L25/L26 - Balance of Payments and The Exchange Rate

Question 1

What is an appreciation in the pound?

Answer 1

A rise in the external value of the pound (i.e. a rise in the exchange
rate)

Question 2

What is a depreciation in the pound?

Answer 2

A fall in the external value of the pound (i.e. a fall in the exchange
rate)

Question 3

Where does the demand for money arise from?

Answer 3

All international transactions that generate a receipt of foreign exchange.

i. e.
- UK Exports
- Income Payments and Transfers
- Capital Inflows
- Reserve Currency

Question 4

What are the different types of Exchange Rate markets?

Answer 4

• Spot Market

- Forward/Futures Market

Question 5

What’s a spot market?

Answer 5

Traded for immediate delivery

Question 6

What’s a forward/future market?

Answer 6

Contracts for future delivery

Question 7

What is implied via the demand for one source of currency?

Answer 7

There is a supply of another currency.

And if there’s a supply of pounds. Implies a demand of dollars.

Question 8

What causes the shifts in demand and supply that lead to changes in
exchange rates?

Answer 8

• a rise in the domestic price of exports
• a rise in the foreign price of imports
• Changes in price levels
• Capital movements

If the price level of one country is rising relative to that of another
country, the equilibrium value of its currency will be falling relative to
that of the other country.

Question 9

Why have Exchange rate been volatile?

Answer 9

View that PPP theory explains it.

Theory holds that a currency will tend to have the same purchasing power when it is spent in its home country as it would have if it were converted to foreign exchange and spent in the foreign country

exerts a strong influence on exchange rates in the long
term

Question 10

What is a fixed exchange rate system? (like Bretton Woods system)

Answer 10

Authorities intervene in the foreign exchange market to maintain the exchange rate within a specified range.

Question 11

What is a flexible (or floating) exchange rate regime?

Answer 11

Exchange rate is market-determined by supply and demand for the currency.

Question 12

What is Exchange Rate Overshooting? (

Answer 12

• Dornbusche’s observation
• Differences in interest rates between countries can trigger large capital flows (since investors seek to place their funds where returns are highest)
• Causes swings in exchange rate between the two countries

(Graph shown on notes)

Question 13

What is the Openness Index?

Answer 13

About how open an economy is.

OI = X+ IM/GDP x100

Question 14

What is the Uncovered interest rate parity?

Answer 14

Used to explain interest rate differentials between countries.

It = It* + Change in Et

Where:
It is domestic interest rate

It* is foreign interest rates

Change (Triangle) in Et refers to change in exchange rates

Question 15

What makes up the balance of Payments?

Answer 15

• The Current Account
• The Capital Account
• The Financial Account

Question 16

What is the Current Account?

Answer 16

Records international flows of goods, services, income and transfer payments.

i.e:
Trade in Goods and Services
Investment Income
Transfers

Question 17

What is the Capital Account?

Answer 17

Records transactions involving capital.

i. e
- Debt forgiveness, Inheritance Taxes, Sales of Tangible and Intangible Assets

Question 18

What makes up the Trade Balance?

Answer 18

Balance between trade in goods and services

Question 19

What makes up the Income Balance?

Answer 19

Balance between Investment Income and Transfers

Question 20

How is the Current Account divided?

Answer 20

Into 3 main sections:

1) Visible Account
2) Invisible Account
3) Current Transfers

Question 21

How can you balance the current account?

Answer 21

By matching it with a balance on the capital and financial accounts of equal magnitude.

So, it overall balances out.

e.g:
If current account in positive, then capital account must be in minus

If all in positive then Surplus
If all in negative then Deficit

Question 22

What do persistent deficits or surpluses involve?

Answer 22

Persistent Deficits or Surpluses, involve a build-up or run-down of a country’s net foreign asset

Nothing inherently good or bad about surpluses or deificits on current account

Question 23

When could a current account deficit be healthy?

Answer 23

It could be a healthy sign when indicates a country is borrowing from abroad to finance investment in Real economic growth

Question 24

When could a current account deficit be unhealthy?

Answer 24

Unhealthy if it involves borrowing to finance unproductive projects

Question 25

What are some examples of crisises?

Answer 25

Mexican Crisis (1994)
Asian Crisis (1997)
Russian Crisis (1998)
Argentina Crisis (2001-2)
Iceland Crisis (2008)

Question 26

What’s the most common reason for a balance of payments crises?

Answer 26

• It’s because investors in a specific economy revise their analysis of an economy’s prospects and come to believe that the level of international borrowing is unsustainable.
• At this point, capital inflows turn into outflows as foreigners try to get their money out and also domestic residents try to move their funds abroad.
• If the exchange rate is pegged by the domestic government, there will be a run on official foreign exchange reserves and this
  will put pressure on the domestic authorities to change their monetary and/or fiscal policies.
• If the currency is floating, the exchange rate will fall sharply and
  this will lead to a sharp increase in domestic inflation.
• The existence of a current account balance of payments deficit
  tells us only that an economy ís total spending exceeds its total
  income and that it has a capital inflow.

Question 27

What are the causes of Balance Of Payment crises?

Answer 27

• It could be political instability or the introduction of wasteful government spending plans.
• Sharp fall in market prices of the countries main export commodity
• General rise in world interest rates that sharply increases the costs of servicing foreign debts

Question 28

What are the roles of the IMF?

Answer 28

• Provision of foreign currencies (via quotas)
• Provision of world liquidity
• The SDR (Spatial Drawing Right): Basically own currency
• IMF Stabilisation Programme (Follows the Washington Consensus)
  i. e Liberalisation of economy, Fiscal and Monetary Contraction. If a country asks for a loan.

Question 29

What groups suffer from the after-effects of BoP crises?

Answer 29

• International banks and other investors who to the country thats in problems as their investment has fallen sharply
• Domestic residents when their incomes fall and wealth too

Question 30

What are the critiques of IMF Policies?

Answer 30

• IMF loans and the
  conditions attached help to bailout international investors do little to help the adjustment pains felt by domestic residents
• IMF Stabilisation programme in general

Question 31

What are the critiques of the IMF Stabilisation programme?

Answer 31

• IMF programmes inappropriate
• IMF programmes inflexible
• IMF support inadequate and too expensive
• IMF dominated by major industrial countries.

Question 32

What are the different Exchange Rate regimes?

Answer 32

• Free Float
• Gold Standard
• Adjustable Peg
• Managed Float

Question 33

What are the features of a gold standard regime?

Answer 33

• Automatic intervention

- Fixed Exchange Rate

Question 34

What are the features of a Free Floating system?

Answer 34

• No intervention

- Floating exchange rate

Question 35

What are the features of an Adjustable Peg?

Answer 35

• Some discretionary intervention

- Fixed Exchange Rate

Question 36

What are the features of a managed floating system?

Answer 36

• A managed floating system

- Some discretionary intervention