Exchange Rate Regime in Resolving BoP Crisis - Coursework Example

International Monetary Table of Contents Introduction 3 Exchange Rate Regime in Resolving BoP Crisis 4 Alternative Approaches in Resolving BoP Crisis4 Viability of Classical and Keynesian Approach with Respect to Exchange Rate Regime 5 Viability of Monetary Approach with Respect to Exchange Rate Regime 6 Interrelationship between the Exchange Rate Regime and the Monetary Approaches in International Monetary Framework 7 Monetary Expansion under the Floating Exchange Rate Regime 8 Conclusion 10 References 11 Bibliography 13 Interrelationship between the Exchange Rate Regime and Viability of the Alternative Approaches to Resolving a Balance of Payment Crisis Introduction This study is concerned about evaluating various measures taken up by the government of a country for resolving balance of payment (BoP) crisis. The aim of this paper is to critically evaluate the degree of relationship between those measures. But before presenting an in-depth discussion on this topic area, it would be essential to understand the root cause of the crisis in balance of payment. This occurs when it becomes impossible to maintain the deficit in the current account. This situation indicates, in general sense, that there will be shortage in the foreign exchange reserves and the particular country is no longer in a position to attract sufficient amount of capital inflows for financing the deficit. For handling this situation of crisis, the government takes measure with the motto of reducing the spending of consumers on imports (Economics Help, 2011). The paper will be presented in a compact manner with the brief explanations about the policies undertaken within the exchange rate regime and alternative approaches and then taking up the interrelationships between the two phenomena along with their critical evaluation. Exchange Rate Regime in Resolving BoP Crisis The approaches under the exchange rate regime are floating, fixed and pegged exchange rate regime. Under the fixed and pegged exchange rate regime, the central bank strives to maintain the stability in local currency’s exchange rate through buying and selling foreign currency. The only difference in the two cases is that in case of fixed exchange rate regime, the central bank does not enjoy any control over the interest rates and monetary aggregates; whereas in the case of pegged exchange rate system, the central bank does so for achieving stability in price. In case of the floating exchange rate regime, the government does not intervene and the rate is determined by the foreign exchange market itself (Olson & He, 2011). Alternative Approaches in Resolving BoP Crisis The alternative approaches to resolve balance of payment crisis deals with the adjustment mechanisms which can be either automatic or discretionary. Automatic adjustment for resolving BoP crisis takes into account four variables under the fixed exchange rate regime. The variables are prices, interest rates, income and money. The alternative approaches, however, are three schools of thought on the adjustment mechanism. The viability of the three schools of thought that will be discussed in this paper are classical approach (1800s - early 1900s) which was centered around standard of gold and mainly emphasized on interest rates and prices, the Keynesian approach (1930s onwards) that emphasized on changes in income affecting adjustment and Monetary approach that emphasized on the role of money in adjustment and changes (Carbaugh, 2005). Viability of Classical and Keynesian Approach with Respect to Exchange Rate Regime The mechanism in the classical approach with respect to price adjustment was that money supply (in terms of gold) was directly related to BoP and BoP deficit would cause the money supply to shrink. This means nations in crisis would lose gold and cause the prices to fall. The lowered prices would result in competitive exports and reduce import demands, thus would restore equilibrium. The problem with this approach is that gold flows are not directly related to domestic supply of money and the nations are not always at full employment. Moreover, decrease in money supply will affect employment and output adversely rather than prices. Another consequence of classical approach with respect to interest rate adjustment is that inflows of gold results in expansion of money supply thus cause the short term interest to fall and vice-versa. Its effect is that the deficit nations would restore equilibrium by receiving gold from other nations for investment. Following the Keynesian approach with respect to income adjustment, it is assumed that deficit nation will experience a fall in income leading to decreased demand in import, thus partially would offset the deficit. Keynesian approach believes the foreign repercussions effect to exist that states deficit of one country means surplus of another country. When the income decreases in one country, its export to a country with rising income will increase. Thus equilibrium will be automatically restored in the BoP of the nations. The problem with the automatic mechanism towards restoring BoP equilibrium is that it demands that the government should not intervene and thus is only effective in case of floating exchange rate regime. Thus, these mechanisms seem inadequate when the nation is faced with shrinking output and unemployment. Viability of Monetary Approach with Respect to Exchange Rate Regime According to the perspective of monetary approach, disequilibrium in BoP is caused as a result of demand and supply in money supply. It postulates that imbalances in the money