ASSIGNMENT

1. Explain Balance of Payments with an example?

Balance of Payments Model

The balance of payments model holds that foreign exchange rates are at an equilibrium level if they
produce a stable current account balance. A nation with a trade deficit will experience a reduction in
its foreign exchange reserves, which ultimately lowers, or depreciates, the value of its currency. If a
currency is undervalued, its nation’s exports become more affordable in the global market while
making imports more expensive. After an intermediate period, imports will be forced down and
exports will rise, thus stabilizing the trade balance and bringing the currency towards equilibrium.

The balance of payments (BOP) is the method countries use to monitor all international monetary
transactions at a specific period. Usually, the BOP is calculated every quarter and every calendar
year.

All trades conducted by both the private and public sectors are accounted for in the BOP to
determine how much money is going in and out of a country. If a country has received money, this
is known as a credit, and if a country has paid or given money, the transaction is counted as a debit.

Theoretically, the BOP should be zero, meaning that assets (credits) and liabilities (debits) should
balance, but in practice, this is rarely the case. Thus, the BOP can tell the observer if a country has
a deficit or a surplus and from which part of the economy the discrepancies are stemming.

EXAMPLE

Imagine a fictional country called "TradeLand" that exports toys and imports electronics. When
TradeLand sells toys to other countries, it earns money, which goes into its current account. When it
buys electronics from other countries, it spends money, which also affects the current account. The
capital account reflects the sale or purchase of assets like real estate, while the financial account
covers investments and loans. By tracking these transactions, the balance of payments offers a clear
picture of TradeLand's economic health and its relationship with the global economy.
2. Explain difference between real and nominal exchange rates?

Real versus Nominal

Rates Real exchange rates are nominal rates adjusted for differences in price levels. Currency is
complicated and its value can be measured in several different ways. For example, a currency can be
measured in terms of other currencies, or it can be measured in terms of the goods and services it can
buy. An exchange rate between two currencies is defined as the rate at which one currency will be
exchanged for another. However, that rate can be interpreted through different perspectives. Below
are descriptions of the two most common means of describing exchange rates.

Nominal Exchange Rate

A nominal value is an economic value expressed in monetary terms (that is, in units of a currency). It is
not influenced by the change of price or value of the goods and services that currencies can buy.
Therefore, changes in the nominal value of currency over time can happen because of a change in the
value of the currency or because of the associated prices of the goods and services that the currency
is used to buy. When you go online to find the current exchange rate of a currency, it is generally
expressed in nominal terms. The nominal rate is set on the open market and is based on how much of
one currency another currency can buy.

Real Exchange Rate

The real exchange rate is the purchasing power of a currency relative to another at current exchange
rates and prices. It is the ratio of the number of units of a given country’s currency necessary to buy a
market basket of goods in the other country, after acquiring the other country’s currency in the
foreign exchange market, to the number of units of the given country’s currency that would be
necessary to buy that market basket directly in the given country. The real exchange rate is the
nominal rate adjusted for differences in price levels.
A measure of the differences in price levels is Purchasing Power Parity (PPP). The concept of
purchasing power parity allows one to estimate what the exchange rate between two currencies
would have to be in order for the exchange to be on par with the purchasing power of the two
countries’ currencies. Using the PPP rate for hypothetical currency conversions, a given amount of one
currency has the same purchasing power whether used directly to purchase a market basket of goods
or used to convert at the PPP rate to the other currency and then purchase the market basket using
that currency.
If all goods were freely tradable, and foreign and domestic residents purchased identical baskets of
goods, purchasing power parity (PPP) would hold for the exchange rate and price levels of the two
countries, and the real exchange rate would always equal 1. However, since these assumptions are
almost never met in the real world, the real exchange rate will never equal 1.
3. Find out difference between floating and fixed exchange rate system.

Floating Exchange Rate

Floating exchange rate, or fluctuating exchange rate, is a type of exchange rate regime wherein a
currency’s value is allowed to fluctuate according to the foreign exchange market. A currency that
uses a floating exchange rate is known as a floating currency. The dollar is an example of a floating
currency.

Many economists believe floating exchange rates are the best possible exchange rate regime because
these regimes automatically adjust to economic circumstances. These regimes enable a country to
dampen the impact of shocks and foreign business cycles, and to pre-empt the possibility of having a
balance of payments crisis. However, they also engender unpredictability as the result of their
dynamism.

