In this modern world, nearly every country is completely dependant on international trade. This has far reaching implications for countries that export much of their output. This leads one to reasoning that theforeign exchange reserves and the current account balance are of paramount importance. There will be surpluses or deficits each year. While having a surplus current account is always the ideal, countries are always realistic enough to understand that deficits are bound to exist some time or the other. In the short run, retained reserves and international financing could meet deficits. It must alsobe remembered that having a balanced current account should not be an end in itself. It should not negate other targets set by the government.
The government has at its disposal, an array of economic tools, which could be used to correct a balance of payments deficit. What must be kept in mind is that these tools are themselves subject to limitations. For example a government could use tariffs andother barriers like quotas as part of its international trade policy. However, these measures are themselves limited by international agencies such as the World Trade Organization (WTO).
A country’s international trade policy could be affected by the economic policies of its trading partners. For example, Ireland could find it very difficult to export to Brazil if Brazil pursued a policy toprotect its infant industries. One consideration could also include that countries in the European Community are part of what is called the Exchange Rate Mechanism (ERM), which allows the exchange rate to fluctuate within a very narrow range.
Therefore, it would be very difficult for countries within the European Community to use their exchange rates as part of their foreign exchange policy indealing with a balance of payments deficit. In short, the factors that will influence the government’s foreign trade policy will be determined by commitments to international agencies, as well as the exchange rate system, government policies, and the state of the domestic economy and the causes of the disequilibrium.
What is of concern at the moment is the type of exchange rate and whether thecentral bank should intervene in supporting the value of its currency in the foreign exchange market.
There are three types of exchange rate systems. There are as follows:
1. Floating Exchange Rate System
2. Fixed Exchange Rate System
3. Managed Floating Exchange Rate System
Floating Exchange Rate System
A government could use floating exchange rates to support the currency in theinternational market. In theory, by simply buying or selling its currency, a government could increase or decrease the value of its currency. In a floating exchange rate system, the currency market sets the value of the currency in question. When one refers to the currency market here, it must be remembered that the currency market is itself composed of banks, governments and other financialinstitutions that have many different objectives. With so many forces coming into play, it may come as no surprise that in some cases, when governments buy and sell currency, their actions might have little or no affect on the value of the currency. However, it must be added that the government is a key player, and what really determines whether the actions of the government results in the appreciationor depreciation of its currency, is determined by the amount of currency which is held by the central bank (Devereux & Engel, 1999, 99-13).
Suppose the Indian government would like to decrease the value of its currency in order to make its exports cheaper in the international market. It would have to sell its own currency and purchase US Dollars. It could only do this if it has adequate...