Page 218 - DECO201_MACRO_ECONOMICS_ENGLISH

Unit 12: Balance of Payments

Advantages of Fixed Exchange Rates Notes

Reduced Risk: By maintaining a fixed rate of exchange, international buyers and sellers of
goods can agree on a price and not be subjected to the risk of later changes in exchange
rates before contracts are settled.
Discipline in Economic Management: Since the burden of adjustment to long-term
disequilibrium in BOP is thrown out of the domestic economy, governments have an
incentive to avoid a rate of inflation that is out of line with that of their major competitors.
Elimination of Destabilising Speculation: Since exchange rates are fixed, it is sometimes
suggested that there is no possibility of speculation causing an overvaluation or an
undervaluation of exchange rate.

Disadvantages of Fixed Rates

BOP Adjustment: They do not provide an automatic mechanism to restore BOP equilibrium
and the burden of adjustment is thrown on to the domestic economy.
Exchange Rate Instability: Fixed exchange rates are inherently unstable in the long run
because different countries pursue policies which are mutually inconsistent under a system
of fixed exchange rates. For example, if one country attaches greater importance to control
of inflation than its trading partners, it is likely to experience a continuing BOP surplus. If
this surplus persists, it will require persistent adjustment of exchange rates. The problem
is that when fixed exchange rates are adjusted, there is an immediate and significant
change in costs and prices which may adversely affect economies.
International Transmission of Inflation: Fixed exchange rates lead to transmission of
inflation from one country to that of its trading partners. This may happen when inflation
in one country leads to an increase in the price of imports in other countries because price
differences are not offset by changes in the exchange rate.
Self Assessment

Fill in the blanks:
14. BOP is in ............................. or deficit if imports (M) are greater than exports (X).
15. In ............................. exchange rate system, the price of foreign currencies varies according
to their market demand and supply position.
16. ............................ exchange rates lead to transmission of inflation from one country to that
of its trading partners.
12.5 Summary

The BOP is a statistical account of the transactions between residents of one country and
residents of the rest of the world for a period of one year or fraction thereof.

BOP is divided into 3 accounts: capital account, current account and Official Reserves
Account. The current account records the net flow of goods, services and unilateral transfers;
The capital account records the net flow of FDI in plant, equipment and long-term, short-
term portfolio (debt and equity) investment; and The ORA measures changes in the holdings
of foreign currency, SDRs and gold by the central bank of a nation.

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