Fixed Exchange Rate

A fixed exchange rate system, or pegged exchange rate system, is a currency system in which
governments try to maintain a currency value that is constant against a specific currency or good. In a
fixed exchange-rate system, a country’s government decides the worth of its currency in terms of
either a fixed weight of an asset, another currency, or a basket of other currencies. The central bank
of a country remains committed at all times to buy and sell its currency at a fixed price.

To ensure that a currency will maintain its “pegged” value, the country’s central bank maintains
reserves of foreign currencies and gold. They can sell these reserves in order to intervene in the
foreign exchange market to make up excess demand or take up excess supply of the country’s
currency. The most famous fixed rate system is the gold standard, where a unit of currency is pegged
to a specific measure of gold. Regimes also peg to other currencies. These countries can either choose
a single currency to peg to, or a “basket” consisting of the currencies of the country’s major trading
partners.

Difference between the fixed and flexible exchange rates:

Fixed Rate Flexible Exchange Rate

Definition

Fixed rate is the system where the Flexible exchange rate is the system which
government decides the exchange rate is dependent on the demand and supply of
 the currency in the market

Deciding authority

Fixed rate is determined by the central Flexible rate is determined by demand and
government supply forces

Impact on Currency

Currency is devalued and if any changes Currency appreciates and depreciates in a

take place in the currency, it is revalued. flexible exchange rate

Involvement of Government Bank

Government bank determines the rate of No such involvement of government bank

exchange

Need for maintaining foreign reserve

Foreign reserves need to be maintained No need for maintaining foreign reserve

Impact on BOP (Balance of Payment)

Can cause deficit in BOP that cannot be Deficit or surplus in BOP is automatically
adjusted corrected

4. How do countries choose their Exchange Rate Regime?

Choosing an Exchange Rate Regime
A PERENNIAL question in international economics—whether in academia or in policy circles—concerns
the optimal choice of exchange rate regime. After the breakdown of the Bretton Woods system in the
early 1970s, and the subsequent adoption of the Second Amendment to the IMF’s Articles of Agreement,
member countries have been free to adopt the exchange rate regime of their choice.
But because countries no longer are obligated to peg their exchange rates in a system overseen by the
IMF, they need a sound basis for selecting the regime best suited to their needs—be it fixed, floating, or
intermediate. Over the past decade, the IMF has produced three major analytical studies on countries’
choices of exchange rate regime—in 1999, 2003, and 2009 (Mussa and others, 2000; Rogoff and others,
2004; and Ghosh, Ostry, and Tsangarides, forthcoming)—that build on the existing empirical literature
both within and outside the IMF (Ghosh and others, 1997; Ghosh, Gulde, and Wolf, 2002; Levy-Yeyati and
Sturzenegger, 2003; and Reinhart and Rogoff, 2004). These reviews, part of the IMF’s surveillance
mandate, help inform member countries of how their choice of exchange rate regime can affect their own
macroeconomic performance—inflation, growth, susceptibility to crises—and contribute to the stability of
the international monetary system.

Evolving views
In practice, the preferred exchange rate regime, particularly for developing and emerging market
economies, has evolved considerably over the past couple of decades. Pegging the exchange rate to a
strong anchor currency (often the dollar or the deutsche mark) was popular in the early 1990s—especially
for nations in transition from command to market economies that were seeking to stabilize their
economies after their initial price liberalizations. But the 1990s also saw a spate of capital account crises in
emerging market countries, with sharp reversals of capital inflows leading to collapsing currencies and
underscoring the fragility of such fixed exchange rate regimes.
By the time of the 1999 IMF review of exchange rate regimes, the received wisdom was that simple pegs
were too prone to crisis and that countries should adopt either “hard” pegs—such as monetary unions or
currency boards—or, at the other end of the spectrum, free floats in which the market determines a
currency’s value without government intervention.
This so-called bipolar prescription, intended primarily for emerging market and developing countries, was
much the same choice that the advanced economies were making. Many of those advanced economies
were headed toward hard pegs in the form of a monetary union, while others were free floating. Some,
indeed, managed to do both: countries in the euro bloc have a hard peg (a currency union) with other
members of the bloc, but the euro itself floats against third currencies.
The bipolar prescription for emerging market countries proved short lived, however. The collapse in 2002
of Argentina’s hard peg (the currency board, which linked domestic peso issuance to dollars in the central
bank) cast doubt on the hard end of the bipolar spectrum.

