International monetary Essay Example | Topics and Well Written Essays - 1500 words

International monetary - Essay Example There is a relationship between real exchange rate and balance of payment crisis. The exchange rate is one of the variables for the BOP crisis (Berg & International Monetary Fund, 1999). The government handles the BOP crises situations by taking up various measures. This paper will discuss the degree of relationship between the measures. The crisis situation in a country’s BOP occurs when it moves beyond the control of the government to remove the current account’s deficit. The crisis situation would lead to deficit in foreign exchange reserves too. Considering these adverse impacts of the BOP crisis, the objective of this paper has been selected that will comprehensively discuss the measures taken up by the government for dealing with the adverse conditions. Nature of the Exchange Rate The exchange rate acts just as the demand and supply of currency in an international market that in turn affects the BOP. There will be minimum effect when a currency of a domestic count ry’s demand and supply is equivalent. This is represented below in figure1 (Pereira, 1998). Figure 1: Interaction of demand and supply with respect to foreign currency and unit prices (Pereira, 1998). The demanded and supplied foreign currencies are exhibited in X-axis, in a specific period. The unitary prices / exchange rates are illustrated in Y-axis for the foreign currencies that are in national currency. At point 4, the demand and supply meet and the exchange rate is maintained. There is less volatility in the exchange rate and it does not develop BOP crisis (Pereira, 1998). If it is now considered that the demand is constant and the supply of the currency has declined, then the rate of exchange declines and there are difficulties in the BOP management. This might lead to BOP crisis if it lasts for long period of time. This is illustrated below in figure 2 (Pereira, 1998). Figure 2: Interaction of demand and supply with respect to foreign currency and unit prices with sh ift in supply curve (Pereira, 1998). The supply has been declined when the demand became constant. The curve SS moves to S†S†. Thus, the exchange rate declines from point 4 to 3. The effect is viewed in the BOP where there are chances of deficits and crisis might be present. The demand and supply of the currency determines the exchange rate fluctuation and its effects are seen in the BOP. The BOP crises are generated with continuous decline in the exchange rate of the domestic country (Pereira, 1998). There are three alternative assumptions of BOP that are discussed here. These theories are known as ‘absorption’, ‘elasticity’ and ‘monetary approaches’ (Ardalan, 2003). Elasticity Approach In this approach the impact of devaluation of the exchange rate on domestic output is believed to be met by distinction in output and employment rather than prices, with the consequences of variations in the level of output is viewed on the balance of payments. The association connecting the balance of payments and supply of money, and linking the supply of money and the cumulative demand are ignored. This is through the assumption of existence of unemployed resources and Keynesian scepticism concerning the influence of money (Ardalan, 2003). According to the Mundell-Fleming Model of elasticity approach to the BOP, there are two effects: (1) The exchange rate outcome contributes to a