Currency Exchange Rate

Currency Exchange Rate: How Is It Determined? The Balance of Payments Approach by T.S. Son, Azizah Abdullah, H.Y. Wong In the previous article of The Malaysian Accountant (August 2000:13-20), we examined the Purchasing Power Parity hypothesis approach to determining the currency exchange rate. This approach is based on the traditional view that the demand for currencies is derived from the demand for goods, and that the exchange rate between two countries is determined by the relative prices of goods in the two countries, If prices in the home country, translated at a given exchange rate are high, relative to prices in the foreign country, there will be a drop in demand for the goods produced by the home country and an increase in demand for the goods of the foreign country. This change in demand for the exports of the two countries will lead to a decrease in demand for the home currency and a corresponding increase in demand for the foreign currency. The shift in demand for the currencies will cause the exchange rate to depreciate so that the difference between the prices in the two countries is reduced. However, there is little empirical support for the Purchasing Power Parity hypothesis; the empirical evidence shows that there are large and persistent deviations from the Purchasing Power Parity. In this article, we will examine the view that the exchange rate is determined by all items in the Balance of Payments accounts. According to the Balance of Payments theory, it is not just the demand for the goods and services, but also international capital transactions that affect the exchange rate; that is, if the demand for investing in the home country increases, then the home currency should appreciate. Since investment abroad is influenced by the relative interest rates at home and abroad, the Balance of Payments theory suggests that it is not only the prices of goods that influence the exchange rate but also the interest rates in the two countries. In order to understand the sources of the demand for and the supply of foreign currency, we will first examine the various accounts included in the Balance of Payments. Then, we will study how the Balance of Payments is related to another set of accounts, the Net International Investments accounts. We will also study the relationship between the current account, savings and investment, and the government’s fiscal policy. Finally, we will describe the Balance of Payments Approach to exchange rate determination and compare how an economy adjusts to imbalance in the current and the capital account, under fixed exchange rates and under flexible exchange rates. We will conclude by critically evaluating the Balance of Payments approach to determining exchange rates. Balance of Payments Account The Balance of Payments account is a statistical record of the flow of all of the payments between the residents of one country and the rest of the world over a given period of time (usually one year). The Balance of Payments is like a country’s statement of sources and uses of international funds, and to record any international transaction, we need to know only the source and the use of the international funds. For instance, if US currency flows in, the Balance of Payments will tell us: • (Source) Why did we receive US currency? Was it a payment received from US or abroad for goods that we exported? Or did foreign investors buy assets from a domestic resident with US currency? • (Use) What did we do with the US currency? Did we keep it in a foreign bank account? Did we buy foreign assets with it? Or did we sell the money to our central bank? The above definition of the Balance of Payments has the following implications. First, the Balance of Payments is a record of the flow of payments over a period of time. It does not describe the country’s stock of foreign assets and liabilities. Instead, it analyses and explains changes in consecutive assets-andliabilities statements. Second, every “source” must be “used” somewhere, which means that every entry must have a counterpart. Thus, by definition, the overall Balance of Payments must balance. Conversely, if you read about a certain country having a balance of payments deficit, it must be referring to some subtotal in the Balance of Payments or some subgroup of accounts rather than the whole Balance of Payments account. Thus, when you hear about a deficit, you should always ask yourself to which subaccount of the Balance of Payments reference is being made. Third, the Balance of Payments is intimately related to the exchange market. That is, all transactions that affect the inflow (source) or outflow (uses) of foreign currency are recorded in the Balance of Payments. Let us first look at a framework of the Balance of Payments and discuss the main subaccounts in the Balance of Payments, the way an economist would present it. SOURCES I) Current Account • Export of goods • Export of services • Inward unilateral transfers -private -public USES • Import of goods • Import of services • Outward unilateral transfers -private -public BALANCE ACCOUNT • Trade balance • "Invisible" balance • Net inward transfers - private - public SA = Current account balance = Net inflow from current