Fixed Exchange Rates and Balance of Payments

Fixed Exchange Rates and Balance of Payments

1. Dynamics of Currency Pegging

• When domestic currency appreciates above the peg:

  • Action: Authorities will buy foreign currency and sell domestic currency.

  • Result: This action floods the market with domestic currency, increasing its supply, which ultimately reduces its price.

• When domestic currency depreciates below the peg:

  • Action: Authorities will sell foreign currency and buy domestic currency.

  • Result: This action reduces the supply of domestic currency, leading to an increase in its price.

2. Balance of Payments

• Formula:

  • $ext{Balance of Payments} = ext{Current Account} + ext{Capital Account}$

  • For countries where exchange rates (ER) are determined by market forces:

  • $ext{CAB} + ext{KAB} = 0$

  • For countries where ER is fixed:

  • $ext{CAB} + ext{KAB} = ext{change in FOREX reserves}$

3. Reasons for Fixing Exchange Rates

• How to fix exchange rates:

  1. Requires large reserves of foreign exchange (FOREX).

  2. Often necessitates restrictions on imports, leading to a forgoing of gains from free trade.

• Why fix exchange rates?:

  • Promotes certainty in international transactions.

  • Enables cheaper imports by pegging to a stronger currency, preventing market undervaluation.

  • Enhances international competitiveness by increasing net exports (NX) and aggregate demand.

• Limitations:

  • Restricts monetary policy since the country must align with the pegged exchange rate.

4. Currency Boards

• Defined as an extreme form of fixed exchange rates where the central bank is solely tied to maintaining the fixed exchange rate.

5. Current and Capital Accounts

• The current account balance and the capital account balance should ideally be equal; discrepancies often arise from statistical errors.

A. Current Account:

• Represents money flow from activities such as trade, tourism, and income.

B. Capital Account:

• Involves buying and selling of assets:

  • Official Transactions: Managed by official institutions like the Reserve Bank of Australia (RBA).

  • Non-official Transactions: Conducted by private entities.

C. Current Account Deficits and Surpluses

• When a country has a current account deficit (where imports > exports):

  • Accompanied by a capital/financial account surplus.

• When a country has a current account surplus (where exports > imports):

  • Accompanied by a capital/financial account deficit.

• Implication of Current Account Deficits:

  • If imports exceed exports, funding sources for the deficit include capital inflows (which can come from borrowing or foreign investment).

  • Liabilities: Represent credits; Acquisitions: Represent debits.

  • Capital inflows are characterized by foreign purchases of domestic assets.

Interest Rate Dynamics and Investment

1. Interest Rate Relationship

• When domestic interest rate (R) is greater than foreign interest rate (Rf):

  • Resulting capital inflow increases demand for domestic assets.

  • This increased demand leads to:

  • Price of Domestic Assets: Increases.

  • Interest Rate on Domestic Assets: Falls until it equals the foreign rate (r = rf).

2. National Savings and Investment

• Equation:

  • $ext{NS} + ext{KI} = ext{I}$

  • National Investment (I) is financed through National Savings (NS) and Net Capital Inflow (KI).

3. Borrowing and Lending Dynamics

• When a country does not generate enough to finance its spending:

  • It resorts to borrowing from international lenders.

• When a country has a surplus:

  • It lends to countries that require funds.

4. Key Relationships and Terms

• Net Exports (NX):

  • Defined by the equation:

  • $ext{NS} - ext{I} = ext{NX}$

A. Capital Outflows:

• Represents the purchase of foreign assets by domestic citizens.

• Capital outflows occur when the domestic interest rate exceeds the foreign interest rate, making foreign investments attractive.

• In response to higher demand for domestic assets, bond prices increase, leading to a decrease in domestic interest rates due to the inverse relationship between prices and interest rates.

• This inflow of capital will continue until domestic and foreign interest rates equalize.

B. Exceptions to General Trends

• Risky Economies:

  • These require a risk premium on their interest rates to attract lenders.

• Expectations of Exchange Rate Changes:

  • Investors may factor in potential future exchange rate fluctuations which can affect their investment behavior.

Trade Deficits

1. Definition of Trade Deficit

• A trade deficit occurs when a country invests more than it saves, necessitating borrowing from abroad to bridge the financing gap.

• This indicates an economic imbalance where expenditures exceed income, requiring foreign capital to sustain spending levels.