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 System
Under 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 pesos
Inflation 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.