Modeling the Exchange Rate and Balance of Payments - Essay Example

Modeling the Exchange Rate and Balance of Payments Exchange rate can be described as the price of one country’s monetary value in terms of another country’s currency, for example, the value of dollar to sterling pound and vice versa. Balance of payment is an accounting statement with recordings showing a country’s international transactions. It is based on a method referred to as double entry bookkeeping where every transaction is entered on both sides of the balance sheet, with one side bearing the credit and the other the debit of a country’s transactions. For most of developed countries, the balance of payments data are normally accounted for quarterly. Many countries use financial institutions, central banks, to invest in several monetary and financial systems and other resources in their quest to predict exchange rate and determine international trade as well as balance of payment. Several theories have been forwarded to determine the value of exchange rate and balance of payments, and in this summary, we will discuss the determinants of balance of trade, the IS-LM-BP approach and the monetary approach in relation to the two (Melvin and Norrbin, 225). The elasticity approach to the balance of trade explains that the economic behavior involves satisfaction of the unlimited wants with limited resources. One effect of this is that, consumers and business firms end up substituting the expensive good for the more affordable ones as prices change to stretch their budgets as far as they can. Relative prices normally change relative to demand and supply for individual goods. Such changes may be caused by alteration in tastes, the method of production, government taxes, or subsidies amongst other possible causes. If the changes concern the prices of goods at home relative to the foreign goods, the international trade patterns may actually be altered. The elasticity approach to the balance of trade involves the way changing of relative prices of the domestic and foreign goods will affect and possibly change the balance of trade. Furthermore, it provides an analysis of how the issue of devaluation affects the balance of trade in relation to the elasticity of supply and demand for foreign exchange and foreign goods in the concerned market (Melvin and Norrbin 226). The devaluation of a country’s currency domestically normally raises the price of foreign goods in relation to the domestic goods within that country. With the increase in prices of foreign goods, the total payments to importers either rise or decrease depending on the elasticity of demand for the imports. Devaluation conventionally is allegedly believed to be a mode that can be used to increase the country’s balance of trade. Devaluation leads to a phenomenon referred to as the J-curve effect, which can be described as the pattern of the balance of trade that is formed as a result of devaluation of a country’s currency. Through the J-curve effect, an explanation can be arrived at that when the devaluation increases the price of imports relative to the domestic goods of the country and decreases the price of domestic goods relative to the foreign buyers, it causes a short-run period during which the balance of trade falls. Devaluation leads to two periods: the pass through analysis and the currency contract period. The currency contract period refers to a situation just after devaluation when the contracts that had initially been negotiated upon become revalued. In the pass through analysis period, the traders have small effect to the changes regarding the response of new prices that have been set, although eventually the response to these changes becomes effectively complete (Melvin and Norrbin, 237). The IS-LM-BP approach refers to a situation where goods market equilibrium, money market equilibrium, and the balance of payment equilibrium are determined by three factors the IS curve, LM curve and the BP curve. In IS curve, the equilibrium is determined when the out-put of goods and services supplied equals quantity of goods and services demanded. Basing on the principles of economies of scale, the macro-economic equilibrium exists only when the leakages are at the same level to the injections of spending in the economy. Whereas when the leakages from the expenditure are equal to the injection, the value of income from the production of goods and services will be the same to the quantity of out-put in demand (Melvin and Norrbin 245). Through the LM curve, the quantity of money supplied is normally equal to its quantity in demand. If the supply of money increases, then money demand will have to increase to restore the equilibrium (Melvin and Norrbin 249) .The relationship that exist between the interest rate and the demand for money in an economy is a result of caused by dynamics of the interest as the opportunity cost of holding money. In common terms, money usually does not earn interest; hence, the higher the interest rate, the more an individual has to give up in order to hold money, and so, less money is held (Michael Melvin and Stefan C. Norrbin 249). In the BP curve, the current account’s deficit is normally equal to the capital account overflow, making the official settlements of balance of payments to equal to zero. This curve is normally drawn for a given domestic price level, the exchange rate, and sometimes the net foreign debt. The slope of the BP curve is normally determined by the degree of capital mobility. In the situation where there is perfect capital mobility between countries, the BP curve will be horizontal. In regarding the IS curve, the LM curve, and the BP curve, the equilibrium in the economy requires that all the three factors, markets the goods market, the money market, and the balance of payments be in equilibrium. This happens when the IS, LM, and BP curves meet at a common equilibrium level of the interest rate and income (Melvin and Norrbin, 251). In general, with perfect substitute and better capital mobility, the domestic interest rate will most likely be equal to the foreign interest rate of a country. A country that has fixed exchange rates cannot independently conduct monetary policy that will enable it change its domestic income. The only way to change equilibrium income is through fiscal policy. Floating exchange rates as a monetary policy can effectively be used in advent of changing domestic income, although fiscal policy has no effect on income because of its tendency to have a complete crowding-out effect after change in the balance of payments. The international policy coordination is a system that stabilizes the exchange rates through coordination of each country’s fiscal and monetary policies with the aims of achieving the best international outcome (Melvin and Norrbin, 265). The basic premise of the monetary approach is that any balance of payment or the dynamism of the exchange rate movement is based on a monetary disequilibrium, which describes the differences existing between quantity of money people wish to hold and the quantity supplied by monetary authorities. If peoples’ demand for money is more than that which is being supplied by the central bank, then the increase in demand for money would be satisfied by the inflows of money from other countries or in simple terms, the appreciation of the currency. Another situation is that, if the central bank is supplying more money than is demanded, the increase in the supply of money is eliminated by outflows of money to other foreign markets or countries, a situation that will have necessitated a depreciation of the currency. Hence, the monetary approach puts emphasis on the determinants of money demand and money supply. This approach can be can be analyzed separately for fixed and floating exchange rates. If the exchange rate is fixed, then the monetary approach pertains to the balance of payments (Melvin and Norrbin 271). The principles of macroeconomics explain that the Federal Reserve controls money supply by making changes on the currency plus commercial bank reserves held against deposits, commonly referred to as the base money. When the base money changes, lending ability of commercial banks also in the same breath changes too; for instance, increases in the base money causes an expansion of the money supply, whereas the decreases in base money leads to contract the money supply (Michael Melvin and Stefan C. Norrbin , 272). Two applications of the monetary approach are the monetary approach to the balance of payment and the monetary approach to the exchange rate. The monetary approach to balance of payments states that the balance of payments disequilibria are essentially monetary phenomena, must be transitory, and can be handled with domestic monetary policy rather than with adjustments in the exchange rate. Furthermore, the domestic balance of payments will essentially be improved with the increase in domestic income through an increase in money demand, if not offset by an increase in domestic credit. The monetary approach to the exchange rate describes that the relationship between fixed and floating exchange rates is essentially important. When exchange rates are fixed in two countries, there will be an observation of money flowing between those countries to adjust the disequilibrium (Melvin and Norrbin, 278). All in all, the exchange rate and balance of payment are basically determined by the value of the of the currency, the fluctuation in the supply and demand for money, fiscal policies of the country, the factor of import and export in an economy, balance of trade and market forces in general. Work Cited Melvin, Michael and Stefan C. Norrbin. International Money and Finance. Oxford: Academic Press, 2013 Read More