14 Budget Deficits and the National Debt

Upon completion of this chapter you should
be able to explain how a nonzero balance of payments affects the economy when the exchange rate is (a) flexible and (b) fixed;
understand how international forces affect the strength of monetary and fiscal policy, including the dramatic result that monetary policy is completely ineffective under fixed exchange rates; and
know how the government can influence the foreign exchange market and thus the exchange rate.

16.1
International Imbalance with a Flexible Exchange Rate
Exactly what are the forces for change that an imbalance in the balance of payments engenders? This is a crucial question, the answer to which depends on whether the economy is operating on a flexible or a fixed exchange rate system. Let us first examine a flexible exchange rate system.
Under a flexible exchange rate system, the government allows the forces of supply and demand to determine the exchange rate. If there is a balance of payments surplus, demand for our dollar on the foreign exchange market exceeds its supply, so market forces cause a rise in the value of our dollar. Those who want the extra, unavailable dollars try to obtain them by offering extra foreign currency for them, so our dollar becomes more valuable in terms of foreign currency. This appreciation of our dollar is often described by the statement "The exchange rate has risen."
This process operates in reverse if there is a balance of payments deficit. In this case, the demand for our dollar on the foreign exchange market is less than its supply, so market forces cause a fall in its value. This depreciation of our dollar is often described by the statement "The exchange rate has fallen."
Note that under a flexible exchange rate system, any tendency toward a balance of payments surplus or deficit is automatically and instantaneously eliminated by a flexing of the exchange rate, so that our measure of the imbalance (the balance of payments) is always zero. The balance of payments measure is nonzero only if the government engages in some net buying or selling of foreign currency. In the context of a flexible exchange rate, the terminology "balance of payments surplus or deficit" must be interpreted as reflecting a surplus or deficit that would appear if the exchange rate were not permitted to adjust instantaneously.

 



Macroeconomic Essentials. Understanding Economics in the News 2000
Macroeconomic Essentials - 2nd Edition: Understanding Economics in the News
ISBN: 0262611503
EAN: 2147483647
Year: 2004
Pages: 152

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