Economics Coursework
To Determine If the country runs a balance of payments deficit or surplus
Balance of payments (BOP) measures the net current account (CA), capital account and financial account balances. Current account balance 10 billion ( indicates a surplus), financial account balance - 6 billion (- indicates a deficit) and capital account balance 0.
BOP Current Account Balance Capital Account Balance Financial Account Balance
10 billion 0 (- 6 billion) 4 billion
Since the balance of payments appears with a positive sign, the country is running a balance of payments surplus.
2. To Determine
i. Countrys Exchange Rate Regime
ii. Whether Foreign Exchange Reserves are Rising or Falling
Answer
In a floating exchange rate system, an imbalance between demand and supply of currency in the Foreign Exchange Market is immediately corrected by a change in exchange rate. Consequently, a balance of payments deficit or surplus usually ceases to exist under a floating exchange rate regime. Consequently, the country is following a fixed exchange rate regime.
A balance of payments surplus is a transaction marked by purchase of foreign currency and assets. Since the country is running a balance of payments surplus, its foreign exchange reserves are rising.
3. To Determine Whether Central Bank is Selling or Purchasing Foreign Currency
The Central bank is buying foreign currency. A balance of payments surplus implies that net exports exceed net imports. Since the nation is running a surplus, it is receiving more foreign funds from trade and international investments than it is paying to the other country. With increased supply of foreign currency on FOREX, it is essential for the central bank to buy the excess foreign currency to prevent domestic currency appreciation. This is necessary for maintaining the fixed exchange rate value.
4. To Determine if Exchange rate is Good or Bad for the Country
Answer A fixed exchange rate regime has its advantages and disadvantages, depending upon the present economic climate of the country and the world. A major drawback of the fixed exchange rate regime is that foreign currency reserves can lose their value with inflation. Such has been the case with many nations that have fixed their currency value relative to US dollar. With inflating reserve currency, the central bank will need to invest capital that could be put to more constructive uses, to maintain their purchasing power in international markets. If the country lets its currency appreciate freely in the markets import costs will decline. Further, the country can rid itself of any negative inflationary outcomes caused by fixing domestic currency against a nation experiencing a high domestic inflation rate. A fixed exchange rate regime may also be preventing implementation of prudent monetary policies by constraining the monetary autonomy of the central bank. In the light of the aforementioned factors, a fixed exchange rate regime is bad for the country.
On the contrary, the fixed exchange rate regime is protecting exporters from the devastation caused by significant currency appreciation. If the country has been able to maintain the system with few currency devaluations and revaluations, the regime is successfully minimizing volatility, risk and instability. This promotes foreign trade and investment. Further, if the available foreign reserves are not imposing a significant threat on the governments expenditures and it can counter expected future balance of deficits well to maintain the credibility and advantages of the fixed rate system, then the fixed rate is good for the country. Lastly, if the domestic currency value is fixed relative to a stable currency or gold, the system may be more beneficial than damaging. Thus, the fixed rate regime will be good or bad for the nation contingent on the present domestic and international economic climate and trader and investor expectations.
5. Given UK pound was worth 2 a couple of years ago. At present pounds value oscillates between 1.60 and 1.70.
To Determine If Pound has Depreciated or Appreciated
Answer The value of pound has depreciated over the period of time. Currency depreciation implies that its value has fallen relative to foreign currency. Thus, one unit of depreciating currency can purchase fewer units of another currency. Since, it was possible to buy more dollars (2) with one pound a couple of years back than it is at present (160-1.70), it can be concluded that pound has depreciated in value over the considered time span.
6. Pros and Cons of a Flexible Exchange Rate Regime
A flexible exchange rate regime has multifarious advantages. Firstly, it allows the value of a currency to adjust in response to market conditions. This in turn removes or eliminates any imbalances in balance of payments. Secondly, in such systems there are no intervention costs. The government does not use its resources to buy and sell currency and can focus all its attention on domestic economic issues. Further, governments can freely choose their domestic policies. The flexible exchange rate regime automatically ensures correction of balance of payments disequilibrium that might result from policy implementations. The flexible rate regime also insulates a country from external economic events by ensuring that domestic currency is not tied to a high world inflation rate. It neutralizes the impact of external and real macroeconomic shocks and effect of inflation on competitiveness of exports. Cheaper export prices encourage competition.
On the negative side, regular currency value changes, characteristic of flexible exchange rate regimes, make planning difficult. Such a system makes trade and financial transactions more volatile and risky. This can deter trade and foreign investment transactions, traders and investors prefer predictability. Since the currency varies regularly, in response to demand and supply, speculation is encouraged which causes instability. Further, exchange rate variations without government intervention may be incapable of restoring equilibrium. Competitive devaluations facilitated by a flexible system may result in regional instability. Flexible exchange rate regimes can delay structural adjustments since price changes mask underlying system rigidities. Lastly, flexible exchange rate regime makes payment of internal and external debt unpredictable and can severely alter a countrys obligations to its disadvantage.