transactions II) Capital Account • Classified as private versus government • Or classified by type of transactions: inward portfolio investment short term long term inward direct investment    outward portfolio investment short term long term outward direct investment    net inward portfolio investment  short term  long term net inward direct investment CA = Capital account balance = Net inflow from capital transactions III) Setting Transactions • Central Bank transactions  Decrease in foreign reserves • Errors and Omissions Unrecorded inflows   Increase in foreign reserves Unrecorded outflows   Net decrease in foreign reserves (-RFX) Errors, Omissions (EO) Grand total of Balance of Payments O = SA + CA - RFX + EO The Balance of Payments in this exhibit is split into three parts: the current account, the capital account, and settling transactions. For each account, there are three columns. The first column lists items that are sources of foreign exchange; the second column lists transactions that use foreign exchange; and the third column gives the net source of foreign exchange, that is, sources minus uses. Current Account (SA) Balance The current account (SA) of the Balance of Payments is a record of the trade in goods and services, and unilateral transfers between a country and the rest of the world. The current account balance includes the merchandise account, a record of the trade in goods between a country and the rest of the world. Recorded in this account, for example, are the export of palm oil, lumber, rubber, and oil, and the import of cars, machinery, and computers. The balance in this account, the excess of exports over imports, is called the Balance of Trade. The current account also includes trade in services, or “invisible” factors, for example, exports or imports of services such as consulting, tourism, insurance, finance, and banking. This subaccount also includes dividends and interest income, which are the return on the risk-free or risk-bearing capital that has been exported or imported. Finally, the current account includes unilateral transfers. Unilateral transfers are payments made abroad, or received from abroad, for which there is no corresponding international flow of goods or services. Transfers include items such as development aids, gifts, and wages repatriated by foreign workers. No goods or services are received in return for such transfers. In the following illustrations, we will examine three transactions to see how they are recorded in the current account of Malaysia. Considering a scenario when Ceria Berhad, a Malaysian international trading company, imports RM10 million worth of farm products such as fruits, wheat, oats, etc. from Australia. There will be a negative accounting entry in the current account for this side of the transaction in order to reflect the outflow of funds to pay for the imports. There must also be a corresponding accounting entry for the source of foreign exchange that is used to pay for the imports. For instance, Ceria Berhad may have earned the funds by exporting furniture and the rubber products to Australia; this transaction would be reflected as a positive entry in the current account. If a freight charge of RM5,000 is paid to a British shipping line by Ceria Berhad, this import of service will be recorded with a negative entry in the current account in order to reflect the outflow of funds to the British firm. Again, a corresponding transaction that generates the foreign exchange to pay for the import of British services will be needed. Let us assume that the source of foreign exchange is the export of some furniture and commodities to the British by Ceria. On the other hand, if a Malaysian company, named Chemco Berhad, a producer of pharmaceutical and other chemical products, exports RM2 million worth of medicine to Iraq, a positive entry will be recorded in the current account because it represents a source transaction. The use side of the transaction could be imports, if Chemco Berhad uses the funds to buy petroleum from Iraq or chemical compounds from abroad. Alternatively, if the Malaysian government donates RM2 million worth of Chemco medicines to Iraq, there will again be a positive entry in the current account (to reflect the export of medicine). The second part of this transaction will be a negative entry in the transfer account (also a part of the current account) to reflect the “import of goodwill” rather than petroleum or chemical compounds. Capital Account (CA) Balance The Capital Account (CA) is a record of inward and outward investment and amortisation flows between a country and the rest of the world. The capital transactions recorded include those that result from the purchase or sale of real or financial assets. Capital account transactions can be classified in one or two ways. The first way is to classify them as private or public transactions, that is, transactions made by private investors or by the government. The second way is to divide capital account transactions into “direct investment” or “portfolio investment”. Direct investment is a transaction in which the investor has a controlling share or participates in the management of the firm. Portfolio investment, on the other hand, is