Fear of floating
The 2003 review used a de facto classification of exchange rate regimes that was based on the actual
behavior of the exchange rate rather than on what formal, or de jure, commitment the central bank had
made. The 2003 review found that pegged exchange rates provided little benefit to emerging market
countries in terms of either inflation or growth performance. Because such regimes are associated with
greater likelihood of currency or financial crises, the review concluded that emerging market countries—
and developing countries as they became more financially integrated—should adopt freely floating
exchange rates.
But in practice, few central banks were (or are, for that matter) willing to follow such a policy of benign
neglect because they cannot be indifferent to the value of their currency. When the value of the currency
declines, authorities worry about both imported inflation and the balance sheet effects of an exchange
rate depreciation on borrowers that have borrowed in foreign currency and suddenly find that debt more
expensive to service. On the other hand, when a currency’s value rises, there is a loss of export
competitiveness.
This fear of floating, as it has been called, is particularly prevalent among emerging market and developing
countries for which sharp appreciations or depreciations of the exchange rate—or, more generally,
currency volatility—may be particularly deleterious. But it is also noteworthy that among advanced
economies, euro area members avoid currency volatility by maintaining irrevocably fixed exchange rates
(through the monetary union) with the countries with which they have the deepest economic ties, such as
trade.
In sum, the bipolar prescription ruled out intermediate regimes (including simple pegs), the collapse of
Argentina’s currency board ruled out the hard end of the spectrum, and in practice few countries were
willing to go to the soft end of free floating. So which regime should a country adopt? It was clearly time
for a fresh look at this question.

What they do and what they promise to do

The just-completed review, based on a data set of IMF member countries over the period 1980–2006, is
the most comprehensive study of exchange rate regimes. Not only does this study examine the impact of
the exchange rate regime on a wider range of variables (monetary and fiscal policies, inflation, output
growth and volatility, cross-border trade and capital flows, crisis susceptibility, and external adjustment)
than did the earlier reviews, it is also the first to use both de jure (what they promise to do) and de facto
(what they do) classifications of the exchange rate regime in its analysis.
As a result, the message about the relative merits of various exchange rate regimes is more nuanced than
those in the earlier reviews.

Inflation performance
There is ample evidence that, for developing and emerging market countries, pegged exchange rate
regimes are associated with the best inflation performance. The only exception occurs when the peg is at
an undervalued rate and the country is unable to offset the growth of the money supply that occurs when
persistent current account surpluses and resulting accumulation of foreign reserves translate into
excessive monetary growth; in such cases (a small minority in the IMF data set), the inflation benefit from
pegs does not occur.
The inflation benefit from pegged regimes may seem at odds with the findings of the 2003 study, which
found that emerging economies captured little inflation benefit from pegging. The explanation is
straightforward and results from the 2009 study’s use of both de jure and de facto classifications of the
exchange rate regime, whereas the 2003 review focused exclusively on the de facto classification. An
important part of a peg’s inflation benefit comes from the credibility of a formal commitment by the
central bank to maintain the parity—not just from its de facto foreign exchange intervention or the
behavior of the exchange rate. In nearly every case in which the central bank makes a formal commitment
to a pegged exchange rate regime, it in fact maintains that peg. In other words, when it comes to pegging
the exchange rate, deeds nearly always back words. The opposite case—a de facto peg without a de jure
commitment—is much more common but does not deliver the same benefit in terms of anchoring
inflation expectations and reducing inflation. By using both de jure and de facto classifications, the 2009
study was able to pick up on such subtleties, which were missed in earlier reviews.
How growth fares
Growth performance is best under intermediate exchange rate regimes—those that maintain relatively
rigid exchange rates but do not formally peg to a single anchor currency. This is largely because such
intermediate regimes represent a happy balance between pegs and free floats. Pegged regimes are
associated with lower inflation, lower nominal and real exchange rate volatility, and greater trade
openness—all of which are associated with faster growth. But pegged regimes are also more susceptible
to exchange rate overvaluation, which hurts competitiveness and undermines growth performance.
Compared with pegged regimes, floating exchange rates are at less risk for overvaluation, but they also
fail to deliver low inflation, reduced volatility, or better trade integration.
Between these extremes, intermediate regimes achieve the best balance and are associated with faster
per capita output growth of about half a percentage point a year (after taking into account other factors
that affect growth). Pegged exchange rate regimes are associated with better growth performance than
floating regimes—but only if they are able to avoid real exchange rate overvaluation and loss of
competitiveness.

