the management of foreign exchange rate regime in a market-oriented economy

P a g e | 1
TABLE OF CONTENTS
ACKNOWLEDGEMENT 5
INTRODUCTION 6
1.The essential of the research 6
2.Research Methodology 8
3.Research scope: 9
4.Research structure: 9
CHAPTER 1: THE MANAGEMENT OF FOREIGN EXCHANGE RATE REGIME IN A
MARKET-ORIENTED ECONOMY 10
1.1.The history and development of exchange rate regime 10
1.2.Categories of exchange rate 11
1.2.1. Definition of exchange rate and exchange rate regime 11
1.2.2. Categories of exchange rates 12
1.2.2.1. Official and unofficial exchange rate 12
1.2.2.2. Nominal and real exchange rate 12
1.2.2.3. Real Exchange Rate and Real Effective exchange rate 13
1.2.3. Categories and trends of foreign exchange rate regimes in the world 13
1.2.3.1. Categories of foreign exchange rate regimes 13
1.2.3.2. Trends of foreign exchange rate regimes in the world 15
1.3.Effects of foreign exchange rate regime on the macroeconomics variables 17
1.3.1. Balance of Payment 18
1.3.1.1. Current Account 19
1.3.1.2. Capital Account 20
1.3.1.3. Effects of exchange rate and exchange rate regime on BOP 21
1.3.2. Inflation 23
1.3.3. The Effectiveness of Fiscal policy 24
1.4.The management of foreign exchange rate and exchange rate regime 26
1.4.1. Rate of Exchange Under the Gold Standard: 26
1.4.2. Rate of Exchange Under Managed Paper Standard 27
1.4.3. Rate of Exchange Under Exchange Control 28

1.5.Theoretical Determinants of Exchange Rate Regimes 28
1.5.1. OCA Theory 28
1.5.2. Impossible Trinity 29
1.5.3. Currency crisis 29
1.5.4. Political economy 31
Supervisor: MSc. Le Phong Chau Student: Dang Vuong Anh
P a g e | 2
2.1.The management of foreign exchange rate regimes and the fluctuation of foreign exchange
rate in Vietnam through periods 33
2.2.Evaluation of the foreign exchange regime management on Vietnam’s economy 35
2.2.1. Effects of foreign exchange rate regime on BOP 35
2.2.2. Effects of foreign exchange rate regimes on inflation 38
2.3.Factor effecting the selection of foreign exchange rate regime 41
2.3.1. Interest rate 41
2.3.2. The expectation level of changing foreign exchange rate regime 42
2.3.3. Inflation 42
2.3.4. The decrease in the intervention level of Central Bank 43
2.4.Shortcomings of SBV’s management on current exchange rate regime 44
3.1.The economy of Vietnam in the recovery period 46
3.1.1. The opportunities 46
3.1.2. The difficulties and challenges 46
3.1.3. Implication to the foreign exchange rate regime 48
3.2.Recommendations on selecting an appropriate foreign exchange rate regime in the
recovery period 49
3.2.1. Recommendations on foreign exchange rate regime selection and management 50
3.2.1.1. Narrow the gap between official and unofficial exchange rate market 50
3.2.1.2. Implement the crawling floating exchange rate regime 51
3.2.2. Suggestions about supporting policies for regulating exchange rate regime 53
3.2.3. Others recommendations 56
3.2.3.1. Building and following up the early warning model of foreign exchange rate and

market crisis 56
3.2.3.2. Controlling foreign exchange rate regime through other factors 60
CONCLUSION 64
LIST OF TABLES
Table 1.Categories of foreign exchange rate regimes………………… …………… 12
Table 2.Exchange rate regimes in Vietnam , 1989-2009…………………….… … 31
LIST OF FIGURES
Supervisor: MSc. Le Phong Chau Student: Dang Vuong Anh
P a g e | 3
Figure 1. Exchange rate around the official rate, 03/1989 to 12/2009…………….….32
Figure 2.Nominal exchange rate and trade balance of Vietnam……………….….… 35
Figure 3.Vietnam's inflation over the period 1991-1999………………….……….….38
Figure 4.Vietnam’s Balance of Payments……………………………….………….….41
Supervisor: MSc. Le Phong Chau Student: Dang Vuong Anh
P a g e | 4
ABBREVIATION
BOP : Balance of Payment
CPFF : Commercial Paper Funding Facility
FDI : Foreign Direct Investment
FII : Foreign Indirect Investment
GSO : General Statistics Office (Vietnam)
IMF : International Monetary Fund
GDP : Gross Domestic Products
LIBOR : London Interbank Offered Rate
NEER : Nominal Effective Exchange Rate)
OER : Official Exchange Rate
PPIP : Public Private Investment Program
PPP : Purchasing Power Parity
REER : Real Effective Exchange Rate
SBV : State Bank of Vietnam

TALF : Asset-Backed Securities Loan Facility
TARP : Troubled Asset Relief Program
WB : World Bank
WTO : World Trade Organization
Supervisor: MSc. Le Phong Chau Student: Dang Vuong Anh
P a g e | 5
ACKNOWLEDGEMENT
First of all, I would like to give a warm thanking to all the lecturers of Advance
Program of National Economics University in accordance with all the staff of National
Research Department of the National Financial Supervisory Commission – NFSC for
giving me such a good basic knowledge of economics in general and exchange rate
regime in particular during the time of my internship.
Especially, I would also want to give a sincere gratitude to my supervisor Dr. Le
Phong Chau who directly guides me in the process of making my report. Moreover, Dr.
Le Xuan Nghia – the Vice chairman of National Financial Supervisory Commission is
also the person that gives me lots of constructive comments to improve my report.
In two months working at Research Department of the National Financial
Supervisory Commission – NFSC, I have tried my best to get information and
proposed some recommendations to selecting an appropriate foreign exchange rate
regime in the recovery period in Vietnam. However, there are certain limitations and
mistakes due to the lack of time and information. Therefore, I am willing to receive any
comments and suggestions. This two months of training at NFSC is such a valuable
experience that I will never forget. It does help me a lot in preparing for my future
career.
Dang Vuong Anh
Supervisor: MSc. Le Phong Chau Student: Dang Vuong Anh
P a g e | 6
INTRODUCTION
1. The essential of the research
Vietnam’s economy is now in the process of transformation and development with

deep integration with the world economy especially after its participation to WTO in
2006. In order to develop a strategy for the sustainable development, the Party and
Government have determined to create a platform for macroeconomic stability, a stable
position before the integration era. However, the process of expanding economy has
created more pressure on the financial system. This requires timely reformations in
mechanisms and operating policies to achieve the objectives of sustainable
development, reduces trade deficits, inflation, and efficiently absorbs foreign
investment flow.
Exchange rate regime has long been considered one of the most important tools for
monetary policy. For a developing country like Vietnam, it is the key variable to
stabilize the economic situation by its influences not only on the framework of trade
and investment, but also on both monetary system, the entire macro economy and
financial system. Moreover, the exchange rate also contributed to the cause of global
economic and financial crises. Fundamental objectives of exchange rate regime are to
limit the negative externalities and to support the commercial activities to minimize
and prevent risks to the economy.
In the context of integration and multi-dimensional impacts, the monetary,
exchange rate policy in Vietnam is expressing increasingly shortage of conformity in
the future when the economy is highly opened. In addition, increasingly strong
fluctuations of the turnover of capital flows along with the development of diversified
financial institutions and financial instruments caused the exchange rate management
policies become more complex and difficult to control. A reasonable and flexible
mechanism for exchange rate adjustment is very important factor in order to support
Supervisor: MSc. Le Phong Chau Student: Dang Vuong Anh
P a g e | 7
the control of inflation, dollarization, as well as to maintain competitiveness and
promote export’s growth.
After the great impact of the 2008 financial crisis on the Vietnam’s economy, the
government has clearly defined the target in 2009 is to be against the economic
downturn and to ensure the social welfare. Strategic objectives with specific criteria of

economic development vision 2011 – 2015 were proposed by the Ministry of Planning
and Investment such as 5-year GDP average (2011-2015) increased by 7.5-8% per
year, budget deficit in 2015 is 4.5%, current account deficit in 2011-2015 at about USD
30.7 billion, balance of capital surplus is 69 billion dollars, the overall balance of
payments surplus is about USD 25.6 billion. Among various instruments to achieve
these goals, the VND/USD exchange rate management is important. The
competitiveness capacity of exports, the trade balance and balance of payments status,
the national reserves, changes in production structure and confidence in the currency
and the government, which are all factors measuring the health and motivation
dominated developing country's economy, depend deeply on the official exchange rate.
The flexibility of exchange rate policy is also reflected in the flexibility in the
selection of the target rate of the policy. It is really difficult to satisfy multiple
objectives with an exchange rate policy in the same time, but keep applying an
exchange rate policy just to serve a certain goal though a long period of time and
ignore the changes in the environment is also not an appropriate strategy. For example,
in order to reach the goal of reducing debt obligations, maintaining a low-rate policy,
which valued its currency, may be essential in the time of maturity, but if this policy is
maintained for too long, it could harm the long-term goal rather than maintain the trade
balance’s stability or boosting exports. Therefore, every single period of the economy
needs clearly defined objectives consistent to the specific context in order to promote
the effectiveness of the exchange rate regime.
Observing the current trend of the economy, I have decided to do my research on
the topic “Selecting an appropriate foreign exchange rate regime in the recovery period
Supervisor: MSc. Le Phong Chau Student: Dang Vuong Anh
P a g e | 8
in Vietnam” with the aim of evaluating the effectiveness of the exchange rate regime
applied at present time, particularly in the recovery period after the crisis, focusing on
opportunities and challenges along with of the medium and long term economic
development’s orientations of the Communist Party and Government, proposing some
recommendations for improving the exchange rate regime in the near future.

2. Research Methodology
In the process of researching, the method of qualitative and quantitative analysis,
simulation and synthesis comparison.
Qualitative analysis: based on proven economics theorems, practical experience
applied in other countries and the actual conditions of Vietnam’s economy, combined
with logical thinking, reasoning and dialectical analyzing, I have made identifications,
descriptions and commentaries on the issue.
Quantitative Analysis: Given limited time and knowledge, the research just limited
within evaluating data, converting raw data into informative charts and computing
forecasting indicators rather than constructing of new model.
Simulation method: is a method of creating an assumed economic environment to
investigate the extent of the economy reactions to the vagaries of macroeconomic
variables or shocks from crises, economic downturns.
Synthesis comparison method: information and data of different countries in the
same period of time were collected and compared to Vietnam’s.
Because of the fact that exchange rate is a macro-economic variable, the data used
in this research are secondary information (available from different sources), with their
accuracy and reliability were verified.
Supervisor: MSc. Le Phong Chau Student: Dang Vuong Anh
P a g e | 9
3. Research scope:
The scope of my research limited to the role, impact and effectiveness of the
exchange rate’s regime and mechanism currently applied in Vietnam to
macroeconomic variables during the period of economic recovery. On that basis, other
preferential policies were studied and proposed.
4. Research structure:
The research consists of three parts.
Chapter 1: The management of foreign exchange rate regime in a market-oriented
economy.
The aim of this chapter is introducing the scientific rationale of selecting an

appropriate foreign exchange rate regime in the recovery period, going deep on the
history of the formation and development of the exchange rate regimes, categorizing
and analyzing various types of mechanisms being applied now, the impact of those
mechanisms to macroeconomic variables and relating factors.
Chapter 2: The evaluation on the current foreign exchange regime of Vietnam.
This chapter evaluates the Vietnam’s exchange rate regime through each period
with the focus from 2009 until now, proposes comments on the implications, factors of
the mechanisms and the exchange rate regimes in the last period.
Chapter 3: Selecting an appropriate foreign exchange rate regime in the period of
recovery in Vietnam.
Propose some solutions to improve the exchange rate regime in Vietnam during the
period of economic recovery.
Supervisor: MSc. Le Phong Chau Student: Dang Vuong Anh
P a g e | 10
CHAPTER 1: THE MANAGEMENT OF FOREIGN EXCHANGE RATE
REGIME IN A MARKET-ORIENTED ECONOMY
1.1. The history and development of exchange rate regime
At the dawn of human kind, barter is the first and most common payment method
among countries. About 4000 years ago in the Middle East, the turning point occurred
when coins were used and the first professional money dealer appeared and exchanged
a certain amount of coins of this country for a corresponding amount of coins of
another country, marked the birth of the exchange rate and foreign exchange market.
After the collapse Roman Empire and at the early stage of Medieval Ages witnessed
the decreasing in the currency exchange activity among countries due to unstable
political situation, religious and international trade restrictions. Not until the 19th
century, the foreign exchange trading activities officially boomed again.
World War I and the Great Depression 1929 - 1933 made the foreign exchange
market brake up into small pieces; the exchange rate regime based on the gold standard
was also collapsed in 1931. After the World War II (1939 - 1945), with the support
from the huge gold reserves - 70% of the world's gold reserves at that time (obtained

from selling weapon to parties participating in the war and reparation fee paid by
defeated countries which was forced to pay in gold by the US. ) – the U.S. dollar
(USD) has become one of the main currency of international economy. Besides, the
role of government was reflected dramatically in the foreign exchange market’s
stability, tight controlling value for money, and exchange rate regime adjustment.
Bretton Woods agreement (1944) had brought a new order, determined the US. Dollar
as the reserves and the mean of international payment. Other currencies were fixed to
US. Dollar. US. Dollar’s value is anchored to gold at the exchange of $ 35 per ounce of
gold. Most central banks chose US. Dollar as the world reserve currency because of the
unlimited gold exchange of the U.S. central bank. However, that fixed exchange rate
system was under great pressure during the period 1967 - 1971 due to a serious
Supervisor: MSc. Le Phong Chau Student: Dang Vuong Anh
P a g e | 11
imbalance in the trade balance between countries which had too much of U.S. dollar
reserves. In addition, the official price of gold based on Bretton Woods Agreement was
cheaper than that of gold on the black market, followed by the speculation and massive
exchange from dollars into gold. August 15th 1971, U.S. officially stopped gold
exchange activity and Bretton Woods exchange rate system collapsed. The floating
exchange rate regime began to diversify and extend to the present time. A noteworthy
point in the development history of the exchange rate and foreign exchange market was
the introduction of the European common currency, marked a turning point when the
exchange rate between the members’ currencies could be anchored at the same equal
rate, shared a common mechanism.
1.2. Categories of exchange rate
1.2.1. Definition of exchange rate and exchange rate regime
The exchange rate is a comparison of price between the two currencies of different
countries or could be considered as the price of one currency expressed in a different
currency.
Example: (04/11/2010 - Vietcombank) 1USD = 19,495 VND
An exchange system quotation is given by stating the number of units of "quote

currency" (price currency, payment currency) that can be exchanged for one unit of
"base currency" (unit currency, transaction currency).
For example, in a quotation that says the EUR/USD exchange rate is 1.2290
(1.2290 USD per EUR, also known as EUR/USD; the quote currency is USD and the
base currency is EUR.
When currency X appreciated against the currencies Y (or Y devaluated against X),
the exchange rate between X and Y on the foreign exchange markets base on Y will be
reduce, but that based by X will increase.
Supervisor: MSc. Le Phong Chau Student: Dang Vuong Anh
P a g e | 12
The exchange rate regime is the way a country manages its currency in respect to
foreign currencies and the foreign exchange market. It is closely related to monetary
policy and the two are generally dependent on many of the same factors.
1.2.2. Categories of exchange rates
1.2.2.1. Official and unofficial exchange rate
With the floating exchange rate, exchange rate is determined by the market. With
the fixed exchange rate, exchange rate is determined by the Government. Some
countries, in which both market’s and government’s regulations participate in
stipulating the exchange rate, have an official exchange rate (listed by the Government)
and an unofficial rate, also known as the parallel exchange rate or black market
exchange rate. The official exchange rate also has several types: the interbank
exchange rate, exchange rate of commercial banks, accounting exchange rates
1.2.2.2. Nominal and real exchange rate
Nominal exchange rate is the exchange rate which does not consider relative prices
or inflation between the two countries. In contrast, Real exchange rate is the actual rate
based on the relationship of prices or inflation between the two countries, thus reflects
the purchasing power and competitiveness of a country. One of the most important
elements of the real exchange rate is the international competitive position of a
country. Real exchange rate volatility along with the depreciation of currency to reflect
production costs for domestic goods of that country increase. If the production costs of

other countries do not change, this country will take advantage of international
competitiveness.
The relationship between these two types of exchange rates
Real exchange rate = Nominal exchange rate *
Supervisor: MSc. Le Phong Chau Student: Dang Vuong Anh
P a g e | 13
= Nominal exchange rate *
1.2.2.3. Real Exchange Rate and Real Effective exchange rate
Real exchange rate is the actual rate based on the relationship of prices or inflation
between the two countries, thus reflects the purchasing power and competitiveness of a
country.
Real effective exchange rate is the exchange rate between currency A with a variety
of other currencies at the same time. This rate is calculated based on the value
weighted average of real exchange rates between currency A currency with each other
currency.
1.2.3. Categories and trends of foreign exchange rate regimes in the world
1.2.3.1. Categories of foreign exchange rate regimes
Since the end of the fixed exchange rate regime Bretton Woods in 1971, most
countries around the world had applied floating exchange rates. However, the fixed
exchange rate continues to exist and be transformed into many different intermediate
formats. Here are the classifications provided by the International Monetary Fund IMF
(2008)
Table 1. Categories of foreign exchange rate regimes
Exchange rate
regime
Characteristics
No of
countries
1997
No of

countries
2008
Representative
1. Floating
- The exchange rate is
determined by the
market’s demand and
44
(24.31%)
40
(21.28%)
UK, US, EU,
Japan
Supervisor: MSc. Le Phong Chau Student: Dang Vuong Anh
P a g e | 14
supply.
- The State bank hardly
intervenes and there is no
targeted exchange rate.
2.Managed
Floating
- The exchange rate is
determined by the
market’s demand and
supply.
- The State bank may
intervene and there is
targeted exchange rate.
23
(12.71%)

44
(23.4%)
Thailand,
Singapore,
Malaysia, India
3. Pegged with
margin
- Free fluctuation in the
margin of > ±1%.
- The base exchange rate
adjusted regularly
11
(6.08%)
2
(1.06%)
Costa Rica,
Azerbaijan
4. Managed
Pegged
- The base exchange rate
adjusted regularly
7
(3.87%)
8
(4.26%)
China
5. Pegged in
margin
- Fixed base exchange
rate

- Free fluctuation in the
margin of > ±1%.
26
(14.36%)
3
(1.6%)
Syria
Vietnam
6. Fixed Pegged
- with one
currency
- with one
- Fixed base exchange
rate
- Free fluctuation in the
margin of > ±1% in at
52
(28.73%)
68
(36.17%)
Russia, Jordan
Supervisor: MSc. Le Phong Chau Student: Dang Vuong Anh
P a g e | 15
basket of
currencies
least 3 months.
- The State Bank may
adjust the base exchange
rate but not regularly
7. Fixed Pegged

with one strong
currency
- Pegged with another
currency with fixed rate -
The State Bank intervenes
regularly to maintain the
exchange rate
12
(6.63%)
13
(6.91%)
Hongkong,
Brunei, Bungary
8. Completed
Dollarization
- Do not use domestic
currency
- Use other country’s
currency
6
(3.31%)
10
(5.32%)
Bolivia, Panama
Source: IMF (statistics) (2008)
1.2.3.2. Trends of foreign exchange rate regimes in the world
The first trend - Unifying the exchange rate regime: According to the IMF, the
transition from the regime of two or more exchange rates to unified exchange rate
regime is a global trend and widespread. From 1973, shortly after the collapse of
Bretton Woods, approximately 50% of the countries applied bilateral exchange rates,

but by 2001 this figure is only around 7%. A study by Rogoff (2004) showed that the
economy which has two exchange rate regimes often has 2 – 3 times poorer growth and
higher inflation rates than countries with unified exchange rate regime.
The second trend - Moving towards the two extremes: In the past two decades, most
countries tended to whether completely fixed or floating exchange rate regime, in
which the floating regime increasingly dominated the fixed one.
Supervisor: MSc. Le Phong Chau Student: Dang Vuong Anh
P a g e | 16
Fixed exchange rate regime restricts the fluctuation of exchange rates, so there is no
need to reserve for exchange rate risk. When applying this mechanism, governments
and central banks easily achieve the targeted goals. However, this mechanism makes
the FOREX market underdeveloped and creates potential risks of demand and supply
imbalance. Foreign currency shortage becomes frequent, limiting the growth of
international trade. In addition, intervention costs and foreign exchange reserves
management cost is huge.
Floating exchange rate regime provides the clear reflection about the current supply
and demand situation as well as the volatility of the foreign exchange market. This
mechanism ensures regulations of the foreign exchange market, prevents the domestic
market from the outside market's volatility, and protects economic stability and growth.
However, applying this regime, the government will face more difficulties and
challenges in selecting the appropriate economic policy because of frequently and
unpredictable changes. And because of no interference of the government's role,
central bank has very limited power.
Kurt Schuler's research has shown that the historical evidence proved that these two
basic mechanisms are less influenced by the financial and monetary crisis then the
intermediary regimes. For example, the crisis in 1997 caused heavy damage to the
countries of Southeast Asia, Russia and Brazil, which officially or unofficially have
linked their currencies, but do not drop floating or anchored entirely with the U.S.
dollar. Meanwhile, countries like Panama (no central bank, with no local currency and
foreign exchange transaction), Jordan (Central Bank formally adopted a fixed

exchange rate 0.709 Dina / US dollar and no foreign exchange transaction), Cuba,
China are less affected or easily overcome the crisis.
The regime of fixed exchange rates appears to be suitable with the developing,
under-developed economies or dependent on another economy. The advantages of this
exchange rate regime are economic stability, low inflation, crises prevention and the
maintenance of the prestige and role of government. It is relatively suitable for
Supervisor: MSc. Le Phong Chau Student: Dang Vuong Anh
P a g e | 17
countries with large foreign exchange reserves, with clear and consistent competitive
advantage and strategic orientation such as China.
However, countries with emerging economies and are in the transition period such
as Thailand, Philippines, Singapore when apply a fixed exchange rate regime will
often face with the financial crises, resulting in speculation and finally a floating
exchange rate has to be applied. As the highly-opened and sensitive economy with high
growth of international trade, fixed exchange rate regime does not show its
effectiveness and even stifles the economic growth. However, these countries still
consider floating exchange rate mechanism as a potential threat that could reduce the
credibility of the Government's role, affect export when domestic currency
appreciate… As a result, these central banks typically apply strong interventions such
as stabilizing foreign exchange reserves funds, open market operations, controlling of
capital to keep the exchange rate objectives.
For countries with highly developed economies like Japan, EU the financial and
monetary systems are at high level, a floating exchange rate regime has proved to play
quite a large role in promoting their economic growth, curbing inflation and
minimizing the impact of economic shocks and recession.
1.3. Effects of foreign exchange rate regime on the macroeconomics
variables
Today, in the context of liberalization and globalization which was characterized by
rapid capital flows between the economic sectors, the exchange rate has become a very
effective tool in regulating the external economic relations among countries. Along

with the transformation of the world economy, countries tend to shift gradually to the
application of a floating exchange rate regime. But there are still some countries which
governments peg their currencies to a currency of another or a basket of currencies at a
fixed exchange rate.
Supervisor: MSc. Le Phong Chau Student: Dang Vuong Anh
P a g e | 18
Exchange rate regime is one of the most important macroeconomic policies of the
developing countries or countries which have their economies in the transition period.
Impacts of these policies are extremely robust to many other macroeconomic variables
such as inflation, balance of payments, money supply, as well as the effectiveness of
fiscal and monetary policies in general.
1.3.1. Balance of Payment
A balance of payments (BOP) sheet is an accounting record of all monetary
transactions between a country and the rest of the world. These transactions include
payments for the country's exports and imports of goods, services, and financial
capital, as well as financial transfers. The BOP summarizes international transactions
for a specific period, usually a year, and is prepared in a single currency, typically the
domestic currency for the country concerned. Sources of funds for a nation, such as
exports or the receipts of loans and investments, are recorded as positive or surplus
items. Uses of funds, such as for imports or to invest in foreign countries, are recorded
as a negative or deficit item.
When all components of the BOP sheet are included it must balance – that is, it
must sum to zero – there can be no overall surplus or deficit. For example, if a country
is importing more than it exports, its trade balance will be in deficit, but the shortfall
will have to be counter balanced in other ways – such as by funds earned from its
foreign investments, by running down reserves or by receiving loans from other
countries.
While the overall BOP sheet will always balance when all types of payments are
included, imbalances are possible on individual elements of the BOP, such as the
current account. This can result in surplus countries accumulating hoards of wealth,

while deficit nations become increasingly indebted. Historically there have been
different approaches to the question of how to correct imbalances and debate on
whether they are something governments should be concerned about.
Supervisor: MSc. Le Phong Chau Student: Dang Vuong Anh
P a g e | 19
1.3.1.1. Current Account
In economics, the current account is one of the two primary components of the
balance of payments, the other being the capital account. The current account is the
sum of the balance of trade (exports minus imports of goods and services), net factor
income (such as interest and dividends) and net transfer payments (such as foreign aid).
You may refer to the list of countries by current account balance.
The current account balance is one of two major measures of the nature of a
country's foreign trade (the other being the net capital outflow). A current account
surplus increases a country's net foreign assets by the corresponding amount, and a
current account deficit does the reverse. Both government and private payments are
included in the calculation. It is called the current account because goods and services
are generally consumed in the current period.
The balance of trade is the difference between a nation's exports of goods and
services and its imports of goods and services, if all financial transfers, investments and
other components are ignored. A nation is said to have a trade deficit if it is importing
more than it exports.
Positive net sales abroad generally contribute to a current account surplus; negative
net sales abroad generally contribute to a current account deficit. Because exports
generate positive net sales, and because the trade balance is typically the largest
component of the current account, a current account surplus is usually associated with
positive net exports. This however is not always the case with open economies such as
that of Australia featuring an income deficit larger than its trade deficit.
The net factor income or income account, a sub-account of the current account, is
usually presented under the headings income payments as outflows, and income
receipts as inflows. Income refers not only to the money received from investments

made abroad (note: investments are recorded in the capital account but income from
Supervisor: MSc. Le Phong Chau Student: Dang Vuong Anh
P a g e | 20
investments is recorded in the current account) but also to the money sent by
individuals working abroad, known as remittances, to their families back home. If the
income account is negative, the country is paying more than it is taking in interest,
dividends, etc.
1.3.1.2. Capital Account
At high level:
Breaking this down:
Foreign direct investment (FDI), refers to long term capital investment such as the
purchase or construction of machinery, buildings or even whole manufacturing plants.
If foreigners are investing in a country, that is an inbound flow and counts as a surplus
item on the capital account. If a nations citizens are investing in foreign countries that
are an outbound flow that will count as a deficit. After the initial investment, any
yearly profits not re-invested will flow in the opposite direction, but will be recorded in
the current account rather than as capital.
Portfolio investment refers to the purchase of shares and bonds. It’s sometimes
grouped together with "other" as short term investment. As with FDI, the income
derived from these assets is recorded in the current account - the capital account entry
will just be for any international buying and selling of the portfolio assets.
Supervisor: MSc. Le Phong Chau Student: Dang Vuong Anh
P a g e | 21
Other investment includes capital flows into bank accounts or provided as loans.
Large short term flows between accounts in different nations are commonly seen when
the market is able to take advantage of fluctuations in interest rates and / or the
exchange rate between currencies. Sometimes this category can include the reserve
account.
Reserve account: The reserve account is operated by a nation's central bank, and
can be a source of large capital flows to counteract those originating from the market.

Inbound capital flows, especially when combined with a current account surplus, can
cause a rise in value (appreciation) of a nation’s currency - while outbound flows can
cause a fall in value (depreciation). If a government (or if it’s authorized to operate
independently in this area, the bank itself) doesn't consider the market driven change to
its currency value to be in the nations best interests', the bank can intervene.
1.3.1.3. Effects of exchange rate and exchange rate regime on BOP
Balance of payments consists of two main parts: current accounts and capital
accounts. For capital account, the major factors which affect the balance of capital
account are investment and interest rates; when the domestic interest rate changes, it
will stimulate the flow of capital in or out of that country. While the exchange rate
factor hardly affects the balance of capital and just only take the form of exchange
between one currency to other currency to invest in a country with attractive interest
rates.
Supervisor: MSc. Le Phong Chau Student: Dang Vuong Anh
P a g e | 22
For current account, income and one-way current transfers are not affected by
exchange rate factors; the change in exchange rate does not alter the balance of income
and one-way transfer. Because the balance of income depends on the amount of
precious investment, when the exchange rate changes, it does not affect the
profitability of this investment. Besides the balance of one-way current transfer is
income distribution between economic entities and abroad.
Exchange rate directly affects the trade balance and service balance; the fluctuation
of exchange rate causes these two factors change. Normally, exchange rate changes
will impact strongly on the trade balance through export-import activities of a country
in open economy.
The exchange rate regime in which the domestic currency is undervalued may have
good impact on export and restrict import, balance the current account from deficit to
surplus. Conversely, when the domestic currency appreciates, making domestic goods
more expensive to export, resulting in loss of competitiveness, while the demand for
imports increases makes the state’s deficit will become more apparent. Therefore,

Supervisor: MSc. Le Phong Chau Student: Dang Vuong Anh
P a g e | 23
selecting appropriate exchange rate will make the trade balance or current account
automatically balanced.
When considering the impact of exchange rate regime on trade balance, in fact just
focus on the impact on trade balance through export-import activities, positive impact
on international trade activities International.
1.3.2. Inflation
One important goal of monetary policy is to control the inflation in the economy.
The exchange rate is part of monetary policy that central banks want to use to achieve
this goal, so exchange rate is the derived element in the process of inflation in a
country.
Supervisor: MSc. Le Phong Chau Student: Dang Vuong Anh
P a g e | 24
With other factors remain constant, when the exchange rate rises and the currency
loose its value against foreign currencies, this will create pressure on inflation. Growth
rate makes the price of imported goods in domestic currency increased, including
goods for personal consumption and intermediate goods for production, makes the
price of the whole economy increases eventually. Conversely, when exchange rate
falls, price of imported goods goes down, contributing to the domestic price level goes
down and reduces inflation pressure. This relationship is expressed through the
following formula:
• With: α – Proportion of domestic manufactured goods.
(1- α ) – Proportion of imported goods.
P - Price of domestic manufactured goods (in domestic currency).
P
*
- Price of imported goods (in foreign currency).
E – Exchange rate (No units of Domestic currency/1 unit of foreign currency).
P

1
– General price of goods of the whole economy.
Stabilizing the exchange rate can help boost the confidence in the currency, force
the government to control budget deficits and credit growth, thereby enhance the level
of trust in the government's policy and the inflation will gradually be reduced and
become stable.
1.3.3. The Effectiveness of Fiscal policy
Exchange rate regime has close relationship with monetary and fiscal policy. The
analysis is based on the Mundell-Flemming model, developed in 1960 with the basic
assumptions: (i) the economy is considered to be opened, so that any small change in
Supervisor: MSc. Le Phong Chau Student: Dang Vuong Anh
P a g e | 25
interest rate caused by the policy does not affect the world interest rate, (ii) the flow of
capital is circulated freely and completely flexible, (iii) the economy is at its full
capacity stage, so the demand will increase lead to increasing in supply without raising
prices, (iv) no expected changes in exchange rate, (v) the economy satisfies the
Marshall-Lerner’s condition. Results of the analysis indicate that there is a tradeoff
between the effectiveness of monetary and fiscal policy under different exchange rate
regimes in an economy. In an economy with fixed exchange rate regime, the central
banks can not perform effectively independent monetary policy.
In an open economy, money markets and the principle of "Trinity of
Impossibilities" – Mundell - Flemming model always exist together. This theory states
that a country can not simultaneously achieves three objectives of macro policy:
- Exchange rates stability
- Liberalization of capital flows
- Monetary policy independence
A country can not simultaneously achieve all 3 goals in macroeconomic policy; it
only can select a maximum of 2 for 3 as targets. In case of a tight monetary policy is
implemented which makes higher interest rates in the country, free capital inflow
increases, boosts the supply of foreign currency, make the domestic currency

appreciates. When the cash inflow is too much, if government wants to keep exchange
rates stable, the central bank is required to increase supply of domestic currency and
buy foreign currencies, making interest rate fall back.
In conclusion, the exchange rate regime is an important part in the economy which
has a direct impact to the macro-economic variables such as inflation, trade balance,
import, export, unemployment rate as well as the monetary policy. Depending on the
characteristics of each country in each geographic area, specific economic, political
institutions, the government will choose an appropriate exchange rate regime (floating
or fixed). But the ultimate goal is to ensure the stability of the macro economy’s
Supervisor: MSc. Le Phong Chau Student: Dang Vuong Anh