Written by: Edmund Quek

2011 Economics Cafe

All rights reserved. Page 1

CHAPTER 14

THE EXCHANGE RATE SYSTEM AND THE BALANCE OF PAYMENTS


LECTURE OUTLINE

1 EXCHANGE RATE SYSTEM

1.1 Flexible/floating exchange rate system
1.2 Determinants of the demand and the supply of domestic currency
1.3 Fixed exchange rate system
1.4 Managed float exchange rate system

2 BALANCE OF PAYMENTS

2.1 Current account
2.2 Capital and financial account
2.3 Total currency flow
2.4 Net errors and omissions

3 TOTAL CURRENCY FLOW AND EXCHANGE RATE SYSTEM

3.1 Balance of payments equilibrium under the flexible exchange rate system
3.2 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
Written by: Edmund Quek
2011 Economics Cafe
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1 EXCHANGE RATE SYSTEM

1.1 Flexible/floating exchange rate system

The exchange rate of a currency is the rate at which the currency can be exchanged for
another currency.

When foreigners demand domestic goods and services or assets, they need to exchange
foreign currency for domestic currency to pay for the items and this leads to the demand for
domestic currency in the foreign exchange market. By the same token, when domestic
residents demand foreign goods and services or assets, they need to exchange domestic
currency for foreign currency to pay for the items and this leads to the supply of domestic
currency in the foreign exchange market.

Under the flexible exchange rate system, also known as the floating exchange rate system,
the exchange rate of domestic 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 domestic currency
will lead to a rise in the exchange rate (i.e. an appreciation of domestic currency).

















In the above diagram, an increase in the demand for domestic currency (D
$
) from D
$0
to
D
$1
leads to a rise in the exchange rate (E) from E
0
to E
1
. The demand for domestic
currency may rise due to an increase in the foreign demand for domestic goods and services
or assets. The converse is also true.

Under the flexible exchange rate system, an increase in the supply of domestic currency
will lead to a fall in the exchange rate (i.e. a depreciation of domestic currency).
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2011 Economics Cafe
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In the above diagram, an increase in the supply of domestic currency (S
$
) from S
$0
to S
$1

leads to a fall in the exchange rate (E) from E
0
to E
1
. The supply of domestic currency may
rise due to an increase in the domestic demand for foreign goods and services or assets. The
converse is also true.


1.2 Determinants of the demand and the supply of domestic currency

The demand for domestic currency is directly related to money inflows. For instance, an
increase in exports, inward income remittances, inward current transfers, inward capital
transfers or inward foreign investments will lead to increase in the demand for domestic
currency.

The supply of domestic currency is directly related to money outflows. For instance, an
increase in imports, outward income remittances, outward current transfers, outward
capital transfers or outward foreign investments will lead to an increase in the supply of
domestic currency.


1.3 Fixed exchange rate system

Under the fixed exchange rate system, domestic 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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2011 Economics Cafe
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Under the flexible exchange rate system, an increase in the demand for domestic 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 domestic currency
and buying foreign currency to keep the exchange rate unchanged.

















In the above diagram, an increase in the demand for domestic currency (D
$
) from D
$0
to
D
S$1
followed by an increase in the supply of domestic currency (S
$
) from S
$0
to S
$1
leaves
the exchange rate (E) unchanged at E
0
.

Under the flexible exchange rate system, an increase in the supply of domestic 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 domestic currency
and selling foreign currency to keep the exchange rate unchanged.

















Written by: Edmund Quek
2011 Economics Cafe
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In the above diagram, an increase in the supply of domestic currency (S
$
) from S
$0
to S
$1
followed by an increase in the demand for domestic currency (D
$
) from D
$0
to D
$1
leaves
the exchange rate (E) unchanged at E
0
.


1.4 Managed float exchange rate system

Under the managed float exchange rate system, domestic currency is pegged to a foreign
currency within a policy band set by the central bank. As long as the exchange rate of
domestic 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 domestic currency 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 domestic currency and buying foreign currency.

















In the above diagram, a small increase in the demand for domestic currency (D
$
) from D
$0

to D
$1
leads to a rise in the exchange rate (E) from E
0
to E
1
. Since E
1
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 domestic currency (D
$
) from D
$0
to D
$2
leads to a rise in
the exchange rate (E) from E
0
to E
2
. Since E
2
is higher than the policy band, the central
bank will intervene in the foreign exchange market by selling domestic currency and
buying foreign currency.

Under the managed float exchange rate system, the exchange rate of domestic currency 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
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2011 Economics Cafe
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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.


2 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.

Note: Money inflows are recorded as credits and are entered in the balance of payments
with a positive sign. Money outflows are recorded as debits and are entered in the
balance of payments with a negative sign.


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.

The 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.

The 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.

The 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.

Net current transfers
Net current transfers, also known as net unilateral transfers or net unilateral current
transfers, is 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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2011 Economics Cafe
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current transfers is positive when inward current transfers exceed outward current transfers.
The sum of the services balance, the income balance and net current transfers is commonly
referred to as the invisible balance.

Note: 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.


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).

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



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2011 Economics Cafe
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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.


3 TOTAL CURRENCY FLOW AND EXCHANGE RATE SYSTEM

3.1 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
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2011 Economics Cafe
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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.

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.