Module 16 - The balance of payments and exchange rates

Question 1

Balance of payments account

Answer 1

The balance on trade in goods and services plus net incomes and current transfers.

The set of accounts that records the flows of money between a country’s residents and the rest of the world.

Question 2

Current account of the balance of payments

Answer 2

The record of a country’s imports and exports of goods and services, plus incomes and transfers of money to and from abroad.

Question 3

Trade in goods account

Answer 3

Records exports (+), less imports (-), of physical goods (cars, oil, food)

Question 4

Balance of trade in goods / balance of visible trade / merchandise balance

Answer 4

Exports of goods minus imports of goods.

Question 5

Trade in services account

Answer 5

Records income from (+), less expenditure on (-), services. (insurance, shipping, aviation,tourism)

Question 6

Services balance

Answer 6

Exports of services minus imports of services.

Question 7

Balance on trade in goods and services / balance of trade

Answer 7

Exports of goods and services minus imports of goods and services.

Question 8

Current account balance

Answer 8

The balance on trade goods and services plus net incomes and current transfers.

Question 9

Capital account of the balance of payments

Answer 9

The record of transfers of capital to and from abroad.
The account is divided into two sections:
1. Capital transfers such as
- the transfer of ownership of long-term assets
- money brought into the country by migrants
- the payment of grants by governments for long-term overseas projects
- the receipt of funds from international organisations for long-term capital projects
- official debt forgiveness by governments

2. The acquisition or disposal of non-produced, non-financial assets such as patents, copyrights, trademarks and franchises.

Question 10

Financial account of the balance of payments

Answer 10

The record of the flows of money into and out of the country for the purpose of investment or as deposits in banks and other financial institutions.
It is normally divided into the following three subsections:
1. Investment (direct and portfolio)
2. Other investment and financial flows
3. Flows to and from the reserves

Question 11

Net errors and omissions

Answer 11

A statistical adjustment to ensure that the two sides of the balance of payments account balance. It is necessary because of errors in compiling the statistics.

Question 12

Exchange rate

Answer 12

It is the rate at which one currency trades for another on the following exchange market.

Question 13

Exchange rate index or the effective exchange rate

Answer 13

A weighted average exchange rate expressed as an index, where the value of the index is 100 in a given base year. The weights of the different currencies in the index add up to 1.

A weighted average of the exchange rate of a particular currency against all other currencies, where the weights are based on the proportion of transactions between each country.

Question 14

Depreciation

Answer 14

A fall in the free-market exchange rate of the domestic currency with foreign currencies.

Question 15

Appreciation

Answer 15

A rise in the free-market exchange rate of the domestic currency with foreign currencies.

Question 16

Real exchange rate index (RERI)

Answer 16

The nominal exchange rate index (NERI) adjusted for changes in the relative prices of exports and imports.
RERI = NERI * Px/Pm

Question 17

Explain how exchange rates are determined

Answer 17

In a free foreign exchange market, the rate of exchange is determined by supply and demand.
In practice, exchange rates are adjusted second-by-second in response to changes in supply and demand.

Question 18

Explain the possible causes of a depreciation or appreciation [5]

Answer 18

Possible causes of depreciation:

1. A fall in domestic interest rates - so “hot money” would go abroad (thus increasing the supply of the domestic currency and decreasing the demand for it)
2. Higher inflation in the domestic inflation than abroad - so home produced goods become less competitive
3. A rise in domestic incomes relative to income abroad - so the demand for imports increases
4. Relative investment prospects improving abroad - so investment moves abroad
5. Speculation resulting from the expectation that the exchange rate will fall - so dealers sell the currency.

Question 19

Explain how the balance of payments will balance without intervention in exchange rates

Answer 19

As the supply and demand for currency balances, the debits and credits on the balance of payments must also balance. Hence a floating exchange rate will ensure that the balance of payments will automatically balance.

Question 20

Explain how governments and central banks seek to influence exchange rates in the short [3] and long [4] term

Answer 20

Short term:
The government and central bank may choose to counter downward pressure on the exchange rate in the short term by
1. Selling gold and foreign currency reserves to increase demand for the domestic currency.

