Exam 18: A: The Balance of Payments and Exchange Rates

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In the fixed exchange rate system a nation might fix (or "peg") its exchange rate with another nation.In this case, the governments of these nations must intervene in the foreign exchange markets to prevent shortages and surpluses caused by shifts in demand and supply for foreign currencies.One way for a nation to stabilize foreign exchange is for its government to sell its reserves of a foreign currency in exchange for its own currency (or gold) when there is a shortage of the foreign currency.Conversely, a government would buy a foreign currency in exchange for its own currency (or gold) when there is a surplus of the foreign currency.Currency reserves, however, may be limited and inadequate for handling large and persistent deficits or surpluses, so it may use other means to maintain fixed exchange rates.First, a nation might adopt trade policies that discourage imports and encourage exports.Second, a nation might impose exchange rate controls and rationing; but these policies tend to distort trade, lead to government favouritism, restrict consumer choice, and create black markets.A third way for a nation to stabilize foreign exchange rates is to use monetary and fiscal policy to reduce its national income and price level, and raise interest rates relative to other nations.These events would lead to a decrease in demand for and increase in the supply of different foreign currencies.

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Official bank reserves are drawn upon to settle net differences in current and capital account balances so that the balance of payments is brought into balance.However, the change in the status of official reserves represents a disequilibrium in the balance of payments.So-called autonomous transactions did not balance, and official reserves were needed to accommodate the difference.

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When we trade goods within a country we use a common currency.This is not true of trade between nations.The foreign exchange market permits trading countries to purchase each other's' currency so that they might purchase each other's goods.For instance, if the British public wanted to purchase $15 million worth of Canadian automobiles, they would need to have $15 million Canadian dollars.To complete this transaction, they could go to the foreign exchange market.Suppose 1 $\le$ sold for $2 Canadian.If they exchanged 7.5 million $\le$ they could buy $15 million Canadian and use that money to purchase the vehicles.