Balance of Payments and the Exchange Rate - Literature review Example

Finance and Accounting Table of Contents Executive summary 3 Research Question 4 Research plan 4 Reference list 9 Executive summary International Business aims to “merge historically distinct and separate market place into one huge global marketplace” (Allen, 1980). Since the government policies, economic structure, and currencies of the participating countries are different; a specified exchange rate, which is globally accepted, is followed and a balance of payment account is maintained by the countries. The research emphasizes on the impact of balance of payments and exchange rates on economic growth of a country. Recently, it has been noted that the frequent fluctuations in exchange rates and an unbalanced balance of payment are resulting in a negative impact on the economic growth of the countries. This paper establishes the relationship between the balance of payments, foreign exchange rates and economic growth. Balance of Payments of a country is defined as an account which records all the payments to and received from foreign countries (Pearson Education Inc., 2010). The balance of payments is divided into three main accounts, namely; Capital account, Current account, and Financial account. Exchange rates refer to the rate at which the foreign currencies are exchanged. The exchange rates are driven by the demand and supply in the foreign exchange markets. The exchange rates may show the tendency to depreciate if the demand for domestic currency decreases and vice versa. Economic growth of a country refers to its capacity to produce more goods and services in order to cater to the needs of the global market. A country is said to be economically strong when its products and services are in demand in the foreign markets. Research Question The world economy is growing at a declining rate. In spite of the introduction of new products and services in the blue ocean markets, the balance of payments of several countries and the exchange rates has been the barriers to their economic growth. The recent global crisis has been the also reason of unbalanced balance of payments account and fluctuating foreign exchange rates, which created a major impact on the world economy. This crisis turned many countries upside down, and led to the bankruptcy of several big players (Hill and Jain, 2007). In the light of the aforesaid situation, the research question is: How the balance of payments and exchange rates affect the economic growth? Research plan The balance of payment slows down the economic growth when the growth rate is influenced by the availability of external resources. This is determined by the production structure of the country, the resources and the policies of the country. The production structure of the country analyses the balance of payments of the country. There are several ways how the balance of payments hinders economic growth. The same are cited below: Cyclical movements – Balance of payments hinders economic growth when influenced by cyclical swings (Edwards, 1988). The response to variations in raw material and food prices and sharp volatility of capital flows often coincide with the export sector, which results in disequilibrium in the balance of payments. Several American countries and the Indian subcontinent have abundant resources which led to the increase in expectations, but the export incomes of these countries are so less that it gives rise to disequilibrium. The over-abundance of the resources leads to the major balance of payment crisis. Economic fluctuations are the result of unexpected games of the demand and supply in the economy (Edwards, 1988). The domestic cyclical fluctuations in the financial and current accounts of the balance of payments include the aggregate demand of the countries, which is knotted to the state of the business cycle. The balance of payments indicates that the current account deficit can be associated with either of the two factors, an increase in the financial balance or reduction in foreign reserves. The imports and investments increase during a boom period which results to the negative effect on the current account balance (Edwards, 1989; Anon, n.d.). Income Elasticity of Demand – The income elasticity of demand of the goods and services that are produced by most American countries and countries of the Indian subcontinent is lower than those goods which they import. The income elasticity of demand of a good is the percentage change in the demand of the good with respect to the percentage change in the income. If the result is greater than 1, the product has a good demand, and if the result is less than 1, it is termed to be a traditional good. This production specialization not only pressurizes on the trade deficit, but also creates an impact on the rate of technological change. The sudden increase in structuralist ideas came into light when the international business was dominated by the imports of the manufactured goods from other countries, instead of the export of raw materials to other countries. The industrial sector took more advantage of the economies of scale rather than the agricultural sector as the former was subject to technological changes and mass production and generation of employment. Since then, industrialization has become the path economic development of every country (Nesiones Unidas, 2012; Pearson Education Inc., 2010). Worsening of the terms of trade – The terms of trade are the outcome of the changes in the price of the imported goods and the changes in the price of the exported goods. The commodity prices increased at a rate slower than that of the manufactured goods. Since, the developing and the peripheral countries