Influence of the Nominal Exchange Rate's Fluctuations on both Current Balance of Payments and Balance of Foreign Trade
Exchange rates have a significant impact on foreign trade of different countries, affecting the level of prices, wages, interest rates, employment, investment decisions and competitiveness of the economy overall. Supply and demand for foreign currency is constantly changing under the influence of various factors that reflect changes in the country's place in the global economy. Consequently the exchange rate of the national currency is changed. To understand the impact of the exchange rate on the balance of payments and foreign trade balance, let's examine the changes in the economy in terms of the changes in the value of national currency.
If a country adheres to a system of floating exchange rates, the exchange rate is set by floating of supply and demand as the equilibrium price of the currency on foreign exchange market. In this case demand (D) and supply (S) depend on the volume of foreign trade operations. Let's examine two cases of depreciation and appreciation of the national currency (Fig. 7.1).
Figure 7.1. The establishment of the exchange rate under a regime of floating exchange rate
Initially, the exchange rate (e) was in equilibrium at point Fq. Due to the increase in imports, the demand on foreign currency increases, i.e. D curve will shift to the level of Di, the shortage of demand on foreign currency will shift the equilibrium level of the exchange rate to Fi, which means its growth rate. Similarly, the drop in demand on foreign currency by reducing the size of the import results in movement of the demand curve to the level of D2, there is excess supply of foreign currency, resulting in a balance of supply and demand set at a lower level of F2, which means the fall in the exchange rate of the foreign currency. Similar effects are occurred by changes in the volume of exports.
Under a system of fixed exchange rates, the exchange rate is set by the central bank, which assumes responsibility to buy and sell any amount of foreign currency at a fixed exchange rate (Fig. 7.2). In the case of growth in demand on foreign currency the central bank begin to sell foreign currency from its reserves to keep the exchange rate at the level of Fq. With an increase in imports, the demand on foreign currency is also increasing, and the demand curve shifts to the level of D1, while the supply remains the same - S. To keep the exchange rate at the level of Fq, the central bank sells foreign currency and its supply increases and the supply curve shifts to the level of S1. Together with the sale of foreign currency a reduction of the volume of currency in circulation takes place. Decreasing in the money supply leads to a reduction in expenses, including spendings on imports, as residents have less currency in their disposal to buy foreign currency.
Figure 7.2. Exchange rate adjustment by the central bank
As a result, the demand curve D1 shifts back gradually to the level of D2. The adaptation process takes place as long as the supply and demand curves do not intersect at the point of Fi, at which the exchange rate will remain the same Fq.
Typically, economists point to the impact of the exchange rate on the balance of payments. A significant impact on the exchange rate has a current account balance that characterizes the flow of real values. (In) the balance of current account reflects trade in goods and services, net income on investments, and transfer payments of the population and the state. Depreciation of the national currency allows the country's exporters to reduce their prices in foreign currency, to receive the same amount in the national currency during its exchange. This increases the competitiveness of the goods and creates opportunities to increase exports. Imports in this situation slow down, as foreign exporters are forced to raise prices to obtain the same amount in their currency, which reduces demand on goods. At the same time there is an increase in import prices (if import demand is inelastic at prices). Together With the strengthening of the national currency the reverse situation is observed - the decline in exports due to the increase in export prices and reduction in demand on it as well as an increase in imports.
Net effect of exchange rate on the trade balance will depend on price elasticity. At constant price levels in the domestic market and abroad the net export of goods depends on two variables - the real national income and the nominal exchange rate.
With the growth of real income households increase demand not only on domestic but also on foreign goods, so net export of goods decreases. The impact of the nominal exchange rate on net export of goods depends on the ratio of the elasticities of export and import:
where Zex — the coefficient of export elasticity;
— the volume of export; e — the nominal exchange rate;
m — the coefficient of import elasticity;
Qui: — the volume of import.
If the exported goods are elastic at price, their quantity will increase faster than prices fall, and the total revenue from export will increase. Similarly, if the imported goods are elastic, total expenditure on import will decrease. Then, at a given real income the net export of goods that was measured in local currency (Nex (e)), is estimated by formula:
where 2" (e) — the volume of export in national currency; Q,,,, — the volume of import.
In this case the increment in net export (^ex) is defined by formula:
In other words, the increase in the exchange rate leads to a rise in net export of goods, if the amount of the price elasticity of export and import in absolute value is more than one, i.e. the devaluation of the national currency should improve the current balance.