Question

Suppose that a country follows a managed-float policy but that its exchange rate is currently floating freely. In addition, suppose that it has a massive current account deficit. Does it also necessarily have a balance-of-payments deficit? If it decides to engage in a currency intervention to reduce the size of its current account deficit, will it buy or sell its own currency? As it does so, will its official reserves of foreign currencies get larger or smaller? Would that outcome indicate a balance-of-payments deficit or a balance-of-payments surplus? LO39.5

Short answer

A current account deficit does not necessarily mean a balance-of-payments deficit. To reduce the deficit, the country will sell its currency and as a result, foreign currency reserves will increase, indicating a balance-of-payments surplus.

Step-by-step solution

Understanding the Exchange Rate Regime

The country operates under a managed-float policy, which means the exchange rate can fluctuate, but the central bank can intervene to stabilize it if necessary. Currently, the exchange rate is floating freely, which implies no intervention at the moment.

Analyzing the Current Account Deficit

A current account deficit means the country spends more on foreign goods, services, and income than it earns from them. This indicates more foreign currency leaving the country than coming in through trade.

Evaluating the Balance of Payments

The balance of payments includes both the current account and the capital account. A current account deficit does not necessarily mean a balance-of-payments deficit, as it can be offset by a capital account surplus if the country attracts sufficient inflow of capital.

Deciding on Currency Intervention

To reduce the current account deficit, the country might engage in currency intervention. Specifically, it would sell its own currency to buy foreign currency, which would make its currency weaker, encouraging exports and reducing imports.

Impact on Official Reserves

By selling its own currency and buying foreign currencies, the official reserves of foreign currencies will increase as the central bank accumulates more foreign currency.

Implications for Balance of Payments

An increase in official reserves of foreign currencies due to central bank intervention typically suggests a balance-of-payments surplus, as the country is effectively absorbing more foreign currency than it spends.

Key concepts

Managed-Float Policy

A managed-float policy is an exchange rate system where a country's currency is allowed to fluctuate, but with some oversight from the central bank. In this system, the value of the currency is predominantly determined by the market forces of supply and demand. However, the central bank may intervene when necessary to stabilize the currency, prevent excessive volatility, or achieve economic objectives.
Such interventions help guide the currency's value back towards a target rate or within a desired range. Although the currency can float freely part of the time, the central bank's ability to intervene distinguishes a managed float from a purely free-floating exchange rate system.

• Allows for market-driven value
• Central bank can intervene
• Combines aspects of fixed and floating systems

Current Account Deficit

A current account deficit occurs when a country imports more goods, services, and income than it exports. This situation results in more money flowing out of the country than is coming in due to trade. In simple terms, the country is spending more on foreign transactions than it earns.
This can happen for several reasons, such as an increase in domestic consumption of foreign goods, a decline in exports, or greater income payments to foreign investors. While a current account deficit indicates an imbalance in trade flows, it does not always equate to economic problems. It can be managed if offset by a capital account surplus, where foreign investments make up for the deficit.

• More imports than exports
• Can reflect economic growth
• Potentially offset by foreign capital

Currency Intervention

Currency intervention is an action taken by a country's central bank to influence the value of its currency. This process can involve buying or selling the national currency in exchange for foreign currencies.
For a country facing a current account deficit, the central bank might choose to sell its own currency. This action weakens the currency's value, making exports cheaper and more attractive to foreign buyers while making imports more expensive.
Such interventions aim to improve trade balance by encouraging exports and reducing imports. By adjusting the exchange rate, the central bank helps to correct trade imbalances and supports the country's economic goals.

• Central bank action
• Impacts exchange rate
• Encourages trade balance

Official Reserves

Official reserves are holdings of foreign currency, bonds, and other financial assets managed by a country's central bank. These reserves are used to back liabilities and influence currency exchange rates.
When a central bank sells its own currency to buy foreign currency, as part of a currency intervention, the official reserves of foreign currency increase. This buildup of foreign reserves indicates that the central bank has additional financial resources to manage and stabilize the country's currency.
An increase in foreign reserves suggests a balance-of-payments surplus, indicating that the country is taking in more foreign currency than it is spending. Managing reserves allows a country to maintain confidence in its financial stability and support its currency's value.

• Central bank-held assets
• Used in currency stabilization
• Indicator of economic health