Balance of Payments

&
Exchange Rates
Unit 15 - Lesson 3

Learning outcomes:
Explain why a deficit in the current account of the balance of
payments may result in downward pressure on the exchange rate of
the currency.
Explain why a surplus in the current account of the balance of
payments may result in upward pressure on the exchange rate of the
currency.

Free Floating Exchange Rates

No Government or Central Bank Intervention into the market.
Example: Tanzania has Current Account Deficit
Imports (Debits) > Exports (Credits)
Tanzania Supplies Tsh to market - Excess Supply of Tsh
This...
Creates downward pressure (depreciation) of Tsh
Depreciation of the Tsh - Increases Exports - Decreases Imports - until
the Current Account Deficit is eliminated - BoP = 0

Free Floating Exchange Rate

No Government or Central Bank Intervention into the market.
Example: Tanzania - Current Account Surplus
Exports (Credits) > Imports (Debits)
Increase in Demand for the Tanzanian (Tsh) - Excess Demand for Tsh
This
Creates upward pressure (appreciation) of the Tsh
Appreciation Tsh - Increase in Imports - Decrease in Exports - until
Current Account Surplus is eliminated - BoP = 0

Free Floating Exchange Rate Summary

Current Account Deficit

Imports (Debits) > Exports (Credits)

Excess supply of currency in
market
Creates downward pressure
(depreciation) of currency
Exports increase
Imports decrease
Exchange rate changes from
market forces eliminate the deficit
Balance of Payments = 0

Current Account Surplus

Exports (Credits) > Imports

(Debits)
Excess Demand of currency in
market.
Creates upward pressure
(appreciation) of currency
Exports decrease
Imports increase
Exchange rate changes due to
market forces & eliminate surplus
Balance of Payment = 0

Managed Float - Exchange Rate

Exchange Rate is allowed to float within a range. Any movement
outside this range involves Government and/or Central Bank Intervention.
Managed Exchange System: Imbalances in Balance of Payment due to
Managed Float is made to balance (Current Account = Financial Account)
by a combination of Central Bank buying & selling of currencies & market
forces.

Managed Float
Current Account Deficit
Imports (Debits) > Exports (Credits)
Creates downward pressure (depreciation) of the currency.
If the currency depreciates to a point outside the set range/float
Central Bank intervenes Supplying (foreign currency) - Depreciates
Demands (domestic currency) - Appreciates to a point within the band
Within the Float, Balance of Payments will settle at a point = 0

Manage Float
Current Account Surplus
Exports (Credits) > Imports (Debits)
Creates upward pressure (Appreciation) of the currency
If the currency appreciates to a point outside the set range/float
Central Bank intervenes Supplying (domestic currency) - Depreciates
Demands (foreign currency) - Appreciates to a point within the band
Within the Float, Balance of Payments will settle at a point = 0

Managed Float - Example: China & USA

U.S.A has a Current Account deficit with China:
Imports (Debits) > Exports (Credits)
If both countries had free floating exchange rates:
Yuan appreciates - US $ depreciates - US imports less - China exports less Balance of Payments = 0

However..
China - Managed Float
The Trade Surplus China has with the USA should appreciate the Yuan.
But, China maintains a Managed Float - undervaluing their currency in
relation to US $
Keeps Chinese exports cheap to USA - drives economy.
Why does the Yuan not appreciate relative to the US $?
China supplies ($) earned from trade surplus with USA to the market
(depreciation of US $) liquid - Demands US Government debt (illiquid).

Government Intervention by the Central Bank into a market can be done by

not only by the Domestic country, but by other Foreign Central Banks with
Reserve Currencies causing a currency to be under/overvalued in relation to
another.
By China and US Central Bank intervening in the currency market, they are
helping to correct the imbalance/deficit in the Current Account.
Current Account Deficit - US

Financial Account Surplus - US

Imports (Credits) > Exports (Debits)

China buys US Government Debt Debit to Financial Account - Positive

(+) inflow to US

Negative (-) value - outflow to China

Outflows = Inflows from both China & US Central Bank Intervention Balance of Payments = 0