Trade links
That countries in a monetary union have deeper trade links is well known. But the 2009 study establishes
that similar benefits for trade integration derive from simple pegs (and, to a lesser degree, even from
intermediate regimes). The study also finds that—crises aside—capital flows under pegged and
intermediate regimes tend to be more consistent with consumption smoothing than capital flows under
floats. While this latter finding is less sharply defined, one explanation is that the lower real exchange rate
volatility under more rigid regimes fosters greater “stable” forms of capital flows—such as foreign direct
investment—than “hot money” portfolio flows. Indeed, promoting greater trade and cross-border
investment was the economic motivation behind fixed exchange rates and eventual monetary union in
Europe.

Some trade-offs
Nothing is perfect, of course. The study found three major downsides to more rigid (pegged or
intermediate) exchange rate regimes.
First, such regimes (especially pegs) severely constrain the use of other macroeconomic policies. The
“impossible trinity” of simultaneously maintaining a pegged exchange rate, an open capital account, and
an independent monetary policy is well established. What is striking in the 2009 study is that this
constraint seems to hold, even for countries with less-open capital accounts or those that heavily sterilize
reserve flows under pegs. The other striking result is that counter cyclical fiscal policy—cutting taxes and
increasing government spending to counter economic downturns and vice versa—is also heavily
constrained under pegged exchange rate regimes. This presumably happens because capital flows are
related to the business cycle in most emerging market and developing countries. Because expansionary
fiscal policy in a downturn could lead to a loss of confidence and trigger further capital outflows, which
would threaten the viability of the peg, there is less scope for counter cyclical fiscal policy in countries
with pegs. Thus, while pegging the exchange rate provides a useful commitment device for the central
bank to anchor expectations by disciplining policies, it also limits the potential to respond to
macroeconomic shocks.
Second, both the 1999 and 2003 studies found that pegged (and intermediate) regimes are associated
with greater susceptibility to currency and financial crises, such as debt crises, a sudden stop in capital
inflows, or banking crises. The current study confirms these results, especially for developing and
 emerging market countries with more open capital accounts. But it also finds that credit booms, including
those that end in crisis, are about as likely to occur under floating regimes as they are under pegged or
intermediate regimes. Likewise, the study finds that the risk of a growth crisis (a sharp decline in growth
for whatever reason) is not correlated with the exchange rate regime. Thus, greater crisis susceptibility is
a cost of more rigid exchange rate regimes. But countries with floating regimes are not entirely immune—
as indeed the current global crisis, with its epicenter in countries with floating regimes, has amply
demonstrated.
Third, pegged and intermediate exchange rate regimes impede timely external adjustment. On the deficit
side, more rigid regimes are associated with larger deficits that unwind more abruptly and, because the
real exchange rate does not adjust, have a greater impact on output and economic activity than deficits
under floating regimes. On the surplus side, these regimes are associated with large and highly persistent
surpluses that, if large enough in the aggregate, can affect the stability of the overall international
monetary system.

The bottom line

Unlike previous reviews, the current study finds important trade-offs in the choice of exchange rate
regimes. Regimes that are more rigid help countries anchor inflation expectations, sustain output growth,
and foster deeper economic integration. But they also constrain the use of macroeconomic policies,
increase vulnerability to crisis, and impede external adjustment. This trade-off is illustrated by the recent
experience of European emerging market countries. Although many of the countries with less flexible
regimes enjoyed strong growth in the years leading up to the present crisis, they also built up large
external imbalances, increasing their vulnerability to abrupt and disruptive adjustment and limiting their
potential for counter cyclical macroeconomic policies.
At its core, the results of the 2009 IMF review and the trade-offs it finds should
 help bring greater balance to the debate over which exchange rate regimes are appropriate for which
countries,
 allow the IMF greater latitude to take account of country-specific circumstances when tailoring the
policy advice it gives to individual countries, and
 provide a wealth of information and empirical results to help the IMF’s 186 member countries make
better-informed choices for themselves regarding the best choice of exchange rate regime.

