Balance of Payments Theory of Exchange! It is also referred to as demand-supply theory of exchange. The theory stresses that the rate exchange basically relates to the position of balance of payments of the country concerned.
The significance of a deficit or surplus in the BOP has changed since the advent of floating exchange rates. This pressure led to governmental transactions that were compensatory in nature, forced on the government by its need to settle the deficit or face a devaluation. The How exchange rate relates to bop between the BOP and exchange rates can be illustrated by use of a simplified equation that summarizes BOP data: Under a fixed exchange rate system, the government bears the responsibility to ensure a BOP near zero.
If the sum of the current and capital accounts does not approximate zero, the government is expected to intervence in the foreign exchange market by buying or selling official foreign exchange reserves.
If the sum of the first two accounts is greater than zero, a surplus demand for the domestic currency exists in the world. To preserve the fixed exchange rate, the government must then intervence in the foreign exchange market and sell domestic currency for foreign currencies or gold so as to bring the BOP back near zero.
It the sum of the current and capital accounts is negative, an exchange supply of the domestic currency exists in world markets.
Then the government must intervene by buying the domestic currency with its reserves of foreign currencies and gold. It is obviously important for a government to maintain significant foreign exchange reserve balances to allow it to intervene effectively.
If the country runs out of foreign exchange reserves, it will be unable to buy back its domestic currency and will be forced to devalue. For fixed exchange rate countries, then, business managers use balance-of-payments statistics to help forecast devaluation or revaluation of the official exchange rate.
Under a floating exchange rate system, the government of a county has no responsibility to peg the foreign exchange rate. The fact that the current and capital account balances do not sum to zero will automatically in theory alter the exchange rate in the direction necessary to obtain a BOP near zero.
For example, a country running a sizable current account deficit with the capital and financial accounts balance of zero will have a net BOP deficit. An excess supply of the domestic currency will appear on world markets.
As is the case with all goods in excess supply, the market will rid itself of the imbalance by lowering the price. Thus, the domestic currency will fall in value, and the BOP will move back toward zero. Exchange rate markets do not always follow this theory, particularly in the short-to-intermediate term.
Although still relying on market conditions for day-to-day exchange rate determination, countries operating with managed floats often find it necessary to take actions to maintain their desired exchange rate values.
The primary action taken by such governments is to change relative interest rates, thus influencing the economic fundamentals of exchange rate determination.
A change in domestic interest rates is an attempt to alter capital account balance, especially the short-term portfolio component of these capital flows, in order to restore an imbalance caused by the deficit in current account.
The power of interest rate changes on international capital and exchange rate movements can be substantial. A country with a managed float that wishes to defend its currency may choose to raise domestic interest rates to attract additional capital from abroad.
This will alter market forces and create additional market demand for domestic currency. The process also raises the cost of local borrowing for businesses, however, and so the policy is seldom without domestic critics.
For managed-float countries, business managers use BOP trends to help forecast changes in the government policies on domestic interest rates.relationship between exchange rate volatility and BOP in Kenya.
The study adopted a quantitative comparative design to determine the relationship between the two variables. Balance of Payments Theory of Exchange! It is also referred to as demand-supply theory of exchange. The theory stresses that the rate exchange basically relates to the position of balance of payments of the country concerned.
REVISION SHEET #2 The Absorption Approach to the BOP -Relates an economy’s income it its domestic expenditure How will the current account be affected by a changing exchange rate under the Absorption Method?
The first edition of the Balance of Payments BOP manual was published in The balance of payments theory of exchange rate holds that the price of foreign money in terms of domestic money is determined by the free forces of demand and supply on the foreign exchange market.
It follows that the external value of a country's currency will . The balance of payments does not impact the exchange rate in a fixed-rate system because central banks adjust currency flows to offset the international exchange of funds.
The relative version of PPP relates changes over time in an equilibrium exchange rate to changes in a country‟s relative price levels.
In other words, the relative version of .