ECO0006

Economics for Managers

© 2022 Singapore Institute of Management Group Limited

 Lecture 11
Open Economy and Exchange Rates

Ref:
Tan Khay Boon, Economics for Managers Module Book,
SIM Global Education, 2014
Session 11
Learning Objectives
At the end of the lesson, students will be able to:

1. Identify the main components of the balance of

payment account.
2. Identify the various causes of balance of payments
disequilibria under fixed exchange rate.
3. Discuss the advantages and disadvantages of
floating exchange rates.
4. Appreciate the various forms of managed flexibility
and volatility of exchange rates.

3
 The Open Economy

The Balance of Payments

4
 Balance of Payments
• A record of transactions between a country and the
rest of the world
• BOP allows a country to assess if it is
– producing more than it consumes
– borrowing more or less than it lends
– accumulating or depleting its foreign reserves
• Credit entry (+): For payment received
• Debit entry (-): For payment made
• Broadly divided into three accounts

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 Balance Of Payments
The Current Account
• Exports and imports of goods and services
– Export is a credit entry
– Import is a debit entry
• Income transfers
– Payment for resources such as wages
• Unilateral transfers
– Foreign aid or donations
– Income received is a credit
– Income paid is a debit

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 Balance of Payments
The Current Account

• Current account surplus usually arise from exports >

imports
• Current account deficit typically arise from imports >
exports
• Balanced current account occurs when payments
made = payments received

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 Balance of Payments
Capital and Financial Account
• Country’s transactions of assets with the rest of the world
• Include direct investment in
– fixed assets such as land or property
– financial assets such as stocks, bonds and financial
derivatives
– deposits in financial institutions
• Capital inflow (+): Sale of assets or receipt of deposits
• Capital outflow (-): Buy foreign assets or make foreign
deposits

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 Balance of Payments
Capital and Financial Account
• A current account deficit can be funded by a
sale in assets to cover shortfall.

• A current account surplus can fund the

purchase of foreign assets through a capital
and financial account deficit.

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 Balance of Payments
Official Reserves Account
• Amount of foreign currency held
• Debit entry: Payment receipts > Payment
abroad
• Credit entry: Payment abroad > payment
receipts

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 Balance of Payments
Net Errors and Omissions
• To provide for errors in data collection and
computation

11
 Analysis of BOP
• Double entry bookkeeping
• Each transaction is recorded as a credit and a debit,
equal in amount
• Total credit = total debit
• Current Account + Capital & Financial Account +
Official Reserves + Net Errors and Omissions = 0
• However, in reality the BOP account is not always
balanced

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 Analysis of BOP
• Overall Balance in BOP = Current account + capital &
financial account + net errors and omissions
• Overall balance < 0 => BOP deficit
• Receives less money than it pays out to the rest of
the world
• Typically when there is a severe current account
deficit than is funded by asset sale
• However if capital account surplus is insufficient then
funds from foreign reserves are used
• Depleting foreign reserves
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 Analysis of BOP
• BOP surplus
• Overall balance >0
• Receives more money than it pays out to the rest of
the world
• Extra funds will enter the foreign reserves account
• Accumulation of foreign reserves

14
 BOP Analysis
• BOP Equilibrium

• Overall balance = 0

• Payment received equal payment made to the

rest of the world

• No change in foreign reserve account

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 Singapore’s BOP

2011 2012 2013 2014

Current Account Balance 76172.4 62200.8 67674.7 74466.8
Capital and Financial Account -55878.6 -28466.2 -45136.1 -62864.4
Balance
Net Errors and Omissions 1193.9 -1128.7 192.3 -2984.6
Overall Balance 21487.7 32605.9 22730.9 8617.8
Official Reserves -21487.7 -32605.9 -22730.9 -8617.8

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 The Open Economy
Exchange Rates

17
 EXCHANGE RATES
Exchange rate:
• Expressed as the price of foreign currency in
terms of the domestic currency (direct
quotation) or the price of the domestic
currency in terms of the foreign currency
(indirect quotation).
• Direct quotation is usually used to avoid
confusion.

