The government is forced to purchase the domestic currency when an expansionary monetary policy is used in a fixed exchange rate. It reduces the money supply. It causes aggregate demand to decline, which reduces imports. It causes a surplus on the balance of payments (Carbaugh, 2013).
An expansionary fiscal policy involves increased government spending financed by floating bonds, which increases interest rates. It leads to capital inflows by foreigners. Capital inflows create pressure for local currency appreciation.
The monetary authorities respond by purchasing foreign currencies. It increases the domestic money supply. Increase in domestic money supply causes aggregate demand to increase. People have more money to purchase imports at the same prices. The balance of payments experiences a deficit (Carbaugh, 2013).
An expansionary monetary policy under a flexible exchange rate system causes interest rates to fall. It reduces foreign capital inflow, which makes the local currency to depreciate. Imports become expensive, and exports cheaper. It leads to higher exports and a surplus in the balance of payments (Carbaugh, 2013).
An expansionary fiscal policy causes interest rates to rise. It leads to an influx of capital. The local currency appreciates making imports cheaper and exports expensive. The increase in imports causes a deficit in the balance of payments.
International debt cancellation allows the debtor country to use the generated funds to invest in economic activities that increase national income and allows it to increase imports that benefits creditor countries.
Carbaugh (2013) explains that Indonesia and South Korea have been able to service their debts easily without debt cancellation.
Banks may reduce the risk of debtor countries by increasing their reserves, capital bases, and reducing lending. They may also sell loans to other banks at a discount. They may sell loans to the government as well.
Banks accept deposits in the form of foreign currencies. They issue loans in the form of foreign currencies through the Eurocurrency market. Banks engage in the buying and selling transactions of the foreign exchange market. Banks engage in transferring foreign exchange balances from one account to another without necessarily moving the physical cash (Carbaugh, 2013).
The equilibrium rate of exchange is determined by the forces of demand and supply (Carbaugh, 2013). The supply side is derived from the credit side of the balance of payments, which includes transactions that demand the use of the local currency. The debit side covers transactions that require the use of foreign currencies (Carbaugh, 2013).
The U.S. has become a net debtor because of a persistent deficit in the balance of payments. Another factor that has led to the U.S. becoming a net debtor includes the high savings found in the global pool of funds. Other nations are spending less and saving more. The U.S. provides investors with higher interest rates and higher productivity, which increases net capital inflow (Carbaugh, 2013).
Foreign repercussion effect refers to the impact that income and expenditure in one country have on the income of other countries (Carbaugh, 2013).
For example, by China exporting more commodities to the U.S., its income levels rise. Americans income levels decline because of more imports than exports. When China’s income levels rise, appreciation of yen makes Chinese products expensive to Americans. Americans start to consume more of their domestic commodities. China’s national income declines as imports decline until they become cheaper again. The U.S.’s income increases as it consumes more of its domestic commodities. The process is repeated in cycles.
In foreign sourcing, an appreciation of the local currency results in lower costs for inputs, and lower costs for the end product. A depreciation results in higher costs for inputs and higher costs for the end product.
In the crawling peg system, authorities make frequent adjustments to the exchange rate. On the other hand, the adjustable pegged exchange rate consists of adjustments made after a very long period of time. Carbaugh (2013) explains that the crawling peg system may make several adjustments in a year. The adjustable pegged system may make a single adjustment over several years.
A developing country is likely to use the crawling peg because of the high rates of inflation associated with some of the developing countries. The crawling peg method allows authorities to select a few economic indicators, which they use to adjust the exchange rate. It reduces sensitivity to other factors such as volatility created by speculators. It eliminates the uncertainty of the floating exchange rate system. It combines the benefits of the fixed exchange rate system and the floating rate system (Carbaugh, 2013).
Currency boards can prevent currency crises by regulating money creation. Unregulated money creation increases money supply uncontrollably, which affects the exchange rate. The boards also manage a fixed exchange rate system.
Dollarization allows an economy to use the dollar alongside its local currency. It acts as a substitute that may be used by businesses to protect against inflation, fluctuations in the exchange rate, and exchange rate arbitrage (Carbaugh, 2013).
International economic policy coordination refers to a process of formulating domestic economic policies in consideration with international economic interdependence (Carbaugh, 2013).
The Plaza Agreement of 1985 objective was to assist the U.S. to depreciate its currency, which was becoming a hindrance to international competitiveness. It was successful because after two years (in 1987), the G5 nations met again to consider stopping further depreciation of the U.S. dollar. The agreement had met its goal. Carbaugh (2013) explains that it is no longer effective because most central banks have gained independence from their national governments.
Expansionary monetary policy causes interest rates to fall, which leads to the capital outflow or discourages capital inflow. The government releases foreign currency, which reduces the money supply. Aggregate demand falls, and the balance of payment experiences a surplus.
On a contractionary monetary policy, the government decreases money supply through open market operation (Carbaugh, 2013). Higher interest rates cause foreigners to transfer funds into the country. Government purchases foreign currency to stabilize the exchange rate, which increases local currency supply. Aggregate demand increases and the balance of payment experiences a deficit.
The Eurocurrency market works through a “pool of foreign currencies deposited in different countries, and in different banks within the system” (Carbaugh, 2013, p. 478). Governments, commercial banks, organizations, and individuals may engage in making deposits.
The groups that make deposits earn an interest rate when groups that borrow from the fund are charged (Carbaugh, 2013). The Eurocurrency market operates using a different set of rules from national regulation on minimum reserves. It can keep little or more reserves as it wants.
The need for international reserves under a floating exchange rate system is eliminated. The market forces of demand and supply are able to correct the exchange rate by making it cheaper when demand is low and expensive when demand is higher (Carbaugh, 2013).
In the fixed exchange rate system, the monetary authorities have to maintain supplies of international reserves to restore the exchange rate back to the equilibrium rate when it deviates. They release foreign currencies when the demand is high and purchase them when the demand is low (Carbaugh, 2013).
Carbaugh, R. J. (2013). International economics (14th ed.). Mason, OH: South-Western Cengage Learning.