Balance of Payments

Question 1

what’s the case for floating exchange rate systems?

Answer 1

1. less need for currency reserves for use in intervention
2. useful instrument of macroeconomic adjustment
3. provides partial “automatic correction” for a trade deficit by changing the relative prices of exports and imports
   freedom for domestic monetary policy (greater freedom to set interest rates for domestic economic aims and gives policy makers another tool of policy which can be used especially if other instruments of policy are not working as well as hoped)

Question 2

case for fixed exchanges

Answer 2

1. stability and certainty- helpful for trade and capital investment
2. some flexibility (occasional devaluation or revaluation of currency)
3. reductions in costs of currency hedging for businesses
4. fixed rate provides a discipline on domestic producers to keep costs down and to become more productive
5. reinforces gain in comparative advantage (if a country has a fixed rate with another, then differences in relative costs will easily be reflected in changes in the rate of growth and imports)

Question 3

benefits of a cheaper currency

Answer 3

1. competitive boost to export sector and industries facing import competition
2. increase in the value of investment income from overseas assets
3. higher value of subsidies from overseas
4. possible multiplier and accelerator effects
5. helps to rebalance the economy
6. currency depreciation acts as a partial automatic stabiliser for economy

Question 4

risks from a falling currency

Answer 4

1. inflationary effects from higher import prices (cost push)
2. weak currency may deter foreign investors
3. risks for those who have borrowed in a foreign currency
4. low elasticity of demand may limit the impact of currency depreciation on the trade balance and export volume
5. currency devaluation does not turn around what might be long term supply side policy weaknesses in the economy

Question 5

how could a floating exchange rate be a useful instrument of macroeconomic adjustment?

Answer 5

1. lower currency can stimulate aggregate demand
2. sterling’s depreciation may have helped limit the scale of recession
3. appreciation against the US dollar was helpful when world oil prices were very high

Question 6

how could a floating exchange rate allow freedom for domestic monetary policy?

Answer 6

1. allows countries greater freedom to set interest rates for domestic economic aims
2. it gives policy makers another tool of policy which can be useful especially if other instruments of policy are not working as well as hoped

Question 7

how does a cheaper currency give a compensation to export sector and industries facing export competition?

Answer 7

1. improved profitability of exporting
2. relative price of imports rises
3. impact depends on overseas PED for UK exports and domestics PED for imports
4. and whether export industries have sufficient capacity/flexibility

Question 8

how can a falling currency create inflationary effects from higher import prices?

Answer 8

1. higher import prices for raw materials, food and energy
2. imported capital technology becomes more expensive
3. possible second round effects on wages
4. weaker currency increases import prices and thus worsens terms of trade

Question 9

how could a weaker currency deter foreign investors?

Answer 9

1. harder for the government to find foreign purchasers of sovereign debt
2. may require higher bond yields - increases cost of servicing debt
3. greater risk of capital flight

Question 10

what is a pegged exchange rate system?

Answer 10

linked to a basket of other currencies

Question 11

what is a semi fixed exchange rate?

Answer 11

like fixed but the exchange rate can fluctuate within a band

Question 12

What are the consequences of a current account deficit?

Answer 12

1. Loss of Aggregate Demand if there was a trade deficit which causes weaker real GDP growth and reduced living standards and rising unemployment
2. Big current account deficits will cause cause the currency to depreciate, leading to higher cost-push inflation and a deterioration in the terms of trade
3. Can lead to currency weakness and higher inflation and a country may run short of vital foreign currency reserves
4. Trade deficit might be a reflection of lack of competitiveness/ supply-side weaknesses in the economy
5. Some countries running current account deficits may choose to borrow to achieve a financial account surplus - increases risks
6. Unsustainable current account deficits can ultimately lead to a loss of investor consequence, leading to capital flight and a currency/balance of payments crisis