MACROECONOMIC EQUILIBRIUM

The External Balance

Cypher and Dietz,

Ch. 15

Exchange Rates

Exchange rate • The number of units of a foreign currency that can be obtained for

each unit of the domestic currency, OR• The number of units of domestic currency required to buy a unit of

some foreign currency.

Exchange rate regimes • Floating exchange rates: supply and demand determined.• Fixed exchange rates: central authority determined.• Managed Float: mixture of supply & demand and central authority.

Crawling peg

Band exchange rate

Supply and Demand in the Market for Foreign Currency

Example: Market for U.S. $ in Sri Lanka

Demand for US $ in Sri Lanka (those supplying rupees in return for $)

• importers of foreign goods into Sri Lanka• sri lankans traveling abroad• sri lankans investing abroad• any one else currently holding rupees and needs $ in return

Supply of US $ into Sri Lanka (those supplying $ in return for rupees)• exported of Sri Lankan goods into foreign countries• foreigners traveling to Sri Lanka• foreigners investing in Sri Lanka• any one else currently holding $ and needs rupees in return

Fixed Exchange Rate SystemUnder a fixed exchange rate system, an increase in demand for foreign

currency (or decrease in supply thereof) can lead to a shortage of hard foreign currency (shortage of US $ in this case).

The shortage of US $ can be met by the following measures:• Government can sell $ from its official foreign exchange reserves• If insufficient dollars are held as reserves, the government can use

administrative means to ration the foreign ER market such that the available dollars go to priority groups, for example – import licenses (for essential goods)

– limits on the no. of rupees that can be exchanged for $, etc.

Hence Risks of the fixed ER regime: • emergence of black / parallel markets.• depletion of foreign ER reserves

Exchange Rates

Exchange rate • The number of units of a foreign currency that can be obtained for

each unit of the domestic currency, OR• The number of units of domestic currency required to buy a unit of

some foreign currency.

Exchange rate regimes • Floating exchange rates: supply and demand determined.• Fixed exchange rates: central authority determined.• Managed Float: mixture of supply & demand and central authority.

Crawling peg

Band exchange rate

Real Exchange Rates (RER)versus

Nominal Exchange Rates (NER)RER differs from the NER when a country’s inflation rate

differs from the inflations rates of its trading partners.Given: US $ and the Mexican peso;

NER at the beginning of 2005 is $1 = 12 pesosInflation rate in Mexico in 2004 = 20%Inflation rate in the U.S. in 2004 = 0%

If NER is FIXED; then RER will change such that the Mexican peso will have appreciated vis a vis the US $.

For the RER to remain the same despite the inflation differential between the two countries, the NER would need to change under a floating ER system, such that US $ 1 = 14.4 pesos

Balance of Payments

Composed of four parts:• Current account balance• Capital account balance• Financial account balance• Net errors and omissions

Due to double-entry accounting, the following identity always holds:

BoP = CAB + CAPAB + FAB + NEO = 0

Balance of Payments

• Due to double-entry accounting, the following identity always holds:

BoP = CAB + CAPAB + FAB + NEO = 0

What does it mean then for a country to have a BoP problem if the sum is always equal to 0?

It means:• One of the components of BoP < 0, such that some other

component(s) has to be > 0 in order to keep the equality.• Usually it is the CAB < 0, such that FAB needs to be > 0;• i.e. The country will either need to borrow (in the form of direct

loans or foreign investment) or • If unable to borrow it will deplete its foreign exchange reserves.• If the reserves become dangerously depleted, then it will be

unable to run a current account deficit.

Exchange Rate Regimes and Balance of Payments

Monitoring the Balance of Payments

• A beneficial current account deficit

• A debilitating current account deficit

Austerity measures to deal with a debilitating current account deficit

• Devaluation of the currency;• Reduction in inflation rate via greater control of the fiscal

deficit and the money supply that create and perpetuate inflation (“stabilization policies”);

• An increase in domestic interest rates and a reduction in trade barriers with the ROW (“adjustment policies”);

• Limits on wage increases to less than the inflation rate;• Lay-offs of government employees;• Privatization of state enterprises, etc.