Exchange Rate Regimes: Balance of Payments & Foreign Exchange Market

38 Exchange Rate Regimes
(a) Exchange rate
(b) Foreign currency price
2.20
17
15
1.80
13
11
1.40
9
1.00
7
0.60
5
1 9 17 25 33 41 49 57 65 73 81 89 97
1
9 17 25 33 41 49 57 65 73 81 89 97
(c) Quantity
(d) Domestic currency revenue
90
900
850
800
80
750
700
70
650
60
1
9 17 25 33 41 49 57 65 73 81 89 97
600
1 9 17 25 33 41 49 57 65 73 81 89 97
Figure 2.8 The effect of changes in the exchange rate on domestic currency
revenue (100 simulations)
exchange rate, the foreign currency price, the quantity sold and the
domestic currency revenue. Obviously, volatility in the domestic currency revenue is associated with exchange rate volatility.
The balance of payments and the exchange rate
One of the arguments for flexible exchange rates and against fixed rates
pertains to the balance of payments adjustment mechanism under the
two regimes. Therefore, it is worthwhile examining in detail the relationship between the balance of payments and the exchange rate.
This relationship arises because the transactions involving trade and
capital flows, which are recorded on the balance of payments, give rise to
demand for and supply of currencies. Transactions in the market for goods
and services, such as imports and exports, give rise to demand for and
supply of foreign exchange respectively. Equivalently, these transactions
lead to the supply of and demand for the domestic currency respectively.
The Role of the Exchange Rate in the Economy 39
Transactions in financial markets, which are recorded on the capital
account, also lead to demand for and supply of currencies. The sale of
domestic securities and the purchase of foreign securities give rise to
demand for foreign exchange (supply of domestic currency). Conversely,
the purchase of domestic securities and the sale of foreign securities give
rise to demand for the domestic currency (supply of foreign exchange).
The relationship between the balance of payments and the foreign
exchange market is, therefore, obvious. For each transaction on the
foreign exchange market there is a corresponding entry on the balance
of payments. For the purpose of illustrating this relationship further we
will examine the foreign exchange market from the perspective of the
foreign currency, such that the exchange rate, E, is measured as the
domestic currency price of one unit of the foreign currency. Three
possible cases are illustrated in Figure 2.9, which shows the demand
for and supply of foreign exchange curves (D and S respectively). In
Figure 2.9(a), the foreign exchange market is in equilibrium at the
exchange rate E0, at which the supply of and demand for foreign
exchange are equal. This is equivalent to saying that the balance of
payments is in equilibrium. In Figure 2.9(b), there is excess demand
for foreign exchange at the exchange rate E1, which is below the equilibrium exchange rate. This excess demand is equivalent to a deficit on the
balance of payments. Finally, Figure 2.9(c) shows the case when there is
excess supply of foreign exchange, which is equivalent to a surplus on
the balance of payments. This occurs at the exchange rate E2.
Let us for simplicity concentrate on the current account of the balance
of payments by assuming that exports and imports are the sources of,
supply of and demand for foreign exchange. Given this simplifying
assumption about its structure, the relationship between the balance
of payments and the foreign exchange market can be restated by examining the demand for and supply of imports and exports as represented
in Figure 2.10. Since we are still examining the relationship from the
*
perspective of the foreign currency, the prices of imports and exports, Pm
*
and Px respectively, are expressed in foreign currency terms. Figure
2.10(a) shows the supply and demand curves for imports, Sm and Dm,
both of which are drawn as linear functions relating the quantity of
imports, Qm, to the foreign currency price of imports. The area of the
rectangle defined by the axes and the point of intersection of the supply
and demand curves represents the amount of foreign exchange spent on
imports (that is, import expenditure). Recalling that the demand for
imports leads to demand for foreign exchange, import expenditure
should be equivalent to the demand for foreign exchange. Likewise,
40
(a) Balance of payments equilibrium
E
S
E0
D
Q
(b) Balance of payments deficit
E
S
E1
Excess demand
D
Q
(c) Balance of payments surplus
E
S
E2
Excess supply
D
Q
Figure 2.9 The relationship between the balance of payments and the exchange
rate
The Role of the Exchange Rate in the Economy 41
Px∗
Pm∗
Sx
Sm
Dx
Dm
Qm
(a) Import expenditure = demand for
foreign exchange
Qx
(b) Export revenue = supply of
foreign exchange
Figure 2.10 Import expenditure and export revenue
the rectangle in Figure 2.10(b) defines export revenue and hence the
supply of foreign exchange. Bearing these points in mind, we can proceed to derive the demand for and supply of foreign exchange curves by
considering what happens to import expenditure and export revenue as
the exchange rate changes.
