Kenneth R. Szulczyk
cents ($0.14) to manufacture a one-hundred dollar bill. Thus, the Federal Reserve earns $99.86,
when this bill enters circulation. Unfortunately, dollarization severely limits a central bank’s
power.
Countries using the current exchange rate regimes encourage world-wide inflation. For
example, if a country’s currency is depreciating from a rapid expanding money supply, then
another country could counteract its currency appreciation by rapidly expanding its money
supply. Consequently, these countries would maintain stable exchange rates, although these
countries are afflicted with high inflation rates (Gold Standard, p. xii).
Financing Balance-of-Payments Deficits and Surpluses
Exchange rate regime determines which strategies a country must undertake to finance a
balance-of-payments deficit or surplus. Surpluses are easier to finance than the deficits. Some
call a “deficit with tears” because a central bank or government must use its resources to finance
it. On the other hand, a balance-of-payments surplus allows a government or central bank to
accumulate foreign assets.
Fixed rate regime is the most difficult to maintain because a government must maintain a
balance-of-payments (BOP) deficit or surplus close to zero. Unfortunately, this regime weakens
a central bank’s power for monetary policy. For instance, if the central bank expands the money
supply, then the country’s interest rate falls. Next, the international investors cash out of the
country because they invest in other countries with higher interest rates. Consequently, the
demand for that country’s currency weakens and depreciates. For the government or central
bank to maintain the fixed exchange rate, it must enter the international market and buy its
currency, causing its currency to appreciate. Unfortunately, a central bank must focus on its
exchange rate, reducing its focus on other goals.
A country with a fixed exchange rate can use two strategies:
Strategy 1: If a country has a balance-of-payments deficit, it has an excess supply of
currency on the foreign exchange markets. Thus, a central bank buys its currency using official
settlements reserves, such as foreign currencies, gold, SDRs, or a loan from the IMF. As a
country removes its currency from the international markets, its balance-of-payments deficit
falls. If the central bank has no reserve assets, then it must devalue its currency, or a black
market could form.
Strategy 2: If a country experiences a balance-of-payments surplus, subsequently, that
country has a shortage of currency on the foreign exchange markets. A central bank can easily
finance a surplus because it sells its currency to buy foreign currencies, accumulating official
reserves.
Floating exchange rate regime is the easiest to maintain because a government does not
intervene with its currency exchange rate. Government or central bank allows the exchange rate
to correct any surpluses or deficits. If a country experiences a balance-of-payment deficit, then
its currency tends to depreciate over time, causing exports to increase while imports decline. On
the other hand, a balance-of-payment surplus does the exact opposite.
A country could experience the J-curve Effect, when the trade deficit becomes worse
temporarily as its currency depreciates as shown in Figure 1. For example, a country allows its