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Explain the Balance-of-Payments BoP - Essay Example

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1. Explain the Balance-of –Payments (BoP) and its relationship to the foreign-exchange (“forex”) market under: a) a free-floating currency regime; and b) a “fixed-rate” currency regime. The Balance of Payments Manual (BPM) published by the International Monetary Fund defines Balance of Payments (BoP) as “the statistical statement that systematically summarizes, for a specific time period, the economic transactions of an economy with the rest of the world” (International Monetary Fund 1)…
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Explain the Balance-of-Payments BoP
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Explain the Balance-of-Payments BoP

Download file to see previous pages... This definition provides the fundamental relationship between BoP and the foreign exchange market. Foreign exchange is considered as a transaction made by citizens, organizations and businesses within a country with foreigners, hence, it is included in the national summary to keep track and calculate transactions with other countries. Specifically, the foreign exchange market creates a demand for foreign currency in addition to a supply of the domestic currency in the forex market. Gwartney et al. explains that since the foreign exchange market will bring quantity demanded and quantity supplied into balance, it will also bring the total debits and total credits into balance” (420). Foreign exchange is different from a simple demand for money. When country demands money it means people of such country require or demand money they would be able to hold and use. In foreign exchange, the currency is treated like a product being transacted, wherein the demand for such currency means that one is offering another within a form of exchange. In an open economy, particularly, the balance of payments surpluses and deficits are considered equivalent to imports and exports of domestic currency, which means the internal disparities that arise between the demand for and supply of money are correctable through the balance of payments (Riesenhuber 285). This is best depicted within the fixed exchange rate regime. In a fixed exchange rate regime, a country’s Central Bank has control over the exchange rate. This is achieved through the readiness of the bank to purchase or sell its home currency at a specific rate when required. Marin used the case of the United Kingdom as an example: There is a UK balance of payments surplus so that there is an excess demand for ?, the Bank of England has to sell ? in order to mop up the excess demand which (like any other demand) would otherwise cause a rise in the foreign exchange price of the ?, i.e. an appreciation (Marin 149). In the fixed foreign exchange rate, the government involvement or actions can induce changes and affect certain variables such as those that make up the balance of payments (i.e. the balance of goods movements). Most of the foreign exchange markets and regulatory regimes use this model because of the recognized need for the government’s role in stabilizing fluctuations. The fixed-rate regime is also being made imperative by explicit balance of payment policies, which favor managed flexibility especially on the need to insulate the domestic economy from foreign disturbances (Arize 177). In Free Floating Exchange Rate Regimes, the Central Bank or similar authority is not involved in the foreign exchange market. It is determined freely by the demand for, and the supply of, foreign currencies by private parties (Arize 177). The transactions that transpire are reflected in the balance of payments of a country as is, without any correction made. 2. Explain the so-called “interest-parity” condition and use this to discuss the effects of a country’s monetary expansion on its interest rate, exchange rate, and output (hence employment) when this policy is: ...Download file to see next pagesRead More
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