International Monetary - Essay Example

International Monetary Table of Contents Introduction 3 Nature of the Exchange Rate 4 Elasti Approach 6 Absorption Approach 10 Monetary Approach 11 Conclusion 14 References 15 Bibliography 18 Introduction Balance of Payment (BOP) is related to the transactions between individual countries with others and is recorded for a precise period. BOP compares the difference in Dollars due to exports and imports in a country and also includes financial exports and imports (Investopedia, 2011). The exchange rate decision of the government policy affects the balance of payment. It is the policy that might turn out to be positive or negative, which might lead to BOP crisis (Williamso, 2004). There is a relationship between real exchange rate and balance of payment crisis. The exchange rate is one of the variables for the BOP crisis (Berg & International Monetary Fund, 1999). The government handles the BOP crises situations by taking up various measures. This paper will discuss the degree of relationship between the measures. The crisis situation in a country’s BOP occurs when it moves beyond the control of the government to remove the current account’s deficit. The crisis situation would lead to deficit in foreign exchange reserves too. Considering these adverse impacts of the BOP crisis, the objective of this paper has been selected that will comprehensively discuss the measures taken up by the government for dealing with the adverse conditions. Nature of the Exchange Rate The exchange rate acts just as the demand and supply of currency in an international market that in turn affects the BOP. There will be minimum effect when a currency of a domestic country’s demand and supply is equivalent. This is represented below in figure1 (Pereira, 1998). Figure 1: Interaction of demand and supply with respect to foreign currency and unit prices (Pereira, 1998). The demanded and supplied foreign currencies are exhibited in X-axis, in a specific period. The unitary prices / exchange rates are illustrated in Y-axis for the foreign currencies that are in national currency. At point 4, the demand and supply meet and the exchange rate is maintained. There is less volatility in the exchange rate and it does not develop BOP crisis (Pereira, 1998). If it is now considered that the demand is constant and the supply of the currency has declined, then the rate of exchange declines and there are difficulties in the BOP management. This might lead to BOP crisis if it lasts for long period of time. This is illustrated below in figure 2 (Pereira, 1998). Figure 2: Interaction of demand and supply with respect to foreign currency and unit prices with shift in supply curve (Pereira, 1998). The supply has been declined when the demand became constant. The curve SS moves to S”S”. Thus, the exchange rate declines from point 4 to 3. The effect is viewed in the BOP where there are chances of deficits and crisis might be present. The demand and supply of the currency determines the exchange rate fluctuation and its effects are seen in the BOP. The BOP crises are generated with continuous decline in the exchange rate of the domestic country (Pereira, 1998). There are three alternative assumptions of BOP that are discussed here. These theories are known as ‘absorption’, ‘elasticity’ and ‘monetary approaches’ (Ardalan, 2003). Elasticity Approach In this approach the impact of devaluation of the exchange rate on domestic output is believed to be met by distinction in output and employment rather than prices, with the consequences of variations in the level of output is viewed on the balance of payments. The association connecting the balance of payments and supply of money, and linking the supply of money and the cumulative demand are ignored. This is through the assumption of existence of unemployed resources and Keynesian scepticism concerning the influence of money (Ardalan, 2003). According to the Mundell-Fleming Model of elasticity approach to the BOP, there are two effects: (1) The exchange rate outcome contributes to a decline of the current account for the reason that imports turn out to be more expensive, and (2) Volume effect adds up for recovering the current account for the reason that exports turn out to be cheaper from a foreign countrys perspective (LSE Dept of Econ, 2011). In the short run, J-curve according to Marshall-Lerner might not continue the situation of maintaining the exchange rate. In the short run period, imports and exports capacity do not change at a great deal so that the price outcome dominates leading to a decline of the current account along with a depreciation of the exchange rate. This progression of the current account resulting to depreciation is shown by a J-curve in the figure 3 below (LSE Dept of Econ, 2011). Figure 3: The J-Curve (LSE Dept of Econ, 2011). In the short run period, the current account gets declined and it affects the balance of payment due to the declining exchange rate. There are deficits in the BOP due to the reduction of the exchange rate (LSE Dept of Econ, 2011). The Mundell-Fleming Model explains that Keynesian practices and believes in the logic that cumulative economic activity is decided by aggregate demand. In the BOP, the current account is valued through the capital account independently. Furthermore, ‘purchasing power parity’ is not constant and volume of surplus of current account depends confidently on the real exchange rate and upon the real income it is negatively dependent (LSE Dept of Econ, 2011). The BOP equilibrium locus under the imperfect capital mobility is illustrated below in figure 4. Here ‘r’ is represented as interest rate, Y is represented as income; and the third endogenous variable relies upon the exchange rate regime that has been taken in account (LSE Dept of Econ, 2011). Figure 4 BOP & imperfect capital mobility (LSE Dept of Econ, 2011). Under the ‘imperfect capital mobility’ the exchange rate regime is affected that results in the decline in the balance of payment (LSE Dept of Econ, 2011). Dependence upon the IS curve is on the nominal exchange rate, which is illustrated below in figure 5. Figure 5 Nominal exchange rates (LSE Dept of Econ, 2011). There is increase in the IS curve due to the exchange rate regime under the normal exchange rate that does not affect the BOP negatively (LSE Dept of Econ, 2011). From figure 4 & figure 5, it can be concluded that in floating exchange rate regime, ‘e’ which is the nominal exchange rate, adjusts so as to maintain the zero BOP condition. In fixed exchange rate regime, ‘e’ is provided and government banks have to accomplish official foreign exchange involvement to preserve the fixed exchange rate (LSE Dept of Econ, 2011). Absorption Approach The absorption approach is an alternative to the elasticity approach. The approach states that a country’s trade balance will develop if its productivity of goods and services is more than its absorption (expenses by domestic population for goods and services). The absorption approach believes that currency depreciation will thrive simply if the space between domestic expenditure and output expands. However, the approach had not considered the account of capital movements in the BOP, ignored the monetary factors, assumed that there will be ‘full employment in the economy’ that is not appropriate and ignored the inflationary consequences of devaluation (Jrank, 2011). The impact of economic expansion and contraction: In the period of expansion of an economy, both income and absorption will tend to increase. This will affect the current account but the change that can occur in the current account will depend upon which one of the two will rise faster. In the period of contraction of an economy, both income and absorption will tend to decrease. This will affect the current account but the change that can occur in the current account will again depend upon which one of the two will fall sooner. According to the absorption approach, the BOP and the exchange rates are determined by the level of production in relation to the level of consumption. The reduction in the absorption does not always provide assurance that it will assist in eliminating deficits, which is same in the case of increase in the level of income (Ubishop, 2011). Monetary Approach The monetary approach views the BOP as the alteration in the monetary base less the modification in the domestic constituents. Monetary expansions under floating exchange rate regime are affected when there is decline in the nominal exchange rate due to the increase in the income. There is a drop in the real interest rate due to the imperfect mobility of the capital and it will continue as long as the capital is ‘imperfectly mobile’ and there are enhancements in the current account of BOP. The monetary expansion under the floating exchange rate regime is illustrated in figure 6 (Ardalan, 2003). Figure 6: Floating exchange rate regime (LSE Dept of Econ, 2011). The prices are fixed, thus the money supply can increase only if there is low level of interest rate. This will introduce outflow of capital and reduce the domestic currency demand. The equilibrium can be achieved when there is reduction in the exchange rate which will enhance the current account (LSE Dept of Econ, 2011). The monetary policy under fixed exchange rate regime: In the short run when there is imperfect mobility of capital, the interest rate will decline and there is increase in the income level. The result affects the BOP by declining the capital as well as current account. In the long run, there are no changes in the BOP, interest rate and output due