The External Balance And The Real Exchange Rate

The external balance and the real exchange rate along with the internal balance are the terms that are consistent with each other. The term external balance is also referred as the current account and is defined as the equilibrium position attained in the current and capital accounts.

Real exchange rate and external balance are co-related terms as, the external balance represents the combination of domestic demand the exchange rate at which the current account equates with the equilibrium level. To specify the external balance is not easy. The external balance tells us about the international flow of capital corresponding to the investment and he national saving over the medium term.

In the absence of governmental institutions or the institutional authorities, with the help of expected net flow of commodities and assets the external balance is approached. Zero current accounts along with the net claim which is unchanged over the other countries is another approach for identifying the external balance.

Balance of Payments Approach to the exchange rates is similar to those which focus on the relationship between a long-term equilibrium value for the real exchange rate and the external balance. In this, the long-term equilibrium exchange rate defines itself if it generates both the external i.e. current account and the internal balance is where internal balance is referred to as full employment. The main focus these days is not on full employment but to achieve a sustainable balance in current account that is not necessarily zero and it will achieve economic and exchange rate equilibrium. According to the Balance of Payments Approach the current account is just one of the mechanisms of transmission for the exchange rate under all the types of exchange rates i.e. may be fixed exchange rates or the floating exchange rates.

The depreciation in the real exchange rates is required to restore the equilibrium when the external balance is curtailed of its previous proportion of deficit levels in the history. Conversely, if it is shows a high external balance surplus, this will make a real exchange rate appreciation for restoring equilibrium. Within the emerging markets, another good example of current account and the real exchange rates is that of Russia. Before August 1998 crisis in Russia, it continued to record significant external balance deficits.

The current account approach suggested real exchange depreciation was required from time to time to restore the equilibrium. However, the Russian rouble and US dollar were pegged due to which the interest rates were highly raised for maintaining the peg. The costs of defending the Russian rouble peg in order to attain monetary independence, high capital mobility and a fixed exchange rate regime proved too much and due to this the rates of rouble were de-pegged and devalued, and for good value Russia defaulted on its domestic debt.