market influence the balance of payments which is measured by international reserves. Under fixed exchange rate regime, excess supply of money determines increased expenditure and thus increases imports. Excess purchases demands financing through running down the foreign exchange reserves which worsens the situation of BoP. The foreign exchange reserves outflow results in decreased money supply until it is equal to the demand for money. Therefore, monetary equilibrium is restored and also halts foreign exchange reserves outflow. An opposite happens when there is excess money demand but the ultimate result is that equilibrium is restored in the BoP (Dhliwayo, 1996). The monetary adjustment to balance of payment concentrates on domestic monetary policy; increased money supply leads to deficits in BoP whereas increased money demand leads to BoP surpluses. The theory under monetary approach in relation to exchange rate regime states that in the long run, devaluation in the exchange rate is ineffective. Interrelationship between the Exchange Rate Regime and the Monetary Approaches in International Monetary Framework The international monetary framework is that system where rates of foreign exchange are determined, accommodation of capital flows and international trade takes place and above all adjustments in the balance of payment are made. The framework details about the real possibilities of generating equilibrium in the BoP taking into consideration that the exchange rate regime is appropriate for the alternative approaches towards the resolving problem. The following facts depict the necessity of certain exchange rate regime on the basis of the premise that countries generally prefer fixed exchange rates (Edwards, 2001). Stability is ensured through fixed exchange rate in trading internationally and it reduces risks for the businesses, thus aid in international trade growth. Fixed exchange rates initiate the country to follow both restrictive monetary as well as fiscal policies because the rates are anti-inflationary. However, the restrictiveness can lead to country’s burden and the country might be willing to pursue policies for alleviating economic problems internally inclusive of high rate of unemployment (Bleaney & Francisco, 2005). Fixed exchange rate regimes demand the central bank should hold large international reserves, both gold and currencies, for utilizing those in case of defending the fixed rate. But the problem is that excessive holdings of reserves have evolved as a trouble for many nations. With the changes in the nation’s economic structure, the exchange rate should also change. Fixed exchange rate becomes inconsistent with the fundamentals of economics but floating exchange rate helps in allowing the trade balances and relationships to evolve efficiently (International Business Finance, 2003). Monetary Expansion under the Floating Exchange Rate Regime From the discussion on certain exchange rate regimes and the viability of alternative approaches for resolving BoP crisis, it can be interpreted that crisis is best resolved in the case of monetary expansion under a floating exchange rate regime. The effects of such a mechanism will result in the following aspects for a nation: The nominal exchange rate will be depreciated ensuring increase in money supply, thus favorable condition for nations will evolve Increase in level of income within the nation will prevail due to higher investment generated by high supply of money The real interest rate will fall for the time being as long as there is imperfect mobility in the capital The current account of the BoP will improve due to restoration of equilibrium in the function of demand and supply of money (Department of Economics, 2011). Conclusion The factor of interrelationship between the exchange rate regime and alternative approaches towards resolving the balance of payment crisis have been arrived from critical analysis of the alternative approaches as well as evaluation of the exchange rate regimes. From the analytical overview, it is clear that BoP crisis can be effectively handled through monetary expansion under the floating exchange rate regime. Fixed exchange rate regime does not allow control over the market mechanism in the hands of any regulator. Economy under this regime has to depend on the automatic mechanism (Jimoh, 2004). Although monetary approach also falls under the automatic mechanism, the results are best expected when it operates under a floating exchange rate regime. This is because, in the floating exchange rate regime, exchange rates are determined by the market system which is the best regulator of currency valuation in the present era of modern economy. The critical factor of modern economy is initiated by the customers’ changing tastes and preferences and also their purchasing power. References Bleany, M. & Francisco, M., 2005. Classifying Exchange Rate Regimes: A Statistical Analysis of Alternative Methods. Credit Research Paper. [Online] Available at: http://www.nottingham.ac.uk/credit/documents/papers/07-05.pdf [Accessed April 01, 2011]. Carbaugh, R. J., 2005. International Economics. Courses. [Online] Available at: http://econweb.umd.edu/~araujo/courses/econ340/slides/Chapter13.pdf [Accessed April 01, 2011]. Department of Economics, 2011. Elasticity Approach to the Balance of Payment. Lecture 6. [Online] Available at: http://econ.lse.ac.uk/staff/gbenigno/own/teaching/Lecture6.pdf [Accessed April 01, 2011]. Dhliwayo, R., 1996. The Balance of Payment as a Monetary Phenomenon: An Econometric Study of Zimbabwe’s Experience. Bitstream. 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