Balance of Payments & Exchange Rates

Question 1

What is the balance of payments and what is in it?

Answer 1

A set of accounts showing all the movements of money in and out of a country within a period of time.

1. Current account
2. Capital account
3. Financial account
4. Net errors

Question 2

What is the current account and what is in it?

Answer 2

The current account records transactions in goods and services between the residents of the country and the rest of the world.

1. Balance in trade and goods and services (largest)
2. Income - mainly dividends and interest from abroad assets own by UK based firms
3. Current transfers

Question 3

What is the financial account and what is in it?

Answer 3

The financial account records transactions in financial assets between the residents of a country and the rest of the world.

1. Direct investment
2. Portfolio investment and financial derivatives
3. Reserve assets
   (See notes for detail)

Question 4

What is meant by a deficit on the current account?

Answer 4

This occurs when more money is flowing out of the country for imports on goods and services than than in for exports. It means that the balance of trade is negative, and as its the major section in the current account, the current balance will be negative too. (Must the overall balance of payments always balance?)

Question 5

Why does a deficit on the current account matter?

Answer 5

1. Seen as undesirable as it shows that UK businesses are generating less income (GDP) and employment in the UK from exports, whereas UK residents are spending more on foreign goods - money flowing out.
2. A surplus is a sign of economic strength as it indicates strong demand for UK exports, generating growth and jobs through an interjection to the circular flow of income
3. Depreciation of the currency - less of the currency is demanded by foreigners and more supplied from UK residents - cost push inflation (only if persistent)

Question 6

What is an exchange rate?

Answer 6

The exchange rate is the amount of one currency that another currency can buy.

(a bilateral exchange rate is the rate at which one currency can be traded against another. It is a nominal exchange rate)

Question 7

What is the effective exchange rate?

Answer 7

Measures the value of one currency against a basket of currencies of other countries, weighted according ti the amount of trade done with each country.

Also known as the exchange rate index and trade weighted index. See notes.

Question 8

What are the four types of exchange rate systems?

Answer 8

1. Free floating exchange rate system - where the value of one currency in terms of another currency - determined by the market forces of demand and supply
2. Fixed exchange rate system - where the value of one currency is fixed against another
3. Semi-fixed exchange rate system - where the value of one currency is allowed to fluctuate within a permitted band of fluctuation against at least one other currency
4. Managed / dirty float - where the exchange rate is determined by the free market forces, but the government intervene from time to time to alter the free market price of a currency