a transaction in which securities are held purely as a financial investment. The accounting rule for recording capital transactions based on the same logic as that used to record transactions in the current account. Suppose that Ceria Berhad were to pay for the import of RM 2 million worth of farm products from Australia by giving the Australian firm a 10% share of Ceria Berhad, a negative entry win be recorded in the current account (corresponding to the import of farm products) and a positive entry in the capital account (to reflect the inward direct investment by the Australian firm in the Malaysian securities). Suppose that payment to the British company for the freight charges of RM5,000 (incurred by Ceria Berhad on the import of farm products) is made with a Malaysian check drawn on a Malaysian Bank, this payment will be recorded as a positive entry in the Malaysian capital account, which reflects inward portfolio investment (Malaysian deposit} by the British firm in Malaysian assets. This positive entry matches the negative accounting record made in the current account (for import services). On the other hand, if the British shipping company uses the Malaysian deposit to buy Malaysian government bonds, the sale of long-term government bonds to a foreign investor is a source transaction to Malaysia, and is recorded as a positive entry in the long-term investment account. The counterpart to this entry is the decrease in short-term inward. Thus, the portfolio rebalancing does not affect the overall capital account. Changes in Official Reserves The official reserves of a country include gold, government holdings of foreign currencies (mostly in the form of commercial paper, treasury-bills and bonds), money deposited at the International Monetary Funds (IMF), and Special Drawing Rights (SDRs) with the IMF. The total value of the transactions in the current and capital accounts is the overall deficit or surplus for the entire economy (excluding the central bank). However, the total Balance of Payments must be balanced. Thus, if the private sector has been a net user of international funds, the shortfall must have been provided by the central bank - or, if the private sector, as a whole, was a net provider of foreign exchange, the surplus must have gone to the central bank. Assuming that there is no error in measuring the transactions in the accounts, the foreign exchange transaction balances in the current account (SA) and those in the capital account (CA) will be equal to the change in official reserves (RFX), that is: RFX=SA+CA ………………… (1) The accounting rule for recording changes in official reserves is the same as that for the capital account: an increase in foreign assets held by the central bank is recorded with a negative sign as an increase in assets held by the central bank is a “use” of foreign currency. Conversely, a decrease in the central bank’s stock of foreign assets is a “source” of foreign currency for the country. Thus, the inflow will result in the “decrease in foreign reserves, (RFX), as a net source of funds. Statistical Discrepancy / Errors and Omissions The last item in the Balance of Payments is the “Statistical Discrepancy”. Since any sources-and-uses statement must balance by definition, the foreign exchange transactions in the current account and those in the capital account should equal the change in reserves. That is, RFX=SA+CA ………………. (1) In practice, there is a problem with measuring all transactions accurately. The government’s records of its official reserves measure the left-hand side of Equation (1) and, therefore, it is reasonable to assume that in most countries, there is little error. However, the measurement of the right-hand side of Equation (1) can be quite difficult and errors can occur easily. Difficulties arise because of the difference in the “timing” between the date on which a transaction takes place and the date on which it is recorded. Furthermore, errors arise because of problems in estimating its such expenditure on travel, and because of illegal or unreported transactions. Thus, in terms of statistically recorded transactions, Equation (1) generally does not hold with equality. For this reason, the item “Errors and Omissions” (EO} is added to the right-hand side to get an equality relationship. RFX = SA estimate + CA estimate + EO ……………. (2) The EO item can be surprisingly large, sometimes of the same magnitude as the SA or CA. Therefore, one needs to be very careful when reading these accounts and very cautious in interpreting the data from the Balance of Payments. In the following section, we will use Equation (1) to analyse the relationship between a country’s fiscal policy and Balance of Payments accounts. Relationship between the Balance of Payments and Fiscal Policy The relationship between the Balance of Payments accounts and a government’s fiscal policy is quite simple once we recall the National Income Accounting identities. Relationship between the Current Account and Domestic Absorption In a "closed economy”, that is, an economy without exports or imports, the GNP or value of all national output, Y, has to be equal to the value of spending on that output (total “absorption” by domestic residents, A, that is