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 Exchange Rate
Example:
Assume Singapore is the domestic country and
Malaysia is the foreign country.
• Domestic currency is S$
• Foreign currency is RM
• If one Singapore dollar can be exchanged for
2.6 Malaysian Ringgit, the exchange rate is 2.6
• RM2.6 = S$1

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 Exchange Rate
• Higher exchange rate => Domestic currency
appreciates
– If exchange rate is 2.7, more foreign currency is
required to exchange for the same amount of
domestic currency

• Lower exchange rate => Domestic currency

depreciates
– If exchange rate is 2.4, less foreign currency is
required to exchange for the same amount of
domestic currency
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 Exchange Rate
Demand for Domestic Currency
• Demand is by foreigners who wants to buy
domestic goods
• Domestic goods are valued in domestic currency
and is sold in domestic currency
• If exchange rate appreciates, more foreign currency
is required to exchange for 1 unit of domestic
currency and domestic products will be more
expensive for foreigners
• Conversely, if exchange rate depreciates, domestic
product is cheaper for foreigners
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 Exchange Rate – Demand Curve
E= RM/S$

A
E1

B
E2

Demand curve for Singapore

Dollar

Q1 Q2
Quantity of Singapore Dollar
Demanded
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 Exchange Rate
Supply of Domestic Currency
• Supply by domestic residents who want to buy
foreign goods
• Foreign goods are valued in foreign currency and sold
in foreign currency
• If exchange rate appreciates, foreign products will
become cheaper for domestic residents
• If exchange rate depreciates, foreign products will
become more expensive for domestic residents

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 Exchange Rate – Supply Curve
E= RM/S$

B
E2 Supply curve for Singapore
Dollar
A
E1

Q1 Q2
Quantity of Singapore Dollar
Supplied
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 Equilibrium Exchange Rate
• In a free market, forces of demand and supply will
always adjust exchange rate to equilibrium
• Qty of domestic currency demanded = Qty of
domestic currency supplied
• Exchange rate higher than equilibrium will create a
surplus of domestic currency => depreciation of
domestic currency until equilibrium is reached again
• Exchange rate lower than equilibrium will create a
shortage of domestic currency => appreciation of
domestic currency until equilibrium is reached

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 Exchange Rate – Equilibrium
E= RM/S$

Supply curve for Singapore

Dollar
Surplus

E
E*

Demand curve for Singapore

Shortage
Dollar

Q*
Quantity of Singapore Dollar
Supplied
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 Exchange Rate – Demand Factors
• Economic Growth
– Higher income in the foreign country will cause
their demand for imports (goods of domestic
country) to increase
– Demand for domestic currency rises
• Inflation
– Inflation in foreign country will make imports
relatively cheaper
– Demand more for imports and hence demand for
domestic currency to rise
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 Exchange Rate – Demand Factors
• Interest rate
– Higher interest rate will attract foreign investment
in assets due to higher returns
– Demand for domestic currency will rise
• Expectation
– Foreigners expect domestic currency to
appreciate, they will want to hold more domestic
currency in the current period
– Speculative purposes or to hedge for future
purchases
– Demand for domestic currency rises
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 Exchange Rate – Supply Factors
• Economic Growth
– Higher income in domestic country will lead
to rise in demand for imports
– Demand for foreign currency rises
– Domestic residents will supply more
domestic currency to exchange for foreign
currency
– Supply of domestic currency rises
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 Exchange Rate – Supply Factors
• Inflation
– Higher inflation in domestic country will
mean imported goods are relatively
cheaper
– Demand for foreign currency rises and
hence domestic residents will supply more
domestic currency

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 Exchange Rate – Supply Factors
• Interest Rate
– Increase in foreign interest rate will cause
domestic residents to buy more foreign assets
– Increase supply of domestic currency to exchange
for foreign currency
• Expectation
– Expect foreign currency to appreciate, domestic
residents will demand for more foreign currency
now
– Speculative purposes or to hedge for future
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purchases
 Exchange Rate
Change in Equilibrium
E= RM/S$

