Week 2 - Balance of Payments and Determinants of Exchange Rates Flashcards
What determines the exchange rate (St)?
The exchange rate (St) is determined by the supply and demand of currencies in the foreign exchange market.
What is the Balance of Payments (BoP)? (2)
- Summary of transactions between domestic and foreign residents for a specific country over a specