How Exchange Rate Targeting by the Central Bank Can Affect the Balance of Payment Position of a Country

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1.Explain how exchange rate targeting by the central bank can affect the balance of payment position of a country (Hint: Consider the current and the capital accounts) Exchange rate targeting is whereby the exchange rate becomes the nominal anchor. The subject of the most favorable monetary regime for small open developing economies is still widely discussed. The advantages and disadvantages of different exchange rate regimes are far too many to be readily captured and used to come up with a specific regime that suits the needs of all. Real exchange rate is perhaps the most popular real target for developing economies. The main advantages of Exchange rate targeting are

a)The nominal anchor of an exchange-rate target directly contributes to keeping inflation under control by tying the inflation rate for internationally traded goods to that found in the anchor country. b)The exchange rate can be directly observed i.e, with a fairly narrow band on a certain exchange rate, it is easy to determine whether the intermediate target is fulfilled c)An exchange-rate target provides an automatic rule for the conduct of monetary policy that helps mitigate the time-inconsistency problem. d)An exchange-rate target has the advantage of simplicity and clarity, as it is easily understood by the public.

The main advantages of Exchange rate targeting are
a)Shocks that change interest rates in the anchor country lead to corresponding changes in interest rates in the target country. b)The targeting country is open to speculative attack on its currency whenever the anchor country pursues tight monetary policy. The close linkage of the exchange rate to the general price levels of the economies produce an economy wide importance of policy making since it affects the real income and wealth of those economies. One of the main objectives of the exchange rate based stabilizations is to improve the Balance of Payment (BOP) performance through international competitiveness....
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