Flexible Exchange rates, Fixed Exchange Rates,

and the Balance of Payments

Both the size and persistence of a nations balance of payments deficits and
surpluses, and the adjustment it must make to correct these imbalances,
depends on the system of exchange rates being used. There are two pure
types of exchange rate systems!
" flexible or floating exchange rate system, by which the rate that
national currencies are exchanged for one another is determined by the
forces of demand and supply. #n such a system, no go$ernment
inter$ention occurs.
" fixed exchange rate system, by which go$ernments determine the rates
at which currencies are exchanged and make necessary adjustments in
their economies to ensure that these rates continue.
Flexible Exchange Rates and the Balance of Payments
%roponents of a flexible exchange rate system argue that flexible exchange
rates automatically adjust to e$entually eliminate balance of payment
deficits or surpluses. To see this, suppose that tastes and preferences in one
country for another countries goods changes &i.e. suppose it increases'.
(eteris paribus, domestic demand for that countrys currency increases &i.e.
domestic demand for foreign exchange rises'. This shifts the demand for
foreign exchange cur$e out to the right. )ue to the change in tastes and
preferences, and its resulting effect on the demand for foreign exchange, the
domestic economy would run a balance of payments deficit &i.e. in this
example, the domestic economy would import more foreign goods than it
exports. Therefore the domestic economy would ha$e a merchandise trade
deficit and, ceteris paribus, a balance of payments deficit. The foreign
economy would ha$e a balance of payments surplus since, ceteris paribus,
the increase in demand for its goods causes that country to export more,
causing a surplus in merchandise trade and hence a balance of payments
surplus'. )ue to the increase in demand for foreign exchange, the exchange
rate rises until the demand for foreign exchange e*uals the supply of foreign
exchange. "t such a point, the balance of payments would restore back to
e*uilibrium.
+ow, " rise in the exchange rate makes the imports to a domestic economy
more expensi$e and their exports more attracti$e &exactly what is needed to
correct the balance of payments deficit-.export more, import less'. /rom the
perspecti$e of the foreign economy, a rising exchange rate implies that their
currency has appreciated. This makes their exports unattracti$e and they will
want to import more foreign goods since it is cheaper for them to do so.
(onse*uently, the foreign economy will import the domestic economys
exports. This will cause their merchandise trade balance to shrink from one
of a surplus to that of e*uilibrium.
The two adjustments-a decrease in domestic imports from the foreign
country, and an increase in domestic exports to the foreign country-are
exactly what is needed to correct the balance of payments deficit.
Disadvantages of flexible exchange rates
Uncertainty and diminished trade! #f an indi$idual in a domestic
economy contracts to buy the exports of another country, a sudden fall in
the exchange rate &i.e. depreciation of the domestic currency' will
increase the price of the goods being imported to the domestic economy.
(eteris paribus, this may result in substantial losses. Because of such a
risk, the domestic importer may want to confine his0her purchases to
strict domestic goods and ser$ices, thereby reducing international trade.
Terms of trade changes! " nations terms of trade will be worsen by a
decline in the international $alue of its currency. /or example, an
increase in the domestic price of foreign exchange &i.e. a depreciation of
the domestic currency in terms of the other country' will mean that the
domestic country will ha$e to export more goods and ser$ices to be able
to finance a gi$en le$el of imports.
Instability! /lexible exchange rates may ha$e destabilizing effects on the
domestic economy because wide fluctuations stimulate then contract
industries producing exported goods. /oe example, if a domestic
economy is at full employment &i.e. it is on its %%(', a depreciation in its
currency will ha$e an inflationary effect since foreign demand for
domestic goods &i.e. domestic exports' rises.
Fixed exchange rates and the balance of payments
#n the example abo$e, what would be the effects to a domestic economy
from an increase in tastes and preferences for foreign goods, The domestic
increase in demand for foreign goods increases the demand for foreign
currency &domestic balance of payments deficit'. 1nder flexible exchange
rates, the exchange rate would rise and restore e*uilibrium in either
countrys balance of payments. Because the exchange rate is fixed, the
domestic go$ernment must inter$ene by supplying more foreign exchange to
the foreign exchange market. The supply of foreign exchange in the market
increase until the demand for and supply of foreign exchange results in no
change in the exchange rate. The problem with this is that a countrys central
bank has a limited supply of foreign exchange &i.e. it cannot continue to
supply foreign exchange to the foreign exchange market to peg the exchange
rate'. 2$entually, a country may be forced to abandon a fixed exchange
rate.