Balance of Payments and Exchange Rates - Essay Example

Balance of Payments and Exchange Rates Introduction Countries around the world have huge economies, and in order to judge how these economies are doing there are a couple of essential elements one must know about. Whereas companies may use a balance sheet in order to show financial status, you can tell a lot about a country's financial status and their imports and exports by looking at their balance of payments. Another essential element that can be an indicator of a country's economic health is their exchange rates. Exchange rates compare the currency of one country to that of another. There are many ways in which the exchange rates can affect an economy. Understanding how exchange rates and balance of payments are linked is important to understanding how a country's economy interacts with that of other countries around the world. Balance of Payments The balance of payments comprises all of the economic transactions between members of one country and members of all other countries. This includes any trade of goods and services, investments, payments and loans. The balance of payments is made up of several accounts. The current account includes goods trade, services trade, income and transfers of ownership. The capital account includes transfers of assets and acquisitions. The financial account is made up of direct investments into the country, portfolio investments, and various investments. In order to balance out the current and financial accounts should offset each other (Moffett, Stonehill, Eiteman 2006, 73). When there is more money coming in than going out balance of payments will be in surplus, and when more money has gone out than come in there will be a deficit. This is what can affect exchange rates as we will see below. Exchange Rates Exchange rates are the value of one country's currency in relation to that of another country's currency. In other words how much is your unit of currency worth in another country's unit of currency. Exchange rates reflect the supply and demand for a country's currency in the world market. However some governments, depending on their monetary policy, may seek to ensure their currency has a certain value in the market. A country with a fixed exchange rate policy maintains a set level for their currency by using reserves to either buy up excess currency so flood the market with currency when there is a demand. Floating exchange rate countries let the market determine their exchange rate; this is normally done by a country with a strong economy. A country operating on a managed float uses factors such as interest rates in order to influence the price or their currency in the market and keep it around a certain level. A government's monetary policy can influence the effect that balance of payments has on exchange rates. Linkages There are significant links between a country's balance of payments and exchange rates. As Layton, Robinson and Tucker (2005, 56) point out "Each transaction recorded in the balance of payments requires an exchange of one country's currency for that of another." The level of a country's exchange rate has an impact on the balance of payments and vice versa. Surplus in the balance of payments usually means that the demand for a country's currency is greater than supply; on the other hand a deficit in balance of payments indicates there is too much of a country's currency in the market. How significant an impact depends on a country's exchange rate regime (Moffett, Stonehill, Eiteman 2006, 76). In this way government policy, specifically monetary policy affects what kind of impacts balance of payments and exchange rates have on each other. In countries with a fixed exchange rate regime the government's policy requires them to act when the Balance of Payments is not near zero. In this case, "the government is expected to intervene in the foreign exchange market by buying or selling official foreign exchange reserves" (Moffett, Stonehill, Eiteman 2006, 77). Governments with a fixed exchange rate must maintain a large amount of reserves in order to be able to keep the balance of payments near zero. If they are unable to do this then they will have to devalue their currency. So in terms of fixed exchange rate policies balance of payments not near zero can cause a country's currency to have to be re-valued in order to maintain the balance. In the case of a country with a floating exchange rate monetary policy a country does not seek to maintain a certain level for their currency but instead lets if float freely in the market. If the balance of payments does not equal zero then, "this will in theory alter the exchange rate in the direction necessary to obtain a balance of payments near zero" (Moffett, Stonehill, Eiteman 2006, 77). Some countries choose to operate under a monetary policy known as a managed float. In this case a country allows it's currency to float in the market but will intervene in order to ensure the exchange rate stays at a desired level. In other words they actively seek to influence the exchange rate. "The primary action taken by such governments is to change relative interest rates, thus influencing the economic fundamentals of exchange rate determination" (Moffett, Stonehill, Eiteman 2006, 77). Interest rate changes affect a currency's value by creating demand for the currency if they are raised because this attracts people and businesses to further invest in the country. Finally it is important to realise that "balance of payment is an important indicator of pressure on a country's foreign exchange rate and changes in the balance of payments may predict the imposition or removal of foreign exchange controls" (Moffett, Stonehill, Eiteman 2006, 64). Conclusion The balance of payments and exchange rates of a country are unavoidably linked, in that each one affects the other. The extent of the affect depends largely on the government's monetary policy. A fixed exchange rate policy requires the most intervention by the government in order to maintain not only a balance of payments near zero, but a certain exchange rate in the world market. Floating exchange rate policies require the least intervention by governments, since if the balance of payments is not at or near zero the market will automatically adjust the exchange rate to make it so. Finally floating exchange rates require government to influence the exchange rate by altering other factors such as interest rates. These can in turn alter the exchange rate to a level that has the balance of payments at or near zero. A country's overall financial picture can be obtained by looking closely at these two factors and so then it is important for us to understand how they are linked, and how they influence one another. References Moffett M., A. Stonehill and D. Eitman. 2006. Fundamentals of Multinational Finance. Boston: Pearson Addison Wesley. Layton, A., T. Robinson and I. Tucker. 2005. Economics for Today, 2nd edition. Southbank, Vic: Thomson. Shapiro, A. 2003. Multinational Financial Management, 7th edition. New York: Wiley. Read More