Supply curve for Singapore

Dollar

E2

E1

E3
D2
D1
D3

Q 3 Q1 Q2
Quantity of Singapore Dollar
Supplied
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 Exchange Rate
Change in Equilibrium
S2
E= RM/S$

S1

S3
E2

E1

E3
Demand curve for Singapore
Dollar

Q2 Q1 Q3
Quantity of Singapore Dollar
Supplied
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 Exchange Rate System
Floating or Flexible exchange rate system:
• Exchange rate determined by market forces of demand
and supply.
• Exchange rate will automatically appreciate or
depreciate to clear any excess or shortage in demand or
supply of the domestic currency
• No government intervention
• Hence no need to maintain large foreign reserves and
no BOP problems
• However there is volatility that increases risk for foreign
investment
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 Exchange Rate System
Fixed Exchange Rate System:
• The exchange rate is fixed by the domestic country
and is typically fixed against another major currency
• The government has to take deliberate action to
maintain this fixed rate
• When the rate is first fixed, the optimal rate is
typically chosen. However changing economic
conditions may alter the optimal rate
• Maintaining a fixed exchange rate comes with its set
of challenges

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 Exchange Rate System
Fixed Exchange Rate System
E= RM/S$
• Countries may undervalue Supply curve
their exchange rate to be
export competitive
• Maintain exchange rate
below market equilibrium E
E*
• Central bank has to supply Demand curve
shortage of domestic E1
currency Q2-Q1 Shortage

• Accumulation of foreign
reserves
Q1 Q2
• BOP surplus Quantity of Domestic Currency
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 Exchange Rate System
Fixed Exchange Rate System E= RM/S$
Supply curve
• Countries may overvalue their
exchange rate to control
inflation Surplus
E2
• Maintain exchange rate above
E
market equilibrium E*
• Central bank has to use its Demand curve
foreign reserves to buy surplus
of domestic currency from Q2-
Q1
• Depletion of foreign reserves Q1 Q2
• BOP deficit Quantity of Domestic Currency
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 Exchange Rate System
Fixed Exchange Rate System
• BOP surplus is less problematic than BOP deficit.
• Persistent deficit
– may trigger protectionism from trading partners
– deplete foreign reserves and result in insufficient
funds to maintain fixed rate
– abandoning fixed rate results in loss of confidence
in currency
– capital flight occurs

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 Advantages of a floating exchange
rate
1. Automatic adjustment:
• If there is a BOP deficit, it will put downward pressure on
the exchange rate.
• Prices of exports fall whilst prices of imports rise.
• This adjustment would help to reduce the deficit provided
the price elasticity of demand for exports and imports is
elastic.

2. Flexibility:
• The interest rate need not be set to keep the value of the
exchange rate within pre-determined bands.
• Central bank can have the flexibility in determining interest
rates.

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 Advantages of a floating exchange
rate
3. Independent monetary policy:
• An expansion of money supply will reduce interest rates.
• Currency depreciates which will increase net exports,
thereby further stimulating aggregate demand.

4. Lower foreign exchange reserves:

• Countries need not keep high foreign reserves to defend the
currency from speculative attacks.
• They can be deployed for other purposes.

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Disadvantages of a floating exchange
rate
1. Uncertainty:
– Since the rate changes in value from day to day, this may
introduce instability into trading and businesses.
– Problem can be reduced by hedging on the forward
exchange market.
2. Speculation:
– There is normally more speculative activity on the floating
system resulting in wild swings in the exchange rate
especially in the short run.
3. Inflation:
– Can caused inflation by allowing import prices to increase
as the exchange rate falls.
– This will have repercussions for the domestic economy
especially if it depends a lot on foreign imports.

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Advantages of a fixed exchange rate
1. More certainty for foreign investment and
trade.

2. Greater control over inflation as inflation will

cause a BOP deficit and a depletion of foreign
reserves to defend the depreciation in
currency.

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Disadvantages of a fixed exchange rate
1. Central Banks has to hold large amount of foreign
reserves to maintain the fixed exchange rate.
2. Higher rate of speculation especially if
government is thought to have little foreign
reserves.
3. Monetary policy is primarily used to maintain the
fixed exchange rate and cannot be used to achieve
other macreconomic objectives such as full
employment, economic growth and inflation.

