MacroeconomicsI_working_version (1)

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Chapter 14
expenditures for imports, the deficit must be paid by borrowing abroad or by selling assets.
Accordingly net capital inflow equalizes (offsets) a country’s current account deficit. Such
behaviour results in country’s a capital account surplus.
External balance precondition: Current account deficit + net capital inflow = 0
As we saw a current account deficit can be financed by private residents who sell off assets
abroad or borrow abroad. However, the central bank also often contributes on financing this
deficit by drawing on reserves of foreign currencies and selling them in the foreign
exchange markets. Alternatively in case of current account surplus, the central bank may
purchase the (net) foreign currency earned by the private sector and add that currency to its
exchange reserves. Therefore the capital account is usually divided into two separate parts:
the transactions of the country’s private sector and official reserve transactions, which
correspond to the central bank activities.
An overall balance of payments surplus occurs when official reserves increase. This
situation is described by following equation 2 :
Balance-of-payment surplus = increase in official exchange reserves
= current account surplus + net private capital inflow
The overall balance of payments could be in deficit when both the current account and the
private capital account are in deficit. In that case the central bank is losing reserves. The
overall balance of payments is zero – neither in surplus nor in deficit – if one account is in
deficit and the other is in surplus exactly in the same amount.
14.2. Exchange Rates: Fixed and Flexible
Analysing systems of exchange rate we must distinguish between fixed and floating
exchange rate systems. In case of fixed exchange rate, the central bank controls and
maintains the national currency in terms of other currencies. Under the fixed exchange rate
system, the central bank intervenes – sells or purchases national currency for foreign
currencies in order to keep exchange rate stable at predetermined level. The other option is
the flexible exchange rate regime, when the central bank may let the exchange rate float
freely or with very limited room for interventions. The exchange rate regime could be a
significant determinant of economy’s behaviour.
14.2.1. Fixed Exchange Rate
Under the fixed exchange rate regime the central bank stands ready to intervene i.e. buy
and sell national currency for foreign currency at a fixed price in terms of domestic
currency. Countries running this system usually fix (peg) their currencies to some stable
foreign currency (or to a basket of stable currencies).
How Interventions Work
The central banks hold exchange reserves – foreign currencies, foreign assets – so that they
could intervene if needed. The interventions mean influencing exchange rate towards
2 See Dornbush – Fischer – Starz [7]