A Floating Exchange Rate Regime

admin — Fri, 26 Jun 2009 21:31:26 +0000

Under a ﬂoating exchange rate regime, we have to consider the capital account as well as the current account. Here, as national income rises, so import demand rises, in turn causing the current account balance to deteriorate. So far, this is just like the ﬁxed exchange rate regime. However, in the case of the ﬂoating exchange rate regime, the exchange rate is able to be the transmission mechanism for restoring the balance of payments to equilibrium. On the capital account side, a rise in national income, causing the current account balance to deteriorate, must be accompanied by a rise in real interest rates. The higher real interest rate will dampen import demand, which will in turn cause the current account balance deterioration to reverse. As that happens, national income will fall back, causing real interest rates also to fall back. If we start off with national income falling, we achieve the same transmission mechanism, only in reverse, with real interest rates falling, causing capital account outﬂows and current account balance improvement to the extent that these developments cause on the one hand a revival in domestic demand and on the other a loss in export competitiveness. Thus, the current account improvement reverses and real interest rates rebound. We can express this transmission mechanism from a change in national income through the balance of payments within a ﬂoating exchange rate regime with the following diagram:
Change in national income -> Change in current account balance -> Change in real interest rates -> Change in capital ﬂows -> National income change reversed -> Current account reversed -> Capital ﬂows reversed -> Real interest rates reversed -> Balance of payments equilibrium restored

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A Floating Exchange Rate Regime