A = consumption expenditure + investment expenditure + government expenditure). That is, Y = A ………(3) In an open economy, however, some domestic expenditure may be on imported goods, and some of the domestic production may be exported. Therefore, for an open economy, the accounting identity needs to add exports and subtract imports from the right-hand side of equation (3). Of course, the difference between exports and imports is the current account balance; and so, for an open economy, equation (3) becomes: Y = A + SA Or Y - A=SA ………… (4) Equation (4) has a number of implications Equation (4) says that SA “surplus” is equal to the excess of domestic income over domestic expenditure. Therefore, an improvement in the SA balance can be achieved either through an increase in Y (production) or a decrease in A (domestic absorption). Any policy that attempts to improve the SA balance by means of a reduction in expenditure, A, is called an “expenditure-reducing policy”: Examples of such a policy include cutting government spending or implementing a general deflationary policy. An alternative policy to increase the SA is the use of an “expenditure-switching policy”. This is a policy that stimulates exports and selectively discourages imports. One frequently used policy instrument is the exchange rate. A devaluation of the exchange rate by the central bank makes imports expensive and exports cheaper relative to foreign goods and leads to an improvement in the SA balance. Other examples of expenditure-switching policies are important tariffs or export subsidies. An expenditure-switching policy can be successful only when the economy is not already operating at its fullemployment level. If the economy is already at the full-employment level, then Y cannot be further increased in the short run, and the only way to increase SA balance is to decrease A, that is with an expenditurereducing policy. Therefore, to improve SA balance when the economy is already at its full-employment level, the government has to use an expenditure-reducing policy. However, an expenditure-switching policy may fail even when the economy is not at its full-employment level. Relationship between the Current Account and Budget Deficit Equation (4) states that a country’s current account surplus is equal to that part of its income that is not absorbed by its residents - the country’s overall savings, that is net private savings (netSavP). and net government savings (netSavG): SA = Y-A = netSavP + netSavG ……. (5) By definition, the SA balance equals the sum of net private savings and net government savings. Net private savings is the difference between private savings and investment, and its sign may vary over time and across countries. In contrast, there is very little variation in the sign of net government savings; virtually all governments actually “dissave”. We can obtain an explanation that uses the term “budget deficit”, by rewriting equation (5) as follows: SA = (private savings - private investment expenditure) + netSavG = (private savings - private investment expenditure) - ( - netSavG) = (private savings - private investment expenditure) - Budget Deficit …….. (6) Factors giving rise to Current Account Deficit Using Equation (6), the origins of current account (SA) deficit can be traced to one of the following factors: • Too little private savings, • Too much investment relative to private savings, • A large government budget deficit. Empirically, private savings are relatively stable in the short run. This means that changes in the SA deficit usually reflect changes in aggregate investment and in the government deficit. A SA deficit that reflects an investment boom is not necessarily bad. During the Reagan era, US Treasury officials argued that the increase in the SA deficit of the US and its CA surplus (that is, US foreign borrowings) was due to a boom in investment rather than to a budget deficit. Many economists, however, argued that the SA deficit was due to the budget deficit. In the US, private savings are very stable and rather low; thus, changes in the SA deficit essentially reflect changes in the budget deficit and changes in investment. Financing Budget Deficits By rewriting Equation (6), we can establish the link between budget deficits and the capital account balance, CA. Budget (private savings – private Deficit = investment expenditure) – SA ……………… (7) Now, substituting the expression for the SA given in the equation (1), we have: Budget Deficit = netSavP +CA - RFX ………………………. (8) Thus, a budget deficit must be financed either (a) through private savings, (b) through the sale of private assets to foreigners or, (c) through a sale of official reserve assets. Under flexible rates and without any intervention in the exchange market by the central bank, there is no change in the official reserves and therefore choice (c) is not a feasible way of financing a budget deficit. Are Current Account Deficits Always Bad? It should be clear from the discussion above that current account surplus or deficit is neither good nor bad in and of itself; a current account deficit is good or bad relative to the circumstances that give rise to it. If current foreign capital inflows are used to finance consumption rather than investment, then sooner or later, a country will have difficulty in repaying these loans. That is, international capital inflows that are used for investment purposes are quite different from those used for consumption. If investment is more productive at home than abroad, that is, if the rate of return on investment is higher at home, then, we should expect to see an inflow of foreign capital (CA> 0). Then, if RFX = 0, it follows that a current account deficit will develop. However, this deficit is not necessarily bad if investment is made in “productive” projects such that money bon-owed abroad can be repaid. The Net International Investment Account As described previously, the Balance of Payments is an account that keeps track of the flow of foreign exchange into and out of the country. The Net International Investment (NIl) account, or the external assets account, is used to measure the result of these cumulative inflows and outflows; that is, it measures the net ownership of foreign assets. In other words, the NIl is designed to measure a country’s stock of international assets and liabilities. Suppose that you have kept two accounts. The first account keeps track of your income and expenditure during the year. This account tells you about the inflow (sources) and outflow (uses) of funds and is analogous to a nation’s Balance of Payments account. The second account shows you how much money you have at the bank and your net asset position; and this account represents your solvency at a given point in time. This second account is analogous to the NIl account. The NIl account is what we should look at in order to judge the solvency of a country. Thus, while the Balance of Payments tells us whether a country’s economy is getting better or worse, the NIl tells us how good or how bad things actually are at a given point in time. Now, suppose that a country has been running a current account deficit of USD 10 billion for each of the last three years, but its Nil has a positive balance of USD 100 billion. Then, even though the current account balance in the Balance of Payments reflects a deficit, given large positive balance in the Nil, this current account deficit is not a problem - at least, not at this point of time. The Balance of Payments Approach to Exchange Rate Determination In this section, we will examine the factors that determine the exchange rate according to the Balance of Payments theory. We will then examine the adjustment to imbalances in the current or capital account in two extreme economies - one where the exchange rate is fixed, and one where the exchange rate is perfectly flexible. If the demand for foreign exchange exceeds its supply, then either the price of foreign exchange, the spot rate, will increase and/or there will be an increase in the inflow of foreign exchange. If the price of foreign currency is fixed, then the imbalance is offset by a change in the quantity of official reserves. If the exchange rate is perfectly flexible, then the adjustment comes through a change in the exchange rate. Since exchange rates are rarely perfectly flexible, an imbalance in the current and capital accounts will typically come through an adjustment in both the exchange rate and the quantity of official reserves. Factors Affecting Exchange Rates according to the Balance of Payments Theory The price for foreign exchange, the spot rate, is determined by supply and demand for foreign exchange. In the previous article, we examined the view that the demand for a particular currency was derived from the demand for the goods produced by that country - the Purchasing Power Parity theory. In this section, we extend the Purchasing Power Parity approach. Now, the demand for foreign currency depends not only on the demand for foreign goods but also on the desire of investors to invest abroad; that is demand for foreign exchange is derived from transactions in the current account and those in the capital account. This approach to determining the exchange rate is called the Balance of Payment theory. The Balance of Payment theory of exchange rate tries to explain: (a) why exchange rates and prices are not as predicted by the Purchasing Power Parity theory and (b) why there are continuous capital flows between countries. The explanation offered for these two observations is based on a Keynesian view of the world that prices of goods are not flexible in the short run. Thus, the Purchasing Power Parity theory fails to explain the determination of the exchange rate in the short run. Moreover, given that prices adjust slowly to a change in economic circumstances, economies are in a state of persistent disequilibrium leading to the flow of capital between countries. The Balance of Payment approach treats a currency like any other commodity and determines its price from its supply and demand. According to this theory of exchange rate, the supply and demand for a currency arises from the elements of the Balance of Payments - trade in goods and services, portfolio investment, and direct investment. The elements that determine the flow of foreign currency are divided into two categories; - the current account and the capital account. The current account is determined by