4.6.4 Relationship between the current account and the exchange rate (HL) Notes

The current account has a different relationship to the different types of exchange rate systems, impacting how the exchange rate itself shifts.

We will bring up the balance of payments example table for Country A from 4.6.2 Components of Balance of Payments.

The current account and exchange rates

Floating Exchange Rate System

At equilibrium

1. Recall, under a floating exchanging rate system, the market forces (demand and supply) solely determines the equilibrium exchange rate, where there is no intervention from the government or central bank.
2. For our example with Country A, this would mean the reserve assets would be 0, as there would be no buying or selling of currencies.

1. Observing the Figure A above, the initial exchange rate is at $0.34 \text{ ecocoins } = 1 \text{ dollar}$, where the supply and demand of dollars are equal (equilibrium).
2. Hence, the sum of credits is equal to the sum of debits in US balance of payments.
3. Meanwhile observing Figure B, there is equilibrium at the same exchange rate of $3 \text{ dollars } = 1 \text{ ecocoin}$, where sum of credits is equal to the sum of debits.

Change in equilibrium

1. The demand for the dollar increases from $D_1$ to $D_2$ if Econland's demand for imports from the US increases.
2. Looking back at the initial equilibrium, now there is an excess demand for dollars, which can be calculated by the horizontal distance between the initial equilibrium exchange rate A and point B.
3. Therefore, the US has a surplus in its current account or excess credits in its balance of payments, leading to an imbalance.
4. For Econland, the increased demand for imports from US, causes the supply of ecocoins to increase from $S_1$ to $S_2$. At the initial equilibrium rate, there is an excess supply of ecocoins, which can be calculated by the distance between A and B.
5. Therefore, Econland has a current account deficit.

Return to equilibrium

1. For floating exchange rates, the market forces cause the exchange rate to change.
2. When there is a deficit in the current account as with Econland, which lead to the depreciation of the econcoins, a downward pressure is applied on the currency exchange rate.
3. This is because the depreciation causes imports to fall, and exports to increase till the imbalance of the current account is gone.
4. When there is a surplus in the current account as with the US, which lead to the appreciation of the dollar, an upward pressure is applied on the currency exchange rate.
5. This is because the appreciation causes imports to increase, and exports to decrease till the imbalance of the current account is gone.

Managed Exchange Rate System

1. Recall, the managed system is similar to the free floating system, except it has recurring interventions by the central bank to influence exchange changes.
2. As observed in our balance of payments table for Country A, a common intervention method to influence changes includes the buying and selling of reserve assets or currencies.
3. Without intervention, Country A had a balance of payments deficit or excess debits compared to credits, as there was an excess supply of dollars.
4. To maintain the exchange rate and avoid any depreciation, the central bank of Econland sold other currencies to demand and buy 2 million dollars.

Fixed Exchange Rate System

If a country has a fixed exchange rate, then it can do the following points below to keep the exchange rate the same.

1. In the scenario where excess debits persist year on year, unlike managed exchange rate systems, it cannot only sell reserve assets to offset the deficit as it will run out of assets after a period of time.
2. Therefore, the country can and will need to balance its balance of payments by changing its policies.
3. To increase credits, the country can:
   1. increase interest rates, which attracts higher foreign direct investments
   2. borrow from abroad
4. To decrease debits, the country can:
   1. limit imports by trade protection or contractionary policies
   2. impose exchange controls

By doing the above, it can maintain its fixed exchange rate.