Explaining the Balance-of-Payments Sheet - Essay Example

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). According to the BPM transactions, for the most part between residents and nonresidents, “consist of those involving goods, services, and income, those involving financial claims on, and liabilities to, the rest of the world; and those (such as gifts) classified as transfers which involve offsetting entries to balance – in an accounting sense – one-sided transaction” (International Monetary Fund, 1). 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: a. temporary; i.e. will be reversed in the near future; and b. permanent Simply put, the interest rate parity is the no-arbitrage relationship or condition that equates the difference between domestic and foreign interest rates to the expected change in the exchange rate or the forward exchange rate margin (Chen 198). What the concept implies is that the expected return on domestic assets has also the same return on the foreign currency assets. Here, an equilibrium state is achieved wherein interest rates in bank deposits are irrelevant to investors. According to De Brouwer, as cross-border trade in financial instruments increases, returns on identical instruments exhibit a greater tendency to equalize over time (52). He also explained that interest rate parity could either be covered interest rate parity or uncovered interest rate parity. The former condition involves capital flows that equalize expected rates of return on countries’ bonds, despite exposure to exchange risk whereas the latter involved capital flows that equalize interest rates across countries when contracted in a common currency. Closed interest rate parity holds if the rates of return are the same on instruments which are denominated in the same currency and are otherwise identical except that they are traded in different jurisdiction (De Brouwer 52). Uncovered interest rate parity will also hold in the same condition if the difference between rates of return on instruments which are identical except for their currency denominations equals the forward discount on the home currency. Each of the forms of interest rate parity – covered and uncovered – has their respective relationship to the manner by which future exchange rates can be predicted. Now, interest rate parity condition is important in the manner by which monetary policy will affect interest rates because monetary policy works within the dynamics of the exchange rates. What this means is that monetary policies have direct effect not only on interest rates but also an indirect effect on the expected future of exchange rates. The IMF provides an example: Success in halting depreciation with restrictive monetary policy is likely to hinge as much on convincing the market that this policy is relatively permanent (thus affecting the future exchange rate) as in maneuvering a favorable interest rate differential (IMF 23). Monetary expansion leads to a raise in the exchange rates as well as the improvement of the current account. In the context of the interest rate parity principle, capital will flow out of the country, then, the net deficit in the capital account accumulates, resulting to a net current account surplus when the local interest rate is lower than the rest of the world. This is part of the tendency to achieve equilibrium. Monetary expansion, depending on the economic regime of a country, could result to an increase in income, output, and capital outflow, improvement of current account and depreciation of currency. Based from these variables, it is easy to understand how temporary monetary expansions can achieve very limited impact while permanent monetary expansion could provide a larger positive effect on the economy. 3. Explain the basic mechanism(s) of growth, and compare and contrast the original “Harrod-Domar” model with the neo-classical model developed by Solow et. al. In this latter model, what is the engine of growth for developing economies as opposed to that for “advanced” (developed) economies? What, if any, are the implications for the “intertemporal” efficiency of competitive market economies? Borrowing from the words of Reinert, specialization is the basic mechanism by which growth is achieved. He cited that in the past 500 years, this has been the case wherein successful economic policy rests on the ability to recognize the fundamental difference between diminishing-return industries, in which specialization increases unit costs, and increasing-return industries, in which specialization decreases unit cost (Reinert 162). This has been previously explained by the economist Marshall who explained that countries can achieve economic growth by helping and encouraging economic activities that are subject to increasing returns while discouraging those subject to diminishing returns (Marshall 452). The specialization and the focus on increasing-return industries further gained legitimacy when the global economy was integrated and free trade became the norm. Both of these emergent economic phenomena are in themselves mechanisms of growth especially for developing countries since they could take advantage of the hugely expanded global trade and fast-track their industrial development. These mechanisms of growth are included in varying degrees as components of economic