prices of goods at home (P) and prices of goods abroad, translated into domestic terms using the spot rate (SR). The functional relation between the current account balance and the relative prices abroad and at home, SR/P, is assumed to be in such a way that an increase in (SR/P) leads to an increase in the current account balance. The current account is also influenced by domestic national income (Y) and foreign national income (Y*). The effect of domestic income on the current account is through imports. Since imports are a component of total consumption, imports increase with income, resulting in a decrease in the current account. Similarly, an increase in foreign income leads to an increase in imports by foreigners (increase of domestic exports), which increases the current account balance. Thus, the effect of these variables on the current account can be summarised by stating that the current account is a function of SR/P, Y and Y*. SA = Fs (SR/P, Y, Y*) ………………… (9) The transactions in the capital account depend on the relative interest rates at home and abroad. The relationship between the domestic interest rate, r, and the capital account balance is SIR h that an increase in the interest rate at home attracts foreign investment and leads to an inflow of international funds. Analogously, the relationship between the capital account balance and the foreign interest rate, r*, is such that an increase in interest rates abroad, all else being equal, will lead to an outflow of investment funds. Finally, the capital account also depends on the current exchange rate, R, because the value of R will determine the value of the foreign return in terms of domestic units. Thus, in contrast to the Purchasing Power Parity theory of exchange rates, the Balance of Payments theory recognises that the demand for a currency may also arise from investors’ direct and portfolio investment decisions. The effect of interest rates on the capital account can be expressed as: CA = Fc(r, r*, R) ……………. (10) With the information given in Equation (9) and (10), we will first consider adjustment of the imbalances in the current or capital account in a country where the exchange rate is fixed, and then in one where the exchange rate is perfectly flexible. Adjustment Under Fixed Exchange Rates If the plans of the private sector lead to a net demand for foreign exchange, then the central bank makes up for the shortfall, otherwise the excess demand for foreign exchange would lead to an appreciation of the foreign currency, which is not allowed under a fixed rate regime. Similarly, if there is a surplus of foreign exchange, the central bank buys up the net inflow of foreign exchange and adds it to its reserves in order to avoid an unwanted depreciation of the foreign currency. Thus, there is no price adjustment in the exchange market, and the central bank’s interventions are the quantity adjustments that make it possible to keep the price of foreign currency fixed. Thus, if we assume current exchange rate, R, to he constant, one way an imbalance in the current account and capital account can be corrected is through a change in official reserves. That is, the fixed exchange rate, R, determines Fs(SR/P, Y, Y*), and Fc(r, r* , R) Which determines RFX by means of Equation (1): RFX = Fs(SR/P, Y, Fc(r, r*, R) Therefore, one possible cause of a country’s central bank losing reserves is a current account deficit. This could happen when a country imports more than it exports, but does not sell any securities or real assets to foreigners (meaning that the other accounts are in balance). Then, the only way to pay for the excess imports, rider fixed exchange rates, is by decreasing its official reserves of foreign assets. Suppose that of the accounts in the Balance of Payments are balanced, except for trade balance, where imports by Malay exceed exports by USD10 million, then the official reserves of Malaysia will decrease by USD 10 million. That is, Malaysia will pay for its excess spending (the use) by selling some of the central bank’s reserves (the source). The alternative way a central bank can deal with an imbalance is to change the domestic interest rate relative to the foreign interest rate. Suppose, for instance, that there is a deficit in the current account, and the central bank does not want to lose reserves, then the central bank can obtain equilibrium by increasing the capital account, which, in the short run, requires an increase of domestic interest rate, r, relative to foreign interest rate, r*. The higher return on domestic deposits induces investors to finance the current account deficit, and no official reserves have to be used. Adjustment Under Flexible Exchange Rates Under flexible exchange rate regime, there is no intervention by the central bank and no change in the holdings of official reserves. Instead, the adjustment to an imbalance in the demand for foreign exchange comes about through a change in the price of foreign exchange rate, R, and its effects on the current and capital accounts. Suppose that the exchange rate is such that the private sector has an excess demand for foreign exchange. Competition for these scarce foreign funds then leads to a price adjustment, an appreciation of the