to the decline in the foreign reserves. The monetary policy under fixed exchange rate regime is illustrated in figure 7 below (LSE Dept of Econ, 2011). Figure 7: Fixed exchange rate regime (LSE Dept of Econ, 2011). The effects can be minimised when there is increase in the level of money supply. The deficit that is present in the BOP will encourage reduction in the domestic currency demand. The Central Bank will sell its foreign reserves for domestic currency in order to intervene to uphold a fixed exchange rate (LSE Dept of Econ, 2011). The monetary approach focuses upon the decline in the domestic expenditure in comparison to the level of income for reduction of deficit in BOP. The approach contemplates upon excess or deficient nominal demand for securities and goods along with the resulting accumulation or non-accumulation of money. In the short run, it is not possible for the country to fully control the deficit balances in BOP with different approaches, but in the long run with different approaches the country can recover from the deficit BOP situation. In a structure of flexible exchange rates, the concentration of approaches changes from valuation of BOP to valuation of exchange rate (Ardalan, 2003). Conclusion The interrelationship factor between the exchange rate regime and viability of the alternative approaches for resolving the balance of payment crisis has been derived from the discussion. From the analytical point of view, it can be evaluated that monetary policy is more effective in handling the crisis when it can work out in a floating exchange rate regime. This is because in the arena of fixed exchange rate regime, the power of controlling the market stays in the hands of regulators. Thus, the economy has to solely depend on the automatic mechanism of the market for mitigating the crisis in balance of payment of a country. Although it is true that monetary policy even fails under the automatic mechanism, it works best if it can be employed under a floating exchange rate regime. References Ardalan, K., 2003. The Monetary Approach to Balance Of Payments: A Review of the Seminal Long-Run Empirical Research. University of Central Arkansas. [Online] Available at: http://sbaer.uca.edu/Research/allied/2003/Economics/new/Econ02.pdf [Accessed March 31, 2011]. Berg, A. & International Monetary Fund, 1999. Anticipating Balance Of Payments Crises: The Role of Early Warning Systems. International Monetary Fund. Investopedia, 2011. Balance Of Payments – BOP. Finance. [Online] Available at: http://www.investopedia.com/terms/b/bop.asp [Accessed March 31, 2011]. Jrank, 2011. Balance of Payment. Current Account. [Online] Available at: http://social.jrank.org/pages/1492/balance-payments.html [Accessed March 31, 2011]. LSE Dept of Econ, 2011. Elasticity Approach to the Balance of Payment. Economics. [Online] Available at: http://econ.lse.ac.uk/staff/gbenigno/own/teaching/Lecture6.pdf [Accessed March 31, 2011]. Pereira, J. A., 1998. Balance of Payments & Exchange Rates. George Washington University. [Online] Available at: http://www.gwu.edu/~ibi/minerva/Spring1998/Jose.Adriano.Pereira/Jose.Adriano.Pereira.html [Accessed March 31, 2011]. Ubishop, 2011. The Absorption approach to BOP and Exchange Rate Determination. International Finance. [Online] Available at: http://docs.google.com/viewer?a=v&q=cache:iw4eAeRT85MJ:www.ubishops.ca/faculty/cvalsan/InternationalFinance/absorptionbopxchg.ppt+absorption+approach&hl=en&gl=in&pid=bl&srcid=ADGEESjnOcRTqeHGzvoF9P_b_nk9Qtz-Zeq9V0QPiSouk2bQE5Ukf_yIquX8E22Dq-d1sfxTmPg5TxW3weojBRPIF_Kl0fZgrk9WmpkVijWX10Uu-0aP9GvBY-Ecy5KPdO3m6NkkMCZz&sig=AHIEtbTqNBj2yQ1lZC_gTzl4IhnT8EEITw [Accessed March 31, 2011]. Williamso, J., 2004. The Choice of Exchange Rate Regime: The Relevance of International Experience to China’s Decision. Institute for International Economics Publication. [Online] Available at: http://www.iie.com/publications/papers/williamson0904.pdf [Accessed March 31, 2011]. Bibliography Araujo, A. R & Lima, G. T., 2007. A Structural Economic Dynamics Approach to Balance-Of-Payments Constrained Growth. Cambridge Journal of Economics, 31, pp. 755–774. Bouzou, N., 2001. Monetary Policy and Financial Crisis. Ludwig Von Mises University. [Online] Available at: http://mises.org/daily/821 [Accessed March 31, 2011]. Clift, B & Tomlinson, J., 2008. Whatever Happened to the Balance of Payments ‘Problem’? The Contingent (Re) Construction of British Economic Performance Assessment. The British Journal of Politics & International Relations, 10 (4), pp. 607–629. Swansea University, 2011. The Monetary Approach to the Balance Of Payments. Economics. [Online] Available at: http://www.swan.ac.uk/economics/cware/ec312/Lecture%20Notes%20Topic%204%20on%20Monetary%20Approach%20to%20the%20Balance%20of%20Payments.pdf [Accessed March 31, 2011]. Read More