Last Updated 28 Jan 2021

How Exchange Rate Targeting Can Affect the Balance of Payment

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Exchange rate targeting is whereby the exchange rate becomes the nominal anchor. The subject of the most favorable monetary regime for small open developing economies is still widely discussed. The advantages and disadvantages of different exchange rate regimes are far too many to be readily captured and used to come up with a specific regime that suits the needs of all. Real exchange rate is perhaps the most popular real target for developing economies.

The main advantages of Exchange rate targeting are:

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  1. The nominal anchor of an exchange-rate target directly contributes to keeping inflation under control by tying the inflation rate for internationally traded goods to that found in the anchor country.
  2. The exchange rate can be directly observed i. e, with a fairly narrow band on a certain exchange rate, it is easy to determine whether the intermediate target is fulfilled
  3. An exchange-rate target provides an automatic rule for the conduct of monetary policy that helps mitigate the time-inconsistency problem.
  4. An exchange-rate target has the advantage of simplicity and clarity, as it is easily understood by the public.

The main advantages of Exchange rate targeting are:

  1. Shocks that change interest rates in the anchor country lead to corresponding changes in interest rates in the target country.
  2. The targeting country is open to speculative attack on its currency whenever the anchor country pursues tight monetary policy.

The close linkage of the exchange rate to the general price levels of the economies produce an economy wide importance of policy making since it affects the real income and wealth of those economies.

One of the main objectives of the exchange rate based stabilizations is to improve the Balance of Payment (BOP) performance through international competitiveness. Devaluation or depreciation of a country’s currency is aimed at gaining external competitiveness and BOP improvement in an economy. Exchange rate targeting is likely to impact on a nation’s BOP through various means which can be assessed through looking at the various approaches to BOP. In order for xchange rate targeting to be successful, it is vital that international financial support be availed in the form of an injection of foreign currency to increase the supply and perhaps match the demand for forex in the country. At the same time, the central bank should be building its foreign reserves. When the central bank has adequate reserves, then it can enter the forex market to influence the value of the dollar by buying or selling forex to affect liquidity conditions in the market. As investors gain confidence in the economy, foreign investment starts flowing into the country, increasing supply of forex.

Also, as production increases due to a favourable market related exchange rate, exports will increase and so will be the inflow of forex. The main reason why the exchange rate continues to overshoot its real value is because, the central bank lacks the capacity to influence its value due to lack of adequate foreign reserves. Consider the elasticity approach to BOP. The elasticity approach emphasizes price changes as a determinant of a nation's balance of payments. The elasticity approach, therefore, considers the responsiveness of imports and exports to a change in the value of a nation’s currency.

For example, if import demand is highly elastic, a depreciation of the domestic currency will cause a disproportional decline in the nation’s imports. The Marshall-Lerner condition, states that a currency devaluation will only lead to an improvement in the balance of payments if the sum of demand elasticity for imports and exports is greater than one An upwards shift in the value of a nation's currency relative to others will make a nation's exports less competitive and make imports cheaper and so will tend to correct a current account surplus.

The main advantage of manipulating exchange rates is that, if output is traded internationally, changes in exchange rates will have a powerful effect on Aggregate demand. According to Marshal Lerner condition, devaluation currency leads to improvement in the balance of payments if the sum of import and export elasticity’s is greater than one. A weak exchange rate leads to reduction in price of exports and increase the price of the imports. As such, quantity demanded will increase and quantity of imports demanded will decrease. This will increase the current account balance and hence a country remains competitive.

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