Consider the demand side first. It is important to remember that
imports are foreign goods consumed in the home country. Domestic
consumers base their decision concerning the amount of imports they
choose to consume on the domestic currency price of imports. For simplicity we assume that this price can be obtained by converting the
foreign currency price at the current exchange rate, by using the equation
Pm ¼ EPm
ð2:8Þ
*
where Pm and Pm
are the domestic currency and foreign currency prices
of imports respectively. Let us now specify the demand for imports as a
function of the domestic currency price. The import demand function
may be written as
Qm ¼ 0 1 P m
ð2:9Þ
where 0 and 1 are positive constant parameters and Qm is the quantity
of imports demanded. By substituting equation (2.8) into equation
(2.9), we obtain
Qm ¼ 0 1 EPm
ð2:10Þ
42 Exchange Rate Regimes
Hence, the demand for foreign exchange function can be written as
2
1 EPm
Qf ¼ 0 P m
ð2:11Þ
which gives
@Qf
2
¼ 1 Pm
@E
ð2:12Þ
The effect of the exchange rate on the demand for foreign exchange is
unambiguous because the rise in E reduces the quantity of imports
demanded, Qm, without affecting the foreign currency price of imports,
*
*
. Therefore, the product Pm
Qm , which measures import expenditure
Pm
(and hence the demand for foreign exchange), must decline.
Consider now the supply side, starting with the relationship
Px ¼
Px
E
ð2:13Þ
where Px and Px* are the domestic currency price and foreign currency
price of exports respectively. Since exports are domestic goods that are
consumed abroad, the demand for exports is specified as a function of
the foreign currency price. Hence, the export demand function takes the
form
Qx ¼ 0 1 Px
ð2:14Þ
where 0 and 1 are positive constant parameters and Qx is the quantity
of exports demanded. From equations (2.13) and (2.14), we can see that
a rise in E reduces the foreign currency price, leading to an increase in
the quantity of exports demanded. Because the price and quantity move
in opposite directions, the net effect on export revenue, and hence on
the supply of foreign exchange, is ambiguous. It could rise, fall or stay at
the same level. The supply of foreign exchange function is then
Qf ¼ 0 Px 1 Px2
ð2:15Þ
By combining (2.15) and (2.13) we obtain
Qf ¼
0 Px 1 Px2
2
E
E
ð2:16Þ
Hence, the slope of the supply curve is
@Qf
0 Px 21 Px2
¼ 2 þ
@E
E
E3
ð2:17Þ
The Role of the Exchange Rate in the Economy 43
which may be positive or negative, depending on the level of the
exchange rate (positive at low exchange rates and vice versa). In fact
the supply curve will be backward-bending, having a positive slope at
low exchange rates.
Figure 2.11 shows the downward-sloping demand curve and the
backward-bending supply curve. Because the supply curve is backwardbending, the equilibrium exchange rate may not be unique. In Figure
2.11, it is shown that there are three equilibrium values for the exchange
rate: E1, E2 and E3. Multiple equilibria create several problems, the first
of which is that some equilibrium exchange rate values are unstable. It is
typically the case that each unstable equilibrium is bounded by two
stable equilibria. When the exchange rate is above E2, it tends to move
to E3, and when it is below E2 it tends to move to E1. The second
problem is that the equilibrium values of the exchange rate are ranked
differently by the two countries involved in the bilateral exchange rates.
For example, one country may prefer E1 while the other prefers E3.
A situation like this could lead to conflict in the economic policies of
the two countries.
The third problem is that speculation as well as balance of payments
disturbances may cause sharp fluctuations in the exchange rate, which
lead to an unnecessary and wasteful reallocation of resources. For
E
S
E3
E2
E1
D
Q
Figure 2.11 Multiple equilibria in the foreign exchange market
44 Exchange Rate Regimes
example, if the exchange rate rises slightly above E1, speculators will
start buying the foreign currency, thinking that it will rise further. The
exchange rate will rise beyond the unstable level E2, all the way to the
stable level E3. When it reaches E3, speculators sell the foreign currency,
causing the exchange rate to fall all the way to E1. The effect of a balance
of payments disturbance is illustrated in Figure 2.12. A fall in the
demand for foreign exchange is represented by a shift in the demand
curve, and the equilibrium exchange rate falls from E1 to E2. This big
drop is caused by the backward-bending nature of the supply curve.
Changes in the exchange rate would be less dramatic under a normal
upward-sloping supply curve.
The effect of the exchange rate on the current account of the balance
of payments emanates from the effect of changes in the exchange rate
on prices and, therefore, the demand for domestic and foreign goods
(exports and imports). When the exchange rate rises (the domestic
currency depreciates), prices of exports in foreign currency terms fall
while prices of imports in domestic currency terms rise. If the elasticities
of the demand for exports and imports are sufficiently high, then the
demand for imports falls and the demand for exports rises, leading to
improvement in the current account. This chain of reasoning is the basis
of using devaluation to correct a balance of payments deficit.
E
S
E1
E2
D
Q
Figure 2.12 The effect of a balance of payments disturbance when the supply
curve is backward-bending
The Role of the Exchange Rate in the Economy 45
Figure 2.13 illustrates the effect of devaluation of the domestic currency (a higher exchange rate) on the current account. In Figures 2.13(a)
and 2.13(b), devaluation is ineffective because the elasticities of demand
for imports and exports are low. In this case, devaluation results in a
small reduction in import expenditure, as shown by Figure 2.13(a), and
a fall, rather than a rise, in export revenue, as shown by Figure 2.13(b).
