The Process of Economic Development

By James M. Cypher; James L. Dietz | Go to book overview

15

Macroeconomic equilibrium

The external balance
After studying this chapter, you should understand:
• how fixed, floating, and managed float exchange rate regimes function and the impact of changing economic conditions on exchange rates;
• how exchange rates are affected by inflation;
• the importance of the balance of payments and the components of the current and capital accounts of the balance of payments;
• the importance of official foreign exchange reserves;
• the interrelation between exchange rates and the balance of payments;
• the impact of over-valued and under-valued exchange rates on the balance of payments and on economic progress;
• the connections between internal macroeconomic disequilibriums (inflation and the fiscal deficit) and external macroeconomic disequilibriums (exchange rates and the balance of payments);
• the concept of the "twin deficits" and the connection to the balance of payments;
• the difference between "good" and "bad" current account deficits; and
• the importance of monitoring the balance of payments accounts so as to anticipate potential crises.

Introduction

In an increasingly global economy, where barriers to trade and financial flows among nations have tended to be reduced since the early 1970s, policy-makers must be ever vigilant in ensuring that their country's balance of payments and exchange rate evolve in ways that create the possibility of expanded and sustained economic growth and development. In modern economies linked by virtually instantaneous and twenty-four-hour flows among the world's financial markets in London, Paris, Frankfurt, Tokyo, Hong Kong, Seoul, Sydney, Mexico City, Buenos Aires, Toronto and New York, disequilibrium situations that are not corrected fairly quickly can lead to severe crises over the longer term.

It is no exaggeration to suggest that in the current context of economic policy-making, it is the external equilibrium conditions imposed by the balance of payments which are the ultimate binding constraint facing every economy. If these

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