2. Borrowing in the form of a foreign currency loan in order to buy the domestic currency and so increase demand.
3. Raising interest rates to increase deposits from overseas savers (increasing demand) and reduce deposits overseas by domestic saves (decreasing supply), (though this might conflict with other economic objectives, eg economic growth)

Long term:
The government can use a number of policies to improve the balance of payments position and hence counter downward pressures on the exchange rate over the long term.
1. The following contractionary policies can reduce aggregate demand in the domestic economy:
- contractionary fiscal policy involves raising taxes and/or reducing government expenditure
- contractionary monetary policy involves raising interest rates to reduce consumer and company demand

2. Supply side policies can be used to improve the quality and/or the price competitiveness of domestic goods, which will increase exports and the demand for the domestic currency.
3. Government measures to control imports, will reduce imports and the supply of domestic currency.
4. Controls on foreign exchange dealing can be used to restrict the supply of the domestic currency.

Question 21

Explain how government intervention affects the balance of payments

Answer 21

Changes in the supply and demand of a currency can cause floating exchange rate to move in unpredictable ways. This uncertainty may reduce trade and investment. Therefore, governments and central banks may choose to intervene in the foreign exchange markets to stabilise the currency.

Question 22

Floating exchange rate

Answer 22

When the government does not intervene in the foreign exchange markets, but simply allows the exchange rate to be freely determined by demand and supply.

Question 23

Devaluation

Answer 23

Where the government refixes the exchange rate at a lower level.

Question 24

Discuss the advantages [3] and disadvantages [5] of fixed exchange rates

Answer 24

Advantages:

1. International trade and investment are less risky as profits are not affected by the exchange rate.
2. A reduction in speculation on exchange rate movements if everyone believes that exchange rates will not change.
3. More stable economic conditions, as the government is unable to pursue “irresponsible” macroeconomic policies.

Disadvantages:

1. Exchange rate policy may conflict with the interests of domestic business and the economy as a whole.
2. Competitive contractionary policies leading to world depression
3. Problems with international liquidity
4. Inability to adjust to shocks
5. Speculation

Question 25

Discuss the advantages [5] and disadvantages [4] of free-floating exchange rates

Answer 25

Advantages:

1. Balance of payments disequilibria are automatically corrected by movements in the exchange rate
2. There is no problem of international liquidity and no need for central bank reserves
3. Countries are not tied to the inflation rates of others
4. External shocks can be dealt with rapidly by a depreciation or appreciation of the exchange rate
5. Domestic macroeconomic policy isn’t constrained by the need to maintain a fixed exchange rate, eg the government is free to target whatever level of demand is best for the economy, and the central bank is free to set interest rates to achieve its target level of inflation.

Disadvantages:

1. Unstable exchange rates can be a problem for firms with contracts with overseas suppliers or distributors
2. Speculation can lead to high levels of exchange rate volatility
3. Exchange rate uncertainty can discourage international trade and investment
4. Governments may lack the discipline of maintaining a stable exchange rate, and allow the economy to fall into a cycle of expansion and contraction.

Question 26

Explain why exchange rate volatility may be bad for businesses

Answer 26

One way for a firm to overcome the uncertainty in the future price of sales and purchases in overseas currencies is to use the forward exchange market. However these contracts incur costs and tend to be relatively short term. Alternatively, some multinational firms locate in various countries to provide for the local market, which helps to protect them from volatile exchange rates.

Question 27

Describe methods used to manage exchange rates

Answer 27

1. Adjustable peg
2. Managed flexibility
3. Exchange rate mechanism (ERM)

Question 28

International liquidity

Answer 28

The supply of currencies in the world acceptable for financing international trade and investment.

Question 29

Forward exchange market

Answer 29

Where contracts are made today for the price at which a currency will be exchanged at some specific future date.

Question 30

Adjustable peg system

Answer 30

A system whereby exchange rates are fixed for a period of time, but may be devalued (or revalued) if a balance of payments deficit (or surplus) becomes substantial.

Question 31

Managed flexibility (dirty floating)

Answer 31

A system of flexible exchange rates, but where the government intervenes to prevent excessive fluctuations or even to achieve an unofficial target exchange rate.

Question 32

ERM (the exchange rate mechanism)

Answer 32

A semi-fixed system whereby participating EU countries allowed fluctuations against each other’s currencies only within agreed bands. Collectively they floated freely against all other currencies.