The latter occurs because devaluation in this case reduces the foreign
currency price of exports by more than the increase in the quantity of
exports demanded. Hence, devaluation may lead to deterioration rather
(a) Inelastic demand for imports
∗
Pm
(b) Inelastic demand for exports
∗
Pm
Sx
Sm
Dm
Dx
Qx
Qm
(c) Elastic demand for imports
∗
Pm
(d) Elastic demand for exports
∗
Pm
Sx
Sm
Dm
Dx
Qm
Figure 2.13 The effect of devaluation when elasticities are high and low
Qx
46 Exchange Rate Regimes
than improvement in the current account. In Figure 2.13(c) and 2.13(d),
on the other hand, demand is elastic. Hence, devaluation causes a
significant reduction in import expenditure and a rise, not a fall, in
export revenue. The result is improvement in the current account.
This type of analysis is referred to as the elasticities approach to the
balance of payments. The core of this approach is the Marshall–Lerner
condition, which tells us that devaluation will have a favourable effect
on the current account if the sum of the absolute values of the elasticities of demand for exports and imports is greater than unity. This
approach has an important implication for the dynamic response of
the current account to devaluation (or depreciation). The response is
different in the short run (the period immediately following devaluation) than it would be in the long run (the period further out in the
future). This is because the elasticity of demand is lower in the short run
than in the long run. If the Marshall–Lerner condition is satisfied in the
short run but not in the long run, there is a possibility that the current
account may deteriorate even further in the short run before recovering
in the long run. This behaviour is described in Figure 2.14. At time t1, the
current account is in deficit, and a decision is taken to correct it by
devaluation. In the period immediately following devaluation, the current account deteriorates, registering an even greater deficit. With the
passage of time, elasticities increase and once the Marshall–Lerner
condition is satisfied, the current account starts to improve. At t2, the
+
t1
t2
–
Figure 2.14 The J-curve effect
t3
Time
The Role of the Exchange Rate in the Economy 47
deficit reaches its highest value, and from then onwards it starts to
shrink. At t3, the deficit is eliminated, and this is followed by the
achievement of a surplus. The time path of the current account position
resembles the letter J, and this is why this process is called the ‘J-curve
effect’.
Another approach is the absorption approach associated with
Alexander (1952). The starting point is the national income identity,
which can be written as
Y ¼ C þ I þ G þ ðX M Þ
ð2:18Þ
where Y is national output or income, C is consumption, I is investment
(capital formation), G is government expenditure, X is exports and M is
imports. Equation (2.18) can be written as
XM ¼Y A
ð2:19Þ
where absorption, A, is given by
A¼CþIþG
ð2:20Þ
Thus, if Y > A, the current account is in surplus, whereas if Y < A, it is in
deficit. The absorption approach can be illustrated as follows. First,
define consumption as the difference between income and saving,
which gives
C¼Y S
ð2:21Þ
where S is saving. By ignoring G and substituting equation (2.21) into
equation (2.20) we obtain
Y A¼SI
ð2:22Þ
Hence, the equilibrium condition may be written as
SI ¼XM
ð2:23Þ
The difference between the elasticities and the absorption approaches is
that while the former focuses on the X–M schedule (which makes it a
partial approach), the latter combines this schedule with the S–I schedule to obtain an equilibrium condition.
Figure 2.15 shows that the S–I schedule is upward-sloping because
saving, S, is an increasing function of income, Y, whereas I can be
assumed to be independent of Y. Thus, as Y rises, S–I rises. This schedule
shows the excess of domestic saving over domestic investment (or
otherwise) at any level of income. The X–M schedule, which shows the
48 Exchange Rate Regimes
+
S –I
Y0
Y1
Y
X–M
–
Figure 2.15 The absorption approach to the balance of payments
current account position for each level of income, slopes downwards
because M is an increasing function of Y while X is independent of it.
Initially, the current account is in deficit at Y0. If the Marshall–Lerner
condition is satisfied, devaluation (or depreciation) leads to a shift in the
X–M schedule. If the level of income is unchanged at Y0, as implicitly
assumed by the elasticities approach, the current account registers a
surplus. However, an increase in net exports is bound to have an expansionary effect on the economy, leading to a rise in the level of income
to Y1, at which the current account is still in deficit, albeit smaller
than before. The explanation of this result is simple: the rise in income
leads to a rise in imports, reducing the extent of the rise in net exports
resulting from devaluation. Thus, the satisfaction of the Marshall–
Lerner condition is not sufficient for devaluation to have a favourable
effect on the current account. While the elasticities approach is based exclusively on the price adjustment mechanism, the absorption approach
takes into account the income adjustment mechanism as well.
Central bank intervention in the foreign exchange market
The issue of central bank intervention in the foreign exchange market
is crucial and highly relevant for the issue of exchange rate regime
choice. Under a fixed exchange rate regime, the central bank maintains