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Alternative Exchange Rate Regimes
Managed or dirty floating:

• Rate allowed to float but with intervention by central bank

to vary the bands allowed for fluctuation to take place.

• When exchange rate varies out of the bands, the central

bank will intervene to bring it back within the bands (in the
same way as under the fixed exchange rate system).

• Require lesser foreign reserves than the fixed exchange rate

system and is more sustainable

• Some may use this as a guise to keep exchange rate low to

be export competitive and trigger trade wars.

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Alternative Exchange Rate Regimes
Adjustable peg:
– Same as fixed rate with intervention by central
bank to correct short and medium term
imbalances.

– In the long run, the peg is adjusted downwards

(devaluation) or upwards (revaluation)
– Objective is to allow correction of persistent
BOP deficits through revaluation

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Alternative Exchange Rate Regimes
Crawling peg:
• System with flexibility between the adjustable peg system and
the managed floating exchange rate system.
• A fixed exchange rate system where the exchange rate can be
adjusted to clear BOP imbalances.
• The rate is adjusted frequently at a specific regular period
which is announced in advance
• Objective is to prevent large changes in exchange rate that
causes instability for foreign investors and trade

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 Singapore Dollar
The Singapore dollar (SGD) is managed through the
following regimes:

• Against a basket of trade-weighted currencies of her trading

partners and competitors.
• A band where the trade-weighted SGD is allowed to float
within a policy band.
• A crawl where the band itself is adjusted and allowed to
crawl.

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 Discussion Question 1
From the point of view of a particular country, capital
outflows are _________.

A. purchases of domestic goods and services by

foreigners.
B. purchases of domestic assets by foreigners.
C. purchases of foreign goods and services by
domestic households or firms.
D. purchases of foreign assets by domestic households
or firms.
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 Discussion Question 2
The exchange rate is the _____________.
A. market on which currencies of various nations are
traded for one another.
B. price of the a basket of consumer goods at current
year relative to the base year.
C. quantity of foreign currency assets held by a
government for the purpose of purchasing the
domestic currency in the foreign exchange market.
D. rate at which 2 currencies can be traded for each
other.

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 Discussion Question 3
The following table provides nominal exchange rates for the
U.S. dollar.

Based on these data, the nominal exchange rate equals

approximately ______ pesos per Canadian dollar or,
equivalently, ______ Canadian dollars per peso.
A. 0.672; 1.488
B. 9.259; 0.108
C. 6.222; 0.161
D. 7.771; 0.129

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 Discussion Question 4
When a Singaporean buys a US government bond, this
will affect be a _____ entry in the _____ account in
the balance of payments of Singapore.

A. debit, current
B. credit, current
C. debit, capital and financial
D. credit, capital and financial

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 Discussion Question 5
Which of the following policies is unlikely to reduce the
level of unemployment?

A. Increasing subsidies for skills upgrading.

B. Appreciating the country’s exchange rate.
C. Reducing direct taxation.
D. Increase in the public sector borrowing
requirement.

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 Discussion Question 6
Consider the exchange rate between Singapore dollar
(S$) and Thai Baht (Bht). Define the exchange rate as
units of Thai Baht to 1 unit of S$. Use a demand and
supply diagram to evaluate the effects on the foreign
exchange market when there is an increase in
Singapore’s real GDP.

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 Discussion Question 7
The demand and supply of Singapore dollars in the foreign
exchange market are:
Demand = 21000 – 4000e, Supply = 13000 + 6000e
where the exchange rate, e, is expressed as U.S. dollars per
Singapore dollar.

a) What is the equilibrium value of the Singapore dollar if

Singapore adopts a flexible exchange rate system?
b) If the Singapore dollar is fixed at 0.75 U.S. dollars per
Singapore dollar, what does the central bank need to do to
maintain the fixed exchange rate? What will happen to
Singapore’s foreign reserves and balance of payments
position over time?

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Thank you