foreign currency, which induces the private sector to alter its current account and capital account transactions until equilibrium is reached. Thus, a floating exchange rate regime is one in which the exchange rate is such that: RFX = Fs(SR/P, Y,Y*) + Fc (r, r*, R) Suppose that Malaysia has a current account deficit of USD10 million, but the central bank does not intervene in the foreign exchange markets to settle this deficit. In addition, the foreign exchange rate, especially USD, is allowed to float; then, there will be a capital account surplus to finance this; USD10 million worth of assets must be transferred from Malaysian residents to foreigners. For instance, Malaysia may pay in USD, which means that USD10 million is transferred to bank accounts held by foreigners. If exchange rates are not fixed, then in the conventional Balance of Payments view, the price of USD must drop in order to convince foreign investors to hold those additional USD10 million. Suppose now that, investors from abroad are investing large sums of money in Malaysia. Then, there is a positive net portfolio/direct investment in Malaysia, leading to a surplus in the capital account of the Malaysian Balance of Payments. Under fixed exchange rates, the effect of this inflow would be an increase in the official reserves. Under flexible exchange rates, the excess demand for Malaysian assets would lead to an appreciation of the Malaysian Ringgit. Therefore, according to the Balance of Payments theory of exchange rates, a change in price, income, and interest rates (all else being equal) will affect the exchange rate as follows: • • • An increase in domestic prices, P, leads to a decrease in exports and, thus, to a decrease in the demand for the domestic currency, implying a depreciation of home currency. An increase in domestic income leads to an increase in demand for imports and, thus, to an increase in demand for foreign currency, implying a depreciation of home currency. An increase in the domestic interest rate, r, leads to an increase in the demand for domestic assets, a decrease in the demand for foreign assets, and therefore an appreciation of the home currency. The exchange rates in most countries were fixed until the collapse of the Bretton-Woods system in the early seventies. Since then, however, many exchange rates have become flexible, though some central bank periodically intervenes in the exchange markets to revise the spot rate. This system of floating exchange rates with occasional intervention by the central bank is called “managed float or dirty float”. Obviously, under the managed float system, both the official reserves and the nominal and real exchange rates will change in response to imbalances in the capital and current accounts. Conclusions In this article, we have explained the Balance of Payments approach to exchange rate determination, according to which the demand for foreign exchange is derived from both current and capital account transactions. Thus, the Balance of Payments approach extends the Purchasing Power Parity theory to include the effect of foreign investment. The Balance of Payments theory of exchange rates determination is thus an improvement over the Purchasing Power Parity theory as it allows the exchange rate to be influenced by a change in the demand for foreign assets. However, the analysis of the relationship between the exchange rate and portfolio/direct investment is based on fairly restrictive assumptions. In particular, the assumption that the capital account is affected by only the risk-free rates of return in the domestic and foreign country is not very realistic. This theory fails to consider the effect on portfolio decisions of the rates of return on other assets. Nor does it analyse the role of expectation and uncertainty. In the next article, we will examine more recent theories of exchange rate determination, theories that treat the issue of asset demands in a more sophisticated way. References: 1. Clark, Don, 1987, Regulation of International Trade in the United States: Tokyo, Round Journal of Business (April), 297 -306. 2. Craig, Gary A., 1981, A Monetary Approach To the Balance of Trade, American Economic Review (June), 460-466. 3. Kravis, Irving B, and Robert Lipsey, 1978, Price Behavior in Light of Balance of Payment Theories, Journal Of International Economics (May), 193-246. 4. La Civita, Charles, 1987, Currency Trade, and Capital Flows in General Equilibrium, Journal Of Business (January), 113-135. 5. Miles, Marc A, 1979, The Effects of Devaluation in the Trade Balance and the Balance of Payments: Some New Results, Journal of Political Economy (June), 600-620. 6. Neumann, Manfred J.M, 1984, Intervention in the Mark/Dollar Market: The Authorities Reaction Function, Journal of International Money and Finances 3 (August), 223-240. 7. Obstfeld, Maurice,1984, Balance of Payment, Crises and Devaluation, Joumal of Money, Credit, and Banking (May), 208-2 17. 8. Salop, Joanne, and Erich Spitaller, 1980, why does the Current Account Matter?, International Monetary Staff Fund Papers (March), 10 1-134. T.S. Son is an Associate Professor and Azizah Abdullah and H. V. Wong are Senior Lecturers at the Faculty of Accountancy, Universiti Teknologi Mara.