5. How do exchange rate fluctuations affect a nation’s GDP?

What causes currency fluctuations?
Currency fluctuations arise from the floating exchange rate system, which is followed by most major economies.
The exchange rate of currencies against others depends on various factors such as relative supply and demand for
currencies, economic growth of countries, inflation outlook, capital flows, and so on. As these factors are
continually changing, currencies fluctuate with them. The fluctuation of a country’s currency can have a far-
reaching impact on the country’s economy, consumers, businesses and remittance inflows. This means that
whether a country’s currency appreciates or depreciates, it will have both positive and negative impacts on a
country’s economy, depending on the sector. Let’s take a closer look at the impact of exchange rate on economic
growth.

The Economy
One of the most prominent impacts of currency fluctuations can be seen in international trade. Generally, a
weaker currency stimulates exports and makes imports expensive, thus decreasing the country’s trade deficit
depending on the sector. On the other hand, a strong currency can reduce exports and make imports cheaper,
effectively widening the trade deficit. While it is generally assumed that a strong currency is a good thing for a
nation’s economy; in reality, it might not be so. An unjustifiable strong currency can cause a drag on the economy
over the long term, as entire industries are rendered uncompetitive and thousands of jobs are lost. As GDP is
directly linked to exports, a weaker currency may actually help the country’s economy, contrary to popular belief.
Because GDP is based how much money an economy's output is worth, it's subject to inflation. Or, to put it
another way, GDP fluctuates when the value of a currency changes. It's normal for the cost of goods and services
in a country to go up over time. And those gradual cost increases are reflected in the nation's GDP.On the other
hand, a depreciating currency can result in inflation as the cost of importing goods increases. Currency fluctuations
also have a direct impact on the monetary policy of a country, as exchange rates play a vital role in deciding
exchange rates set by a country’s central bank. Constant currency fluctuations can also affect the market
adversely, causing it to become volatile, and affecting both local and foreign trade.

The Consumer
Currency fluctuations have a significant impact on the consumer. As mentioned above, a weak currency increases
the cost of imports and eventually, this cost is borne by the consumer. For example, buying a foreign car might get
more expensive if your country’s currency depreciates, which means that you might end up paying more money to
get an item of the same value. On the other hand, a stable currency allows consumers to buy more. This increased
spending further benefits the overall economy of the country. Gas prices are also affected in a big way due to
foreign currency fluctuations. When the US dollar strengthens against other currencies, we see a dip in oil prices.
To decode why that happens, it’s important to know that major oil-exporting countries like Saudi Arabia have their
currencies pegged to the US dollar. So, when the greenback gets stronger, so does the Saudi Riyal, making Saudi
Arabia’s imports cheaper. Due to this, Saudi Arabia can afford to charge lower prices for oil. With oil prices
affecting the cost of commodities worldwide, consumers can directly feel the effect of these inter-linked
fluctuations.

Business
Currency fluctuations affect all kinds of businesses, but businesses that export or import supplies from other
countries are most severely affected. A change in currency can have a direct impact on a business’s bottom line.
For example, if a company headquartered in the U.S projects a profit margin of USD 6 million in a year, it could
reduce to USD 5.5 million if the dollar weakens against the rupee. Similarly, they could see an increase in their
profit if the dollar performs strongly against the rupee.
Even if a business does not buy or sell to other countries, these fluctuations can have some unforeseen
consequences. For instance, if a company uses trucks to move its products and a currency change fluctuates the
cost of fuel, there will be a direct impact on shipping costs. On the other hand, a depreciating currency can also
help domestic businesses sell more locally by reducing the country’s imports.
Some smaller businesses might lack the back-up finances to deal with exchange rate fluctuations. They usually
establish a ‘forward contract’ to hedge their financial risk and ensure that their business will be protected from
significant losses arising from foreign currency fluctuation.

International Remittances
Remittances not only benefit individuals; they also benefit the economy. According to the World Bank, remittances
come second only to Foreign Direct Investment (FDI) as a country’s resource inflow. For many small and
developing countries, there will be a direct impact on the steady flow of foreign currency into the country.