TOPIC SIX

BALANCE OF PAYMENT AND EXCHANGE RATES (BOP)

-Is a statement which records all the monetary transactions made between residents of a
country and the rest of the world during any given period.It tracks international
transactions ie when funds go to a country,a credit is added to BOP.It is an accounting
system used to measure international flows of money and products/services.
-It is the relationship between value of exports and imports of a country.
-Exports refer to goods and services sold by a country to another country while imports
on the other hand refers to goods and services bought from another country.
-If the money value of exports is higher than the money value of imports then the balance
of payment is said to be favourable and when value of import is more than that of export
then BOP is said to be unfavourable and when equal it is said to be at equilibrium.
-Or when the value of exports is more than that of imports then the balance is surplus
and when value of export is less than that of import then the balance is deficit
-BOP involves both visible goods ie physical goods like motor vehicles and invisible
goods( services) like insurance,tourism and technology.
-On the other hand balance of trade refer to difference between value of visible exports
and value of visible imports over a given period of time usually one year.Visible means
tangible goods such as vehicles,furnatures,coffee,tea etc

CAUSES OF CHANGES IN BALANCE OF PAYMENT

(DISEQUILIBRIUM)
i. Natural factors
-Natural calamities as failure of rains,drought,floods,pests etc can cause disequilibrium in
balance of payment by adversely affecting agricultural and industrial production in the
country.ie the exports may decline while imports go up causing disequilibrium in BOP.
ii. Political instability
-This may lead to large capital outflow and reduce inflows where foreign investors will
shy away from investing in the country thus creating disequilibrium while political
disturbance means frequent changes in government,inadequate support to the
government also discourages inflows of capital leading to deficit due to higher outflows
than inflows

iii.Economic factors/Activities
a.Rate of Inflation
-When there is inflation in domestic economy,foreign goods becomes relatively cheap as
compared to domestic goods.It increases imports which causes deficit in BOP
b.Cyclical fluctuations of exchange rates
-When domestic economy is going through a boom(increased commercial activities in the
economy) then domestic production may be unable to satisfy domestic demand.it leads to
deficit in BOP due to increase in imports.
c.Developmental activities
-Developing countries depend on developed nations for supply of capital goods eg
machineries,equipments,technology etc,this leads to increased level of imports thereby
resulting in a deficit in BOP accounts.
d.Change in demand
-Fall in demand for country’s goods in foreign markets leads to fall in exports and it
adversely affect BOP
iv.Social factors
a.Population
-High population growth in poor countries adversely affects BOP because it increases the
needs of the countries for imports and decreases their capacity to export.
-When a country has increased populace(citizens) and the level of production is low,it
may result to disequilibrium of BOP where the country has to increase imports so as to
satisfy its populace
b.Change in tastes,fashion and preference
-An unfavourable change for the domestic goods leads to deficit in BOP,when people of
a domestic country change from consuming domestic goods and prefer those from
foreign country leads to a deficit in BOP.
c.Demonstration effect
-When people of underdeveloped countries come in contact with those of advanced
countries,they start adopting the foreign pattern of consumption.Due to this reason their
imports increase and it leads to an adverse BOP for underdeveloped country.

v. International competitiveness
-This measures the relative cost and value of countries exports.eg if domestic country
goods and services become more expensive than its competitors(other countries
producing similar goods and services) then it will see a decline in its exports leading to
disequilibrium in BOP.
i. Countries relationship
-A negative relationship of a domestic country with other countries may affect adversely
BOP where a country may be affected negatively on imports or exports leading to deficit
in BOP.

Measures that government may take to address balance of payment deficits

1.Export promotion-Should promote exports by reducing export duties or by giving
subsidies and hence more goods will be exported.
2.Import restriction-Restricting imports so that only the essential goods are imports
3.Currency devaluation-By devaluation,the exports of a country becomes cheaper in the
world market hence more demand
4.International co-operation-Foreign countries and financial institutions can provide
foreign loans to correct a deficit.
5.Deflationary policy-If balance of payment deficit is caused by inflation,it may be
resolved by adopting deflationary measures.
6.Greater production-Production should be increased especially for those goods that are
geared towards exportation.

Monetary measures that may be taken by government to deal with disequilibrium in

the balance of payment
1.Currency devaluation-means a deliberate deduction in the external value of currency
of the country hence encouraging exports.
2.Money contraction-prices of goods and services automatically go down hence imports
are discouraged and exports are encouraged.
3.Exchange control-exporters have to surrender their earnings of foreign exchange to
government in exchange of domestic currency hence government can effect a cut in the
volume of imports.
4.Foreign loans-Government can secure loans from foreign banks or foreign
governments to reduce the deficit in balance of payment.
5.Encouragement to foreign investments-The government induces the foreigners to
make investments in the country by offering them all sorts of incentives and concessions.
6.Incentives to foreign tourists-The government may also encourage the foreign tourists
to visit the country by offering them various facilities and concessional travel.

EXCHANGE RATE
-It is value of one currency for the purpose of conversion to another.
-Can also be defined as the price of one currency in terms of another currency.
-Rate at which one currency can be exchanged for another

Factors that may cause exchange rate movements in an economy

1.Inflation-Countries with lower inflation tends to see an appreciation in the value of
their currency and vice versa as its purchasing power increases relative to other
currencies.
2.Interest rates-Higher interest rates cause an appreciation in the currency and vice versa
as lenders are provided with higher rates therefore attracting more foreign capital
3.Speculation-If people think that the value of a currency will rise in the future,they will
demand more hence causing its value to rise.
4.Change in competitiveness-If goods in a country are attractive and competitive this
will cause the value of exchange rate to rise.
5.Relative strength of other currencies-The value of currency may change because the
market is worried about other economies.
6.Balance of payments-A country which struggles to attract enough capital inflows to
finance a current account deficit(imports and exports) will see a depreciation in its
currency(disequilibrium)
7.Government debt-If market fear a government may default on its debts,then investors
will sell their bonds causing a fall in the value of exchange rate.
8.Government intervention-Some governments attempt to influence the value of their
currency ie if there is political stability exchange rate appreciates because it will attract
investors.
9.Economic performance and monetary policy-A recession may cause a depreciation
in the exchange rates.If a country has a history of strong economic policy and sound
monetary policy,investors are more inclined to seek out those countries,this inevitably
increases demand and value of country’s currency.

