Balanceof payment evaluates a country’s transaction internationally. Itenables an economy to know the amount of money going in and out ofthe country. This explains money supply and the changes involvedenabling us to know when to apply monetary policy. Thus, a countrywill know if there is excess or under-spending. It analyzes theinternational trade market and a country’s vulnerability to thefluctuations in the external economy.
Currentand capital accounts addup to the balance of payments. Currentaccount analyzes international trade and the net income. Capitalaccount analyses miscellaneous activities are not affecting theincome, production or savings of a country. The trade balance isinsightful to the exchange rates because at some point it’s used toevaluate the money supply.
Thegold standard adjusts trade deficits and trade surplus. During tradesurplus, the economy increases the inflow of gold increasing theprices of domestic products, and thus imports will increase fromcheap prices of imported goods. In trade deficits, the outflow ofgold is increased thereby reducing the prices of domestic productsmaking them affordable to foreign countries, therefore increasingexports.
Duringtrade deficit, a country imports more than it exports therefore, acountry employs steps to curb it. For example in 2013, USA had atrade deficit. They produced more consumer products to avoidimporting them, reduced the dependence on foreign oil by developingtheir field of oil to avoid importing. They tried to findalternatives to produce some of the products they were initiallyimporting in order to reduce imports of products.
Financecovers international trade for example the EU, which has advantagesand disadvantages. Advantages include free trade zone among themember countries, economic development in the member countries. Thereis a loss of sovereignty. This is a disadvantage. The membercountries cannot close borders to people from EU members.
Monetaryand economic unions may fail when the currency used in the union maynot be strong compared to other currencies since it might lead totrade deficits, and unstable exchange rates may cause the failure ofsuch. Fluctuating exchange rates may lead to high or low rates. Lowrates will make the currency weak
Acurrency appreciation is good for a country because the cost ofimporting products is reduced. This is because the increase in valueof a currency makes a product cheaper since less cash is needed forthe products. This increases imports since a country can buy productswith lesser cash. It attracts investors, and the economy grows.Currency depreciation will make its products expensive consideringthe other currencies are stable, reducing exports. The reason behindthis is currency depreciation makes the domestic products much moreexpensive. This requires a float exchange regime, where the centralbank intervenes to reduce the appreciation or depreciation andinternational reserves to stabilize any depreciation.
Underthe gold standard, reducing the price of gold below 1 DM increasesinflow of gold in German economy making their products cheaperincreasing their car exports. The German DM will have appreciatedagainst the US dollar. This reduces the US car exports and hurt USsince US dollar took the role of gold in the gold standard. This canbe related to the dollar revaluation after World War 2 when Europeancountries transferred their gold to the USA to reduce their debtscaused by the war and the value of the US dollar rose.
Fixedrates convert currencies directly. Float Rates involve the centralbank to intervene to control appreciation or depreciation. Managedrates are rates that the central bank intervenes. Fixed rates aremore likely to be affected by inflation since, in float rates andmanaged rates, the central bank may intervene to adjust the value ofthe currency to go in hand with inflation.
Interestrate parity is no arbitrage condition expected to be at equilibrium.Arbitrageurs restore equilibrium during interest rates the parity byexchanging domestic currency for different foreign currency. Theyalso invest in a country with low rates and borrowing from a countrywith high rates, They sell high and buy low. Investing the foreigncurrency within the foreign interest rate happens at the current spotrate.
Forwardmarket is where prices of products are agreed on today but deliveredlater. Central bank intervention is buying or selling of domestic orforeign currency to raise or lower its value. This normally happensduring inflation. Cross exchange rates are rates of exchanging twodifferent currencies. Forward premium is the difference between thecurrent spot rates and expected future rates.
Marston,Richard C, (2010). “Interestarbitrage in the Euro currency markets,”European