Question

INSTRUCTIONS

1. YOUR GRADE DEPENDS ON YOUR CONVICTION, CORRECTNESS, ELABORATION AND ELUCIDATION OF YOUR ANSWERS.
2. EACH COUNTS 17 POINTS.
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Explicate how the exchange rates, in a flexible exchange rate regime and in a fixed exchange rate world, are affected by deficits and surpluses.

Answer 1

Trade deficit in a fixed exchange rate system affect the country’s economic position. A trade deficit means that the imports exceeds exports of a country. In such situation, the domestic demand for foreign currency will increase for making the payments for imports and foreign demand for domestic currency to pay for exports will decrease.   The central bank has to intervene by selling foreign currency for the domestic currency. This will decrease the foreign reserves of the country and there will be a balance of payments deficit. When there is a trade deficit in a country with fixed exchange rate system, it will lead to balance of payments deficit. Thus as a result of the sales or purchases of foreign reserves by the central bank, a country will have balance of payments deficit or surplus.

In a floating exchange rate system, in the case of deficits and surpluses, a central bank can intervene in the private Forex to change the exchange rates. Thus sales or purchases of official reserve transactions can make a balance of payments deficit or surplus. But such interventions are not necessary in a floating exchange rate system. Because, in a floating system, any imbalance between supply and demand of private Forex is corrected by a change in the exchange rate. Thus there is no chance for an imbalance in the balance of payments in a floating exchange rate system.