Question

1. Under fixed exchange rates, excessive monetary growth leads to balance of payments problems.
2. Under floating exchange rates, it leads to a currency problem.

Discuss these statements with reference to the monetary approach to the balance of payments.

Answer 1

a. Under fixed exchange rate system, the currency value stays the same, thus when there is excessive monetary growth, there is higher money supply in the economy which lowers the interest rates. This leads to less capital flows in the economy which could affect the balance of payments as foreign investments decline because they get lower return on their investments. The central bank intervenes in the foreign exchange market to maintain the fixed exchange rate by selling or buying domestic currency in exchange for the foreign currency. Thus when domestic money supply increases the foreign currency falls short, and there is excess demand for foreign currency, the central bank intervenes and sells foreign reserves to meet the demand, this leads to BOP deficit as the reserves decline.

b. Under floating exhange rate, the domestic currency will depreciate automatically as there is too much supply in the economy and less demand as compared to it, this leads to scarcity in the foreign currency as it is in less supply as compared to the domestic currency, thus the domestic currency declines in value and as the interventions by the central bank are not necessary in a floating exchange rate regime there are no imbalances in BOP.