Reasons that may lead to weakening of a currency of a country

1.Increasing importation of consumer goods hence increase in demand for foreign
currency
2.Speculative buying of the foreign currency by the foreign exchange dealers
3.Capital plight caused by movement of capital to other countries
4.Currency revaluation by the authorities in the foreign market/country
5.Political instability causing panic or scare among potential foreign investors and
consumers
6.Domestic inflationary tendencies that may lower both domestic and foreign currency
value

Types of exchange rates

i. Floating exchange rates
ii. Fixed exchange rates/Pegged

1. Floating exchange rate/flexible/fluctuating (Kenya uses this type)

-It is a regime where the currency price of a nation is set or determined by the foreign
exchange market based on supply and demand relative to other currencies.Currencies
with floating exchange rate systems are called so because they fluctuate based on supply
and demand relative to other currencies..It generally fluctuates constantly thus it can
become highly unstable especially if large amounts of capital flow in or out of the
country perhaps because of speculation by investors.
-It occurs when the government allow the exchange rate to be determined by market
forces and there is no attempts to influence the exchange rate.
Benefits that can be derived from adopting a floating exchange rate system
1.Automatic stabilization-Any disequilibrium in the balance of payments would be
automatically corrected by change in exchange rate.eg if a country suffers from a deficit
in BOP then other things being equal,the country’s currency should depreciate and this
would make country’s exports cheaper thus increasing demand while at the same time
making imports expensive and decreasing demand.The BOP equilibrium would therefore
be restored.
2.Freeing internal policy-Less power on central banks as changes occur.Balance of
payment deficits can be rectified by changing external price of the currency.This allows
government to pursue internal policy objectives such as full employment growth in the
absence of demand pull inflation without external constraints.
3.Absence of crisis-changes in the exchange rates changes automatically without crisis,ie
the possibility of international monetary crisis originating from exchange rate changes is
automatically eliminated
4.Management-The government enjoys considerably discretion to manipulate the
external value of their currency to their own advantage.
5.Avoids inflation-Helps to insulate a country from imported inflation
6.Lower reserves-There is hardly any need to maintain large reserves to develop
economy.These reserves can therefore be fruitfully used to import capital goods and other
items Disadvantages/Limitations of floating exchange rate
1.Uncertainty-Ie a seller may not be quite sure of how much money he will receive when
he sells goods abroad.it can only be reduced by companies buying currency ahead in
forward exchange contract.
 2.Lack of investment-This type of exchange rate may discourage direct foreign
investment(ie, Investment by multinational companies)
3.Ignorance/Lack of discipline-With this type of exchange rate such short run problems
as domestic inflation may be ignored until they have created crisis situations.

2. Fixed exchange rate/Pegged

A fixed exchange rate is a regime applied by a government or central bank that ties the country's
official currency exchange rate to another country's currency . is a system of currency exchange
in which the value of one currency is tied to another.A fixed exchange rate occurs when a
country keeps the value of its currency at a certain level against another currency .is a strategy
that provides some protection to governments services, and whole economies.The purpose of a
fixed exchange rate system is to keep a currency's value within a narrow band(its operations).It is
a type of exchange rate regime in which a currency's value is fixed or pegged by a monetary
authority against the value of another currency, a basket of other currencies, or another measure
of value.

Benefits derived from adopting fixed exchange rate

 Stability attracts investors/encourages investment,Fixed exchange rates provide greater

certainty for exporters and importers therefore encouraging more international trade
and investment..
 Help the government maintain low inflation by controlling behaviour of a currency
which can have positive long-term effects such as keeping down interest rates. in the
long run, keep interest rates down and stimulates trade and investment and the
temptation by the government to print more money during difficult times is
minimal.
 A fixed exchange rate is typically used to stabilize the exchange rate of a currency by
directly fixing its value in a predetermined ratio to a different, more stable, or more
internationally prevalent
 By pegging one currency to another, there is less fluctuation when exchanging money
or trading between countries. Currencies with fixed exchange rates are therefore more
stable and less influenced by market conditions than currencies with floating
exchange rates

Disadvantages
 1.Potential conflicts with economic objectives,it becomes difficult for a country in Preventing
adjustments for currencies that become under- or over-valued.

2.Limiting the extent to which central banks can adjust interest rates for economic growth.

3.Keeping the value of the currency stable is time-consuming-Once entered into the agreement,
the country is responsible for keeping its currency at the pegged rate. When the rate increases,
they need to sell currency to lower it. And when the rate lowers, they need to buy currency to
increase it. Keeping this balance requires a significant amount of time and resources.

4.Less flexible;If the price of oil jumps overnight, and you’re in a country that imports oil, this
also affects your country’s economy.

5.Government may be forced to increase interest rates-If currency rate is falling below the
exchange rate floor,so as to maintain the exchange rate ie dollar,pounds,euro etc,the government
may be forced to put up interest rates even if it is unsuitable for economy because it may increase
mortgage defaults and recession in economy.