Question

1.[3 Points] Consider the flow theory of exchange rate determination. (a) Explain the role of activities of each account of balance of payment accounts in shaping demands for and supplies of currencies in foreign exchange market. 1. 2. 3.

Answer 1

The Flow Approach to Exchange Rate Determination:

Economists began to see the exchange rate as an instrument to bring about balances in the current account. Capital controls were still in place, demand for and supply of foreign exchange were trade-related, and the major exchange rates were fixed under the Bretton Woods System. In such a world, current account imbalances were serious problems that interfered with stabilisation of the domestic economy. Participants of the Bretton Woods System were obliged to maintain fixed exchange rates and stable current accounts. This obligation took precedence over domestic policy concerns. When macroeconomic policy stances desirable for domestic stabilisation were inconsistent with the requirements of being part of the Bretton Woods System, the latter prevailed over the former.

Economists such as Milton Freedman began to advocate freeing the exchange rate, to use the exchange rate as an instrument to bring about current account balances. Exports give rise to supply of foreign exchange; imports give rise to demand for foreign exchange. Hence exports were equal to imports and the current account was in balance, when supply was equal to demand in the foreign exchange market. If exchange rates were allowed to float, therefore, they will settle at levels that made demand equal to supply, freeing us of the problems caused by current account imbalances. It was natural to see the demand and supply as flow variables, because exports and imports were flow variables. And this came to be called the flow approach to exchange rate determination. The flow approach was at first shown in a partial equilibrium model of the current account as a function of real exchange rates.

In any event, the flow approach to the theory of exchange rate determination was inseparable with the question of how to bring about current account balances.

The balance of payments consists of three major components:

a) current account b)capital account c) Financial account.

1. Balance of payments is the statement of a country's trade with other nations.

2The relationship between balance of payments and exchange rates under a floating-rate exchange system will be driven by the supply and demand for the country's currency and all transactions taking place with other countries.

a) current account :

The current account is related to the national income accounts because the trade balance corresponds broadly to the net export value recorded in the national income accounts as one of the four components of the gross national product (GNP), along with consumption, investment, and government expenditures.

b)capital account:

The capital account records all international capital transfers. Those transfers include the monetary flows associated with inheritances, migrants’ transfers, debt forgiveness, the transfer of funds received for the sale or acquisition of fixed assets, and the acquisition or disposal of intangible assets.

c) Financial account:

The financial account records government-owned international reserve assets (foreign exchange reserves, gold, and special drawing rights with the International Monetary Fund), foreign direct investment, private sector assets held abroad, assets owned by foreigners, and international monetary flows associated with investment in business, real estate, bonds, and stocks.

To conclude:

The balance of payments should always be in equilibrium. The current account should balance with the sum of the capital and financial accounts.If the current account is in equilibrium, the country will find its net creditor or debtor position unchanging because there will be no need for net financing. Equilibrium in the capital and financial accounts means no change in the capital held by foreign monetary agencies and reserve assets. In the case of disequilibrium arising when a country buys more goods than it sells (i.e., a current account deficit), the country must finance the difference through borrowing or sale of assets (i.e., there is an inflow of capital and thus a capital and financial account surplus). In other words, the country uses foreign savings to meet its consumption or investment needs. Similarly, if a country has a current account surplus, the capital and financial accounts record a net outflow, indicating that the country is a net creditor. The exchange rate regime is an important determinant of the adjustment toward the new equilibrium. With fixed exchange rates, central banks must finance the excess demand for or supply of foreign currency at the fixed exchange rate by running down or adding to their reserve assets. Under floating exchange rates, balance of payments equilibrium is restored by movements in the exchange rate.