models that seek to explain and identify way to achieve and maintain economic growth. The Harrod-Domar model is a case in point. Essentially, the Harrod-Domar economic model explains that, “starting from a full employment equilibrium level of income, continuous maintenance of this equilibrium requires that the volume of spending generated by investment must be sufficient to absorb the increased output resulting from investment” (Gupta 132). This model focuses on the capital accumulation as the main driver of economic growth. This has been criticized by other economists especially those who belong to the neo-classical school due to the fact that it is characterized by an instability resulting from a linear capital-output ratio. For instance, there is the Solow model, which built on the neoclassical model of economic growth, which emphasized an understanding of the allocation of scarce resources among alternative ends (Colander 158). The Solow model was primarily designed in response to the Harrod-Domar model and it identified several variables (i.e. saving, population growth and technological progress) that impacts economic growth. As this economic model demonstrates, the neoclassical economic model rejects Harrod-Domar’s proposition arguing that capital is not the only factor that sustain economic growth. It assumed a multifactor model that also treated capital and labor as close substitutes to each other unlike in the Harrod-Domar model wherein they are considered perfect complements (Dwivedi 396). The Solow Model is an important component in the dominant neoclassical economic thought today. It provided the framework by which developing countries and advanced economies could achieve and sustain economic growth. This is explained in his theory that if we assume constant returns to scale and exogenous labor or population growth, then capital accumulation cannot be a source of long-run growth because when capital grows faster than labor, then diminishing return will set in and growth will not be sustainable (Easterly 1). The implication of this for the developing economies is that the productivity of capital would be higher, economic growth would be faster and that lending to these economies would provide higher return. In regard to the advanced economies, it is clear that what is needed is to the sufficient labor force in order to maintain their growth. The Solow Model supports the intertemporal efficiency of market economies. It must be underscored that it emphasizes the proximate drivers of growth – capital, labor, and technology. The model made it possible to conceptually increase production by proportionately adjusting the aggregate inputs. For instance, a high technological capability can be used to enhance production processes. According to Bourguignon, this makes it possible to rationalize increasing returns and to model growth as endogenous to the economy of preferences (497). When increasing returns are present and are external to firms, intertemporal markets prices may be effectively determined by competitive interactions. The mechanisms for economic growth have been the same in the past 500 years. They are successfully identified by economic models that offered formula for achieving and maintaining growth. The manner by which these mechanisms are used and explained in a cohesive framework distinguished each model from the other. Currently, the neoclassical school represented by the Solow Model is dominant economic framework. This is not surprising because it is multifactor in its approach. Works Cited Arize, Augustine. Balance of Payments Adjustment: Macro Facets of International Finance Revisited. Westport, CT: Greenwood Publishing Group, 2000. Print. Bourguignon, Francois. Handbook of Income Distribution. Oxford: Elsevier, 2000. Print. Chen, Zhaohui. Currency Options and Exchange Rate Economics. Singapore: World Scientific Publishing Co. Pte. Ltd., 1998. Print. Colander, David. The Lost Art of Economics: Essays on Economics and the Economics Profession. Cheltenham: Edward Elgar Publishing, 2003. Print. De Brouwer, Gordon. Financial Integration in East Asia. Cambridge: Cambridge University Press, 1999. Print. Dwivedi, D.N. Macroeconomics: Theory and Policy. New Delhi: Tata McGraw-Hill Education, 2010. Print. Easterly, William. Policy Distortions, Size of Government, and Growth. Washington, D.C.: World Bank Publications, 1989. Print. Gupta, K.R. Economics of Development and Planning. New Delhi: Atlantic Publishers & Distributors, Ltd., 2009. Print. Gwartney, James, et al. Macroeconomics: Private and Public Choice. New York: Cengage Learning, 2010. Print. International Monetary Fund. The Exchange Rate System: Lessons of The Past and Options for the Future : A Study. Washington, D.C.: International Monetary Fund, 1984. Print. IMF. Balance of Payments Manual. Volume 31. Washington, D.C.: International Monetary Fund, 1996. Print. Marin, Alan. Macroeconomic Policy. London: Routledge, 1992. Print. Marshall, Alfred. Principles of Economics. London: Macmillan, 1890. Print. Reinert, Edward. Globalization, Economic Development and Inequality: An Alternative Perspective. Cheltenham: Edward Elgar Publishing, 2004. Print. Riesenhuber, Eva. The International Monetary Fund under Constraint: Legitimacy of its Crisis Management. The Hague: Kluwer Law, 2009. Print. Read More