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1. Balance of Payments
The balance of
payments is the score sheet for all economic transactions during a given
period between one country and its residents
(including the governments) and all other countries. Transactions are
reported using double entry
bookkeeping with credit entries balanced on the debit side, and vice versa. The
balance of payments thus necessarily balances. There can be no
surplus or deficit in a country's balance of payments as a whole.
A country's balance of payments is divided into two major sections: the
current account and the capital account.
The current account, in turn, is subdivided into goods and
services and transfer payments.
The capital account is subdivided into
non-monetary
and monetary sectors.
The
overall balance of payments comprises the current account (merchandise and
services), unilateral transfers (gifts, grants, remittances, and so on), and the
capital account (long-term and short-term capital movements). If payments due in
exceed those due out, a country is said to be in overall surplus; and when
payments due out exceed payments due in, it is in overall deficit. The surplus
or deficit must be balanced by a monetary movement in the opposite direction,
and consequently the overall balance including monetary movements must always be
equal.
It
is important not to confuse the 'trade balance' and the balance of payments.
The trade balance refers to trade in goods. An export surplus or deficit
in goods may be matched by net sales of services. There would then
be no deficit in goods and services as a whole. Thus the balance
of payments is a broader
and more significant measure than is the balance of trade in goods alone.
Often the balance of
goods and services is confused with the current account balance.
The current account as a whole has always had a basic importance. A nation with a deficit on total current
account is ipso facto decreasing its capital assets abroad (including gold) or
increasing its capital liabilities to foreigners. A nation with a
current-account surplus is gaining foreign assets or reducing its foreign
liabilities.
A deficit in the
balance of goods and services does not necessarily affect a
country's exchange rate. There may be a matching inflow of investment capital
that strengthens the immediate exchange position and builds up a country's
future exporting capacity. Similarly, a surplus in the balance of goods and
services may not assure a strong exchange rate.
For another explanation see: The Economist
Glossary -
Balance of Payments; Government of Canada
Balance of Payments (a) &
(b); Wikipedia
Balance of Payments;
2.
Exchange Rate
The
'exchange rate' is the price of a country's money in relation to another
country's money. An exchange rate is "fixed" when countries use gold
or another agreed-upon standard, and each currency is worth a specific measure
of the metal or other standard. An exchange rate is "floating" when
supply and demand (including speculation) sets exchange rates.
Generally
when Canada's exports increase, the
exchange rate increases (i.e. fewer Canadian dollars buy a unit of foreign
currency). Increased foreign demand for Canadian currency makes
Canadian goods more expensive. As Canadian goods become more expensive,
exports decline. Decreased demand for the Canadian dollar then
tends to lower the exchange rate making Canadian goods cheaper and so on
and so on in a floating exchange rate system.
P&B
Fig. 36.4 Demand for Dollars (7th
Ed Fig. 25.2)
P&B
Fig. 36.5 Change in Demand for Dollars (7th
Ed Fig. 25.5)
P&B
Fig. 36.6 Supply of Dollars (7th
Ed Fig. 25.3)
P&B
Fig. 36.7 Change in Supply of Dollars (7th
Ed Fig. 25.6)
P&B
Fig. 36.8 Equilibrium Exchange Rate (7th
Ed Fig. 25.4)
P&B
Fig. 36.9 Exchange Rate Fluctuations (7th Ed not displayed)
P&B
Fig. 36. 10 Foreign Exchange Market Intervention (7th
Ed Fig. 25.7)
World
trade now depends on a managed floating exchange system. Governments act to
stabilize their countries' exchange rates by limiting imports, stimulating
exports, or devaluing currencies.
No
economy is self-contained. Central banks must therefore pay attention to
trading and financial relationships with other countries. If goods are bought
abroad, there is a demand for foreign currency to pay for them. Alternatively,
if goods are sold abroad, foreign currency is acquired that the seller
ordinarily wishes to convert into the home currency. These two sets of
transactions usually pass through the banking system, but there is no necessary
reason why in the short-term they should balance. Sometimes there is a surplus
of purchases and sometimes a surplus of sales. Short-term disequilibrium is not
usually significant, but it is important that there be a tendency to balance in
the long term. It is difficult for a country to be a permanent borrower or
to continue building up a command over goods and services that it does not
exercise.
Short-term
disequilibrium can be handled by increasing or decreasing balances of foreign
exchange. If a country has no balances to diminish, it may borrow, but normally
it carries working balances. If the commercial banks find it unprofitable to
hold such balances, the central bank will usually carry them; indeed, it may
insist on concentrating the bulk of the country's foreign-exchange resources in
its hands or in those of an associated agency.
Long-term
equilibrium is more difficult. It may be achieved in three ways: price
movements, exchange revaluation (appreciation or depreciation of the currency),
or exchange controls.
Price
levels may be influenced by expanding or contracting the money supply. If
the central bank wants to stimulate imports, for example, it can induce a a rise
in domestic prices by increasing the money supply. If additional exports are
required, the central bank can force down domestic prices by decreasing the
money supply.
The
objective may be achieved directly by revaluing a country's exchange rate.
Depending on the circumstances, the rate may be increased or decreased, or
allowed to "float." Appreciation means that the domestic
currency becomes more valuable in terms of the currencies of other countries and
exports consequently become more expensive for foreigners. Depreciation involves
decreasing the value of the domestic currency thus lowering the price of export
goods in the world's markets. In both cases, however, the effects are usually
only temporary, and for this reason the central bank usually prefers
relative stability in exchange rates even at the cost of fluctuation in domestic
prices.
Sometimes
governments resort to exchange controls (sometimes combined with import
licensing) to allocate foreign exchange more or less directly in payment for
specific imports. At times, a considerable apparatus has been assembled for this
purpose, and, despite "leakages" of various kinds, the system has
proved reasonably efficient in achieving balance on external payments account.
Its chief disadvantage is that it interferes with normal market processes,
thereby encouraging rigidities in the economy, reinforcing vested interests, and
restricting the growth of world trade.
Whatever
method is chosen, the process of adjustment is generally supervised by some
central authority -- the central bank or some institution closely associated with
it -- that can assemble the information necessary to ensure that the proper
responses are made to changing conditions.
Also see: The Economist Glossary -
Exchange Rate; Wikipedia -
Exchange Rate;
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