Honors Economics Unit 16 Review: Exchange Rates & Balance of Payments

Key Concepts

• Exchange rate measures the value of one currency in terms of another
• Balance of payments tracks all economic transactions between a country and the rest of the world
• Floating exchange rates determined by market forces of supply and demand
  • Influenced by factors such as interest rates, inflation, and political stability
• Fixed exchange rates pegged to another currency or a basket of currencies
  • Requires central bank intervention to maintain the fixed rate
• Appreciation occurs when a currency increases in value relative to another currency
• Depreciation happens when a currency decreases in value relative to another currency
• Current account includes trade in goods and services, income, and unilateral transfers
• Capital account encompasses financial transactions and investments

Exchange Rate Basics

• Exchange rate expresses the price of one currency in terms of another (e.g., 1 USD = 0.85 EUR)
• Nominal exchange rate unadjusted for inflation
• Real exchange rate adjusted for inflation differences between countries
• Bilateral exchange rate between two currencies
• Multilateral exchange rate weighted average of a country's currency relative to a basket of other currencies
• Appreciation makes exports more expensive and imports cheaper
  • Can lead to a decrease in net exports and a trade deficit
• Depreciation makes exports cheaper and imports more expensive
  • Can stimulate domestic production and increase net exports

Balance of Payments Fundamentals

• Balance of payments divided into current account and capital account
• Current account includes trade balance (exports minus imports), net income from abroad, and net unilateral transfers
• Capital account tracks financial transactions and investments
  • Includes foreign direct investment (FDI), portfolio investment, and reserve assets
• Balance of payments always balances, as the sum of the current and capital accounts equals zero
• A current account deficit must be financed by a capital account surplus (net inflow of foreign capital)
• A current account surplus corresponds to a capital account deficit (net outflow of domestic capital)
• Official reserve transactions involve central banks buying or selling foreign currencies to maintain a desired exchange rate

Exchange Rate Systems

• Floating exchange rates determined by market forces without government intervention
  • Clean float no government intervention
  • Dirty float occasional government intervention to stabilize the currency
• Fixed exchange rates pegged to another currency or a basket of currencies
  • Requires central bank to buy or sell foreign currency to maintain the fixed rate
• Managed float combines elements of floating and fixed exchange rates
  • Central bank intervenes to influence the exchange rate without a specific target
• Currency board an extreme form of a fixed exchange rate system
  • Domestic currency fully backed by foreign reserves
• Dollarization occurs when a country adopts a foreign currency (often the US dollar) as its official currency

Factors Affecting Exchange Rates

• Interest rates higher interest rates attract foreign capital, leading to currency appreciation
• Inflation higher inflation typically leads to currency depreciation
• Economic growth stronger economic growth can lead to currency appreciation
• Political stability and risk political instability can cause currency depreciation
• Government debt high levels of government debt can lead to currency depreciation
• Current account balance a current account deficit can lead to currency depreciation
• Speculation and market sentiment can cause short-term fluctuations in exchange rates

International Trade and Currency

• Exchange rates influence the competitiveness of a country's exports and imports
• Appreciation makes exports more expensive and imports cheaper, potentially worsening the trade balance
• Depreciation makes exports cheaper and imports more expensive, potentially improving the trade balance
• J-curve effect a depreciation may initially worsen the trade balance before improving it over time
• Marshall-Lerner condition states that a depreciation will improve the trade balance if the sum of the absolute values of the export and import demand elasticities is greater than 1
• Purchasing power parity (PPP) theory suggests that exchange rates should adjust to equalize the prices of goods across countries
• Exchange rate pass-through the degree to which changes in exchange rates are reflected in import prices

Policy Implications

• Exchange rate policy can be used to influence trade, inflation, and economic growth
• Devaluation a deliberate decrease in the value of a currency to boost exports and economic growth
  • Can lead to higher inflation and reduced purchasing power for consumers
• Revaluation a deliberate increase in the value of a currency to combat inflation and improve purchasing power
  • Can lead to a decrease in exports and slower economic growth
• Capital controls restrictions on the flow of capital into and out of a country
  • Can be used to manage exchange rate volatility and prevent speculative attacks
• Monetary policy changes in interest rates can influence exchange rates and capital flows
• Fiscal policy changes in government spending and taxation can affect exchange rates through their impact on economic growth and inflation

Real-World Applications

• China's managed exchange rate system has been a source of controversy in international trade
  • Critics argue that China undervalues its currency to boost exports
• The European Union's common currency, the euro, has faced challenges during the European debt crisis
  • Some argue that the lack of independent monetary policy has hampered the ability of member countries to adjust to economic shocks
• The US dollar's role as the world's primary reserve currency has implications for global trade and finance
  • Changes in US monetary policy can have spillover effects on other countries
• Currency crises, such as the Asian financial crisis of 1997-1998, highlight the risks of fixed exchange rate systems and capital account liberalization
  • Speculative attacks can lead to sharp devaluations and economic turmoil
• The rise of cryptocurrencies, such as Bitcoin, has sparked debates about the future of money and the role of central banks in the digital age