual elements of the BoP, such as the current account , the capital account excluding the central bank's reserve account, or the sum of the two.

Imbalances in the latter sum can result in surplus countries accumulating wealth, while deficit nations become increasingly indebted. The term "balance of payments" often refers to this sum: a country's balance of payments is said to be in surplus equivalently, the balance of payments is positive by a specific amount if sources of funds such as export goods sold and bonds sold exceed uses of funds such as paying for imported goods and paying for foreign bonds purchased by that amount.

There is said to be a balance of payments deficit the balance of payments is said to be negative if the former are less than the latter. A BoP surplus or deficit is accompanied by an accumulation or decumulation of foreign exchange reserves by the central bank. Economics writer J. Orlin Grabbe warns the term balance of payments can be a source of misunderstanding due to divergent expectations about what the term denotes.

Grabbe says the term is sometimes misused by people who aren't aware of the accepted meaning, not only in general conversation but in financial publications and the economic literature.

A common source of confusion arises from whether or not the reserve account entry, part of the capital account , is included in the BoP accounts. The reserve account records the activity of the nation's central bank. If it is excluded, the BoP can be in surplus which implies the central bank is building up foreign exchange reserves or in deficit which implies the central bank is running down its reserves or borrowing from abroad.

The term "balance of payments" is sometimes misused by non-economists to mean just relatively narrow parts of the BoP such as the trade deficit , [27] which means excluding parts of the current account and the entire capital account.

Another cause of confusion is the different naming conventions in use. The IMF have their own standards for BoP accounting which is equivalent to the standard definition but uses different nomenclature, in particular with respect to the meaning given to the term capital account.

The main difference in the IMF's terminology is that it uses the term "financial account" to capture transactions that would under alternative definitions be recorded in the capital account. The IMF uses the term capital account to designate a subset of transactions that, according to other usage, previously formed a small part of the overall current account.

Balance of Payments and Exchange Rates

Macroeconomics pp Cite as. The balance of payments between the monies that we have spent abroad on imports and the monies that we have received from the sale of exports is important to the economy for a number of reasons. Pounds are not legal tender in, say, France. To buy French goods we must first buy francs or the exporter may accept pounds and then buy francs himself. This is done in the main through the banking system, but the banks only have a limited reserve of foreign currency.

There are two distinct concepts of the balance of payments which must not be confused: the market balance of payments, and the accounting balance of payments. If the exchange rate is fixed, the market balance of payments would be in balance only by chance. If it is not in balance and the exchange rate must be maintained, the monetary authorities would have to intervene to achieve balance by buying their own currency with foreign exchange if the home currency were in excess supply or by selling their own currency for foreign exchange if the home currency were in excess demand. If the exchange rate is allowed to float freely, however, the market balance of payments must always balance because the exchange rate is the price which equates the supply and demand for a currency in the foreign-exchange market. Unable to display preview. Download preview PDF.

PDF | On Jan 1, , A. J. Makin published The Balance of Payments and the Exchange Rate | Find, read and cite all the research you need on ResearchGate.

How Does the Balance of Payments Impact Currency Exchange Rates?

According to the absorption approach, the economic circumstances that best warrant a currency devaluation is where the domestic economy faces: a. Unemployment coupled with a payments deficit b. Unemployment coupled with a payments surplus c. Full employment coupled with a payments deficit d.

The balance of payments also known as balance of international payments and abbreviated B. These financial transactions are made by individuals, firms and government bodies to compare receipts and payments arising out of trade of goods and services. The balance of payments consists of two components: the current account and the capital account.

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To browse Academia. Skip to main content. By using our site, you agree to our collection of information through the use of cookies. To learn more, view our Privacy Policy. Log In Sign Up. Download Free PDF. Salamun Rashidin.

The balance of payments is the record of all international trade and financial transactions made by a country's residents. The financial account describes the change in international ownership of assets. The BOP is reported for a quarter or a year. It must borrow from other countries to pay for its imports. It's like taking out a school loan to pay for education.

Before you order, simply sign up for a free user account and in seconds you'll be experiencing the best in CFA exam preparation. Economics 2 Reading Currency Exchange Rates Subject 6. Seeing is believing! Find out more. Subject 6.

Real exchange rate and structural change in a Kaldorian balance of payments constrained growth model. E-mail: bernardo.

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How Does the Balance of Payments Impact Currency Exchange Rates?


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