someone help with fixed exchange rate problem? (1 Viewer)

[rozken123]

ok, i understand exchange rates fine apart from one thing.
why does fixing the exchange rate create either a BOP surplus if fixed below equillibrium or a BOP deficit if fixed above equillibrium?
i know what the central bank has to do to achieve fixed rate and its difficulty to maintain through monetary policy etc. but just cant get my head around the twin deficit or surplus that is created :S
someone help please!

 

[Zak Ambrose]

i will try my best.

you have to keep in mind that under a FLOATING exchange rate the BoP = 0.
this is because under a floating exchange rate, equilibrium occurs when supply of $A = demand for $A.

Now. the supply of the $A is represented by
- payments for M
- income/transfers overseas (Y debts)
- capital and financial outflow (K outflow)

The demand for the $A is represented by
- reciepts for X
- Y credits
- K inflow

so...

supply = demand

expanded this means

M + Y debits + K outflow = X + Y + K inflow

rearranging this we get

M - X + Y debits - Y credits = K inflow - K outflow

or

CAD = CFA surplus.

so having got that out of the way.
a fixed exchange rate is artificial intervention in the market forces (demand and supply)
so if demand< supply or vice versa then using the rearranged equations above we see that
CAD<CFA surplus or vice versa.


i hope this helped.

 

[gnrlies]

ok, i understand exchange rates fine apart from one thing.
why does fixing the exchange rate create either a BOP surplus if fixed below equillibrium or a BOP deficit if fixed above equillibrium?
i know what the central bank has to do to achieve fixed rate and its difficulty to maintain through monetary policy etc. but just cant get my head around the twin deficit or surplus that is created :S
someone help please!

consider the balance of payments as it would occur under a floating exchange rate enviornment. Of course it balances as you would have studied.

Now place that same 'balance' under a situation where the central bank has to buy or sell reserves. When it buys local currency and sells foreign reserves it is creating a deficit on the balance of payments. And when it buys foreign reserves and sells local currency it is creating a balance of payments deficit.

Essentially all this means is that the transactions demand for money is supplemented with a reserve demand for money which creates an imbalance.

I wouldn't worry about it too much because it isn't something you need to know for the HSC.

 

[rozken123]

thanks a lot guys, that really helped.

4/4 for this question in the assesment haha, so yeah thanks again!