Consequences of fluctuations in

exchange rate
 Customers have greater purchasing power
when the exchange rate increases
 Exporters face more difficult trading
conditions when the exchange rate increases.
 Importers potentially gain from a stronger
exchange rate because this makes it cheaper
to import raw materials, components and
finished goods from abroad.
 Consequences of fluctuations in
exchange rate
 Exchange rate fluctuations also have
consequences for macroeconomic objectives.
 Balance of payments— if a currency
appreciation has a larger impact on exports
than imports (that is, there is a fall in the
value of net exports), then the balance of
payments will worsen
 Employment— a fall in net exports and
profits as a result will, in the long run, cause
job losses in export-oriented businesses.
 Consequences of fluctuations in
exchange rate
 Inflation— lower levels of spending in the
economy, caused by higher unemployment,
will tend to reduce the rate of inflation
 Economic growth— in the long run, as a
result of the higher exchange rate, economic
growth is likely to fall due to the
combination of lower export sales and higher
unemployment
Consequences of fluctuations in
exchange rate

The effects of foreign exchange rate fluctuations on

a country’s export and import prices and spending on
imports and exports depend on the value of the
price elasticity of demand for its imports and
exports.
A currency depreciation or devaluation will have the
desired effects of reducing demand for imports and
increasing demand for exports only if the demand
for import and exports is price elastic.
 Advantages of floating system
 Automatic stabilization due to flexibility
 There is no need to keep reserve of foreign
currency to manage the value
 There is neither over-valuation nor
undervaluation
Disadvantages of floating exchange
regime
 There is uncertainty for businesses
 Lack of fiscal discipline to stabilize price
Practice question
 Fixed exchange rate system
 A fixed (or pegged) exchange rate system:
the value of a currency is tied to the value of
another currency, a basket of other
currencies, or to a commodity such as gold.
 Fixed exchange rate system
 A fixed exchange rate system has the aim of
keeping the value of a currency within a
narrow band.

 The government or the central bank acting

on the government’s behalf will intervene in
the forex market using the reserves of gold
and foreign currency to buy or sell its
currency in order to stabilize or maintain a
fixed exchange rate.
Fixed exchange rate system
Maintaining a fixed exchange rate
 Changes in fixed exchange rate

 It is possible to change the pegged rate over

time though it does not fluctuate frequently
as it is with the floating exchange rate.
 There is a revaluation of the exchange rate if
it is raised against other currencies.
 By contrast, there is exchange rate
devaluation if the value of the currency is
reduced against other currencies.
 Changes in fixed exchange rate
 The changes in the fixed exchange rate is a
deliberate effort of government
 In addition to the factors that cause
fluctuations in the exchange rate,
government intervention is a factor that
causes a change in the fixed exchange
regime
 The consequences of appreciation are the
same with the consequences of revaluation
 While the effects of depreciation and
devaluation are the same.
Advantages of fixed exchange rate

 It reduces the uncertainty for

businesses and importers
 It confers fiscal responsibility on
the government
Disadvantages of fixed exchange rate
system
 Cost of maintaining the fixed
value
 Problem of over-valuation or
undervaluation
 Unit Four

Current Account of Balance of Payment

 Structure of Current Account

 Causes and Consequences of Current

Account Deficit and Surplus
 Policies to Achieve Balance of Payments
Stability
 Objectives
 By the end of this chapter students should be
able to:
• Understand the structure of the current
account of the balance of payments
• Understand the causes of current account
deficit and surplus
• Explain the consequences of current
account deficit and surplus
• Discuss the policies to achieve balance of
payments stability
 Balance of payments
 Balance of payments is a record of all
financial dealings over a period of time
between economic agents of one country and
all other countries.
 The balance of payments has different
components
 The current account
 Capital account
 Financial account
 Net errors and omissions
 The current account
 Current account is the part of the balance of
payments that records transactions between
a country and the rest of the world in terms
of trade in goods and services, income and
current transfer
 Flows of money into the country (receipts)
are recorded as credits and are given a
positive (+) sign.
 Flows of money out of the country
(payments) are recorded as debits and are
given a negative (-) sign
 Structure of the current account
 Current account also has four components
 Trade in goods or visible trade account: this
is where all transactions in visible/tangible
items (goods) are recorded. Examples: crude
oil, cars, phones, books, computers
 Trade in services or invisible trade account:
this is where all transactions in
invisible/intangible items (services) are
recorded. Examples: shipping, banking,
tourism
 Structure of the current account
 Primary incomes or factor incomes: these are
factor rewards exchanged between residents and
non-residents for the use of each other’s factor of
production. This is also known as investment
income. Examples are: profits, dividends, interest
 Secondary incomes or current transfers are
transfers of money or benefits, that are not
payments for goods and services or for the use of
factor resources, between residents and non-
residents. Examples: workers’ remittances,
donations, aids and grants
 Calculating the current account
balance
 Balance of trade in goods: the difference between
exports and imports of goods services
 Balance of trade in services: the difference between
exports and imports of services
 Balance of primary incomes (net factor incomes):
difference between the incomes of factors owned by
the country and the incomes of factors owned by
foreigners
 Net current transfers: difference between transfers
into the country and the transfers out of the
country
 Calculating the current account
balance
 Current account surplus: this occurs if the
total credits (receipts) exceed total debits
(payments). This means the country has
earned more from trade, primary incomes
and transfers. This will increase the national
income of a country
 Current account deficit: this occurs if total
credits are less than total debits. This means
the country has paid more than it earns
from all the components of the current
account
Consequences of current account deficit
 Current account deficit has some
consequences which might call for a concern
or worry. Especially if most of the spending
on imports is for consumption and the deficit
is persistent and large
 The consequences of a current account deficit
include
 Higher level of unemployment
 Falling exchange rate and imported
inflation
 Rising debt and debt servicing
Correcting a current account deficit
 If a country operates a fixed exchange rate
system devaluation could be used to correct
a deficit
 Contractionary fiscal policy
 Increasing interest rate
 Use of trade barriers
 Consequences of a current account
surplus
 A current account surplus seems desirable, but
a large and persistent current account surplus
has negative implications for the economy,
which may include
 Demand-pull inflation
 Pressure from other countries who may be
having deficits
 Higher exchange rate which reduces
international competitiveness and causes
unemployment
 It may be a symptom of undervaluation of the
country’s currency
Correcting a current account surplus
 Revalue the currency if it is a fixed
exchange regime
 Use expansionary fiscal policy
 Lower interest rate
 Remove trade barriers