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Foreign exchange balance policies

1. Exchange rate regimes

   • Fixed
     • Types
       • conventional
       • intermediate
       • Currency board system
       • no separate legal tender
     • advantages
       • countries with chronic inflation problems import the monetary policy of a central bank with more credibility
       • strengthens commercial links and foreign direct investment
     • Problems
       • what is suitable for one country is not suitable for another
       • no longer possible to use the exchange rate as a tool for cushioning external shocks
       • can encourage speculative attacks and financial crisis
     • renewed interest
       • easy to implement and understand
       • countries that intervene much in the foreign exchange market are classified as if the had fixed exchange rate by IMF
       • BUT the increase of countries following this regime is temporary and has many risks
         • solution: countries with fixed exchange rate should take control of the monetary policy and introduce more flexibility
   • Flexible
     • monetary policy framework of inflation targeting - no target for the level of exchange rate - occasional or no intervention in the foreign exchange market

2. External current account deficit

   • excess in expenditure financed by net inflows of foreign capital
   • What is the sustainable level?
     • Not the same for all countries at all times
     • Evaluate whether the country can meet its future payment commitments
       • the level of external debt must not be too high in relation to GDP
         • The level at which net debt stabilizes depends on:
           • external deficit
           • interest rate
           • Nominal GDP rate of growth

3. Current account surplus

   • should this imbalance be corrected?
     • No
       • It is the result of good competitiveness, high per capita income and population structure
       • measures to boost domestic demand in surplus countries would have a limited impact on trade for the rest of EU countries
     • Yes
       • CA surplus is larger than allowed by EU Commission

4. The exchange rate and economic policy

   • Depreciation
     • Aim: to boost domestic demand
     • is advanced economies' expansionary monetary policy a competitive devaluation?
     • Problems if it threatens the economic model of other countries and if it is perceived as deliberate
       • Could lead to a full-blown currency war
   • The exchange rate plays an important role in economic policy decisions
     • Fixed exchange rate
       • Trilemma of the open economy or impossible trinity
         • incompatibility between a fixed exchange rate, capital flows and indipendent monetary policy
     • Floating exchange rate system
       • exchange rate determined by the market, but economic authorities can affect the price of their currency directly or indireclty - via monetary or fiscal policy