excelled in the production of the commodity good and the developed countries in the production of industrial products; the trade terms between these countries worsened which created a difficulty in maintaining the equilibrium of the balance the payments. This imbalance in production led to the import of the same quantities of goods and services by the peripheral countries in exchange of higher quantities of export. The worsening of terms of trade is also a result of difference in labour markets and production structures of the countries. There are several ways how the exchange rates hinder the economic growth. The same are cited below: Fluctuations in price inflation – With the increase in government spending, there has been a significant increase in inflation. The increase in the government spending increases output growth, but at the same time capacity limitation makes it necessary to increase the price in that particular period. The effects of inflation on the monetary growth are significant, both in current and lagged period. Anticipated exchange rate appreciation is the reason for price inflation. The changes in the real effective exchange rate are functions of its lag which depends on lagged price inflation. The positive effect of anticipated appreciated on price inflation implies adjustment of price inflation to the lagged values. Unanticipated appreciation of the rate of exchange reduces the price inflation. It reduces the requirement for exports and lowers aggregate demand. On the contrary, it reduces the costs of imported goods and services, and enhances the aggregate supply (Rodrick, 2008). Fluctuations in consumption growth – The exchange rate fluctuations have an impact on the components of aggregate demand which indicates fluctuations in real with policy variables. The government spending on output growth has been consistent, and along with that there is a significant increase in private consumption. The negative sign on consumption supports the failure of the monetary growth to stimulate growth in the current period. In the case of exchange rate fluctuations, consumption does not change with anticipated changes in exchange rate. Here, unanticipated change in the exchange rate is also insignificant. On the other hand, unanticipated depreciation has a positive impact on the growth and consumption demand (Pettinger, 2014). Fluctuations in investment growth – When the government spending to stimulate growth increases, the demand for investments increases. The failure of monetary growth to stimulate growth is also consistent with a negative and significant effect on investment demand. The current as well as the lagged anticipated appreciation have a negative impact on investment growth, which confirms that there is a negative effect of the anticipated appreciation on the supply side of the economy. The demand for investment decreases when the agents expect a reduction in external demand. On the contrary, the lagged value of unanticipated depreciation has a positive impact on the investment demand which increases the costs of imports and decreases investment demands (Harberger, 2003). Fluctuations in export growth – There is a negative effect on export demand when the government spending increases. The deficit and the interest rate increases due to higher government spending. Monetary growth does not push the economy to output growth, nor to export growth. The increased in lagged energy price decreases export demand. The higher the energy price of the country, the higher is the price inflation, which has a significant negative impact on the export growth (Cassino and Oxley, 2013). In several American countries and the countries in the Indian subcontinent, anticipated appreciation of the exchange rate has a negative effect on the export growth, which reduces competitiveness, switching demand and shrinking demand in favour of non-tradables. Similarly, lagged unforeseen depreciation has a negative effect on the economic growth. On the other hand unexpected depreciation fuel export growth but with a lag (Kandil, Berument and Dincer, n.d.). Reference list Allen, W. A., 1980. Exchange rates and balance of payments adjustments – general principles and some recent experiences [pdf] n.p. Available at: [Accessed 5 August 2014] Cassino, E., and Oxley, D., 2013. Exchange rate valuation and its impact on the economy [pdf] n.p. Available at: [Accessed 5 August 2014] Edwards, S., 1989. Real exchange rates, devaluation, and adjustment: exchange rate policy in developing countries. Cambridge. Massachusetts: MIT Press. Edwards, S., 1988. Real and monetary determinants of real exchange rate behaviour: Theory and evidence from developing countries. Journal of Development Economics, 29(3), pp. 311-341. Harberger, A. C., 2003. Economic growth and the real exchange rate: Revisiting the Ballassa-Samuelson effect [pdf] n.p. Available at: [Accessed 5 August 2014] Hill, C. W. and Jain, A. K., 2007. International business: Competing in the global marketplace (Vol. 6). New York, NY: McGraw-Hill/Irwin. Kandil, M., Berument, H. and Dincer, N., no date. The Effects of Exchange rate fluctuations on economic activity in Turkey. [pdf] n.p. Available at: < http://www.erf.org.eg/CMS/uploads/pdf/1184492772_Kandil_Hakan_Dincer.pdf > [Accessed 5 August 2014]. Nesiones Unidas, 2012. The Balance of Payments as a constraint on growth [online] [Accessed 5 August 2014] Pearson Education Inc. 2010. Chapter 27: Balance of payments and exchange rates [online] Available at: [Accessed 5 August 2014] Pettinger, T., 2014. Effect of exchange rate on business [online] Available at: [Accessed 5 August 2014] Rodrick, D., 2008. The real exchange rate and economic growth [pdf] n.p. [Accessed 5 August 2014]. Read More