Relationship between payment of balance and exchange rate
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Relationship between payment of balance and exchange rate
Today, there has been incidence of high capital mobility and there accounts for threat of speculative attack that makes up to the central issue of certain economic policy. There has been considerable relevance to particular financial crises as of the present wherein payment of balance and exchange rates are a part thus, in accordance to upscale and downscale of situation concerning finances and other matters of certain capital bases. Most of recent attempt have argued that problem lies in the banking system affecting roles of company business balance sheets in determining certain ability to invest as well as of capital flows in affecting real exchange rate. For instance, within the Asian currency turmoil, there has been subject of financial crises that relates to the balance of payments and exchange rate situation, affecting economy at large. There has been about linkage between banking and currency crises due to the latter assumption. The relationship takes account of certain financial liberalization often precedes banking crises, there occur as economy enters recession, following a prolonged boom in economic activity that was fueled by credit, capital inflows, and accompanied by an overvalued currency (Kaminsky and Reinhart, 1999).
Just as the basic determinants behind the supply of and demand for wheat are critical in fully understanding the behavior of wheat prices, so it is important to understand the factors behind the supply of and demand for foreign exchange to determine the price of a foreign currency. For example, there should be stressed that the factors determining the demand for Euros are also the factors determining supply of dollars, factors determining supply of Euros determine demand for dollars. The balance of payments is systematic array of all the factors that determine the foreign exchange rate. There can cause shifts in the demand and supply of foreign exchange thus causing changes in the exchange rates, determinant of demand for and supply of foreign exchange, exchange rates are determinants of the various balances within the overall balance of payments. The factors would tend to cause an increase in the supply of foreign exchange would also tend to cause a surplus in the balance of payments. Factors causing an increase in demand for foreign exchange would tend to cause balance of payments deficits. Ideally, capital flow should be considered in determining balance of payments leading to surplus in balance of payments are factors that supply foreign exchange. The factors leading to deficit in basic balance are factors that demand foreign exchange in the foreign exchange markets. There can be dynamics of balance of payments adjustment under fixed exchange rates and of exchange rate determination under flexible exchange rates, endogenous monetary policy and sterilization operations, multiplicity of tradable and nontradable goods, large countries, capital mobility and portfolio balance. Thus, issues discussed include purchasing power parities, nontraded goods, real exchange rate, currency substitution and interaction between real and monetary factors effecting exchange rates as there characterizes the interaction between the balance of payments and the equilibrium real exchange rate (Frenkel and Mussa, 1985).
Therefore, there is imperative notion of developing certain model upon determination of exchange rates and prices of goods. Changes in relative prices of goods, due to supply or demand shifts, induce changes in exchange rates and deviations from purchasing power parity. The changes may create correlation between exchange rate and terms of trade, but cannot be exploited by the government to affect the terms of trade by foreign exchange market operations. Thus, high volatility of real and nominal exchange rates may be due to the fact that local currency pricing eliminates the pass-through from changes in exchange rates to consumer prices. Exchange rates may be volatile because in a sense they have little effect on macroeconomic variables. There shows the ingredients necessary to construct such an explanation for exchange rate volatility. In addition to the presence of local currency pricing, there is a need of incomplete international financial markets, a structure of international pricing and product distribution such that wealth effects of exchange rate changes are minimized as well as stochastic deviations from uncovered interest rate parity. The elements can produce exchange rate volatility that is much higher than shocks to economic fundamentals, disconnected from rest of economy in the sense that the volatility of all other macroeconomic aggregates are of the same order as that of fundamentals. The theory of balance of payments show that, under perfect foresight, system of fixed exchange rate is not sustainable in the presence of diverging economic policies. There show how and why capital controls succeed in maintaining the principle of fixed, but adjustable, parity. Cases of devaluation and revaluation can be considered also, condition for parity change to credibly present better end means of the matter.
Graciela L. Kaminsky and Carmen M. Reinhart (1999). The Twin Crises: The Causes of Banking and Balance-Of-Payments Problems. The American Economic Review, Vol. 89, No. 3 (Jun., 1999), pp. 473-500 American Economic Association
Frenkel, Jacob A. and Mussa, Michael L. (1985). Asset Markets, Exchange Rates and the Balance of Payments (April 1985). NBER Working Paper Series, Vol. w1287, pp. -, 1985
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