Financial and Economic Global Strategy, Term Paper Example

Expound on the balance of payments/current account view of exchange rates.

Balance of payments measures all global economic exchanges between a country’s residents and their foreign nationals. This balances of payments are similar to the statement of cash flow. The negative numbers represent cash outflow from the US, and the positive numbers represent cash inflow to the US. The generic balance of payments statement consists of 5 accounts, including the Current account, Capital account, financial account, net errors, omissions, and reserves and related items. There are situations in which the balance of payments are at a disequilibrium. These situations are Surplus situations where Exports exceed imports and also a Deficit situation where Imports exceed Exports.

In this essay, I will primarily focus on the various reasons for deficits in the balance of payments. A balance of payments deficit is equal to more money going out than coming in. A budget deficit is a problem that most nations are facing today. The US has the most significant deficit of all nations, with about $4T of debt. If there is a deficit, the dollar will devalue. The dollar lost value, and the Euro gained value. The dollar devalued – we had massive Current account assets. The supply moved out because we were purchasing a lot of foreign goods. The devaluation was not as strong as if the account would be, as a surplus. For the past ten years, the Euro was a stronger currency than the dollar. The dollar devalued even more for the past 3 years due to the US financial meltdown, which led to even more US debt. They include:

• The production in a country adversely affects natural disasters, such as drought, floods, etc. As a result, exports are declining, imports are rising, and the country’s balance of payments is a deficit.
• The cyclical fluctuation of the balance of payments causes cyclical imbalance. In foreign countries, people’s incomes decrease during depression. The result is a decrease in the exports of those countries, which leads to imbalances in the balance of payments of the country of origin. This is when an economy starts to produce more than it needs. For example, on the production possibilities curve, the curve is the most an economy is capable of producing. Anything outside that curve is unobtainable and not recommended. Secular over-absorption is not bad because it autocorrects. In other words, it is a cycle with ups and downs that does not last for long periods. The Current account worsens when we increase spending, and it improves when we increase savings.
• Structural economic changes may also lead to an imbalance in the balance of payments. The structural changes included developing alternative supply sources, developing better substitutes, depleting production resources, transportation route changes and costs, etc. Such changes are included.
• There may also be imbalances in the balance of payments in certain political factors. For example, large capital outflows, inadequacies of domestic investment, production, and so forth may be in a country plagued by political instability. Sometimes, these factors can cause balance of payments imbalances. Moreover, the balance of payments difficulties can also arise from war, changes in world trade routes, etc. The employment act of 1946 government gave jobs to people who need them.

The balance of payments view says that the Current account and the balance of payments determine the currency’s exchange rate.  If the Current account improves, the value of the dollar strengthens. On the other hand, if the United States competitiveness decreases, foreign prices drop compared to the US. We buy more from them, and our exports will decrease in the Current account; if the Current account goes down, the dollar losses its value. In short, if the US relative prices go up, then competitiveness increases, and if our competitiveness improves, then our dollar strengthens. If relative prices decrease, the competitiveness declines, and the US Dollar declines. Suppose the country experiences a higher inflation rate than the trading partner country, and its exchange rate is not changing. In that case, its goods and services export is becoming less competitive concerning similar products manufactured anywhere else. This leads to a shortfall in the balance of payments’ current account unless compensated by financial and capital flows.

Analyze the portfolio balance view

It is a simple theory that talks about the Capital account: the capital inflows and outflows (direct and portfolio investment). The portfolio balance view does not address the Current account, and it addresses the Capital account. In other words, Portfolio Balance was developed last Century by William H. Branson. PB says she does not look at the current account. It looks at the capital account and money movements (money inflows & outflows) and the effect on finances such as bonds and other fixed-income instruments. In other words, PB explains how the interest rate determines the movements of money.

Higher interest rates in the dollar will strengthen the dollar’s value because investors will take their money to convert them in Euro and demand more dollars. If we demand more dollars, the value of the dollar goes up. Suppose the interest rate of dollar is lesser than the interest rate of the Euro. In that case, many people will take their money out of the dollar and put it in the Euro. This will decrease the value of the dollar. The opposite is also true. The higher interest rate in the dollar will make the value of the dollar go up. Interest rates are definitive movers.

Higher interest leads to higher currency value (Non-scientific approach) will attract money to the British pound because of higher interest rates, so international investors will put and park money there.

Relatively Price levels

The higher prices imply higher demand for money. For example, if the prices are higher, we need to borrow more money to buy the same goods that we could offer in the past. Also, if our prices are higher, we hold money, which causes the demand for USD to go up.

Relatively Income Levels

Having a higher income allows us to keep more money. We demand more money, which allows the USD to revalues and increases.

Relatively interest rate levels

A higher interest rate decreases the demand for money. Because people tend to invest their money through bonds and gain higher returns than usual. This situation allows the USD to devalue. The opposite is true if interest goes down, we demand more money, and the USD revalue and increase. In the situation when the Central Bank injects money into the market, we observe the $ devaluates.

The monetary approach to exchange rates

The monetary approach to exchanged rate is a simple approach that asserts the effect of monetary factors on exchange rates. The monetary approach defines E, R$, and PUS in a broader perspective using UIP, also called uncovered interest parity . According to money equilibrium, the supply of money must always balance the demand and supply of money to build purchasing power parity.

The monetary approach to exchange rates provides the empirical validity of monetary models that determines exchange rates. The models affirm that exchange rates given by the relative’s prices of monies are dictated by relative suppliers of the demands of a specific unit of monies instead of the condition and flow of equilibrium in making a balance of payments.  The existing money supplies determine the monetary approach to exchange rates to the money supply level and the real money income between the two countries.

A monetary approach model is a fundamental tool used in exchange analysis because it clarifies the determinants used in the exchange rate.  The monetary approach also provides a workable model used to determine equilibrium for the exchange rates. The monetary approach directly relates to equilibrium rates, thus providing the underlying instruments of the monetary policy. Monetary models are tested by date on Deutsche pound/ mark during floating rates retro. This rate is vital because of the wide variance stressed in the monetary approach.

Contrary to the exchange rate, the monetary approach is based on flows of goods and services taken as the class of stock or assets where changes in relative prices of goods play a minor role in the market. The asset model’s most common feature is based on the exchange rate viewed as the equilibrium of the net stock denominated in foreign exchange—synthesis of monetary approach in explaining the balance of payment.  Most research asserts that market models have been given much attention over the past years in determining the interesting contrast between monetary approach and exchange rates. Models that were developed way back have explained the movement of values in floating currencies, thus incorporating implicitly and explicitly.

The adjustment processes provide prominence to the equilibrium of the country’s money market. Exchange rate models have existing ways of obtaining proper specification of assets. For instance, ignoring the financial aspects of problems can produce better results. Shifting through real life has been pointed out to be the best focus during a period of precise specification in asset models. Therefore feature that separate the monetary model approach and exchange rate from another model of assets. For convenience purposes, nonmonetary models can generally be referred to as portfolio balance models.

Purchasing power parity

Purchasing power parity is the equilibrium condition that places the demand and supply of money at par. The nominal exchange rate involving different currencies will shift as per the expected inflation based on the difference between the two countries. In terms of the preposition, purchasing power parity is a coefficient of inflation equal to 1. Some purchasing power parity is more assets based regardless of whether they are categorized consistently with asset-based models making it noncontroversial. The second and strong preposition hypothesizes that a good exchange rate will move towards a time-invariant equilibrium way dictated by individual price law. When an expectation is rational, then the anticipated depreciation rate will have the same impact as the expected inflation plus an additional linear function.

The gap existing between the level of nominal exchange and the equilibrium value forms the basis of the equation of Dornbusch Frankel. Second and stronger still can easily hypothesize the exchange rate anytime it reaches the equilibrium position. Purchasing power parity always ensures that the existing gap between equilibrium is at e=e or zero. Frankel’s additional last requirement of taxonomy constitutes what is called the monetarist exchange rate is known as the monetary model.  Many hypotheses have been incorporated to test the monetary approach that dictates power parity. There is a coherent and obvious link between PPP and the flexibility of prices. If prices are not flexible, the nominal rate changes will not be affected to offset movements to aggregate price levels. Aggregate levels and typical exchange rates will move in the same direction with nominal rates if fully reflected in flexible change.

Therefore the condition of PPP is fundamentally the same as conditions of natural employment. Prices should be flexible within the country and the natural rate of unemployment to hold important addition. The gradual purchasing power parity, which has changed over time, is an unrealistic hypothesis. The natural corollary’s medium-run towards dissatisfaction has some sense of unemployment rates besides the extended run hypothesis. Purchasing power parity has an important reason.

Work Cited

Financial and Economic Global Strategy, Class Notes, 2020.

Eitman, D., Al Stonehill, and M. H. Moffett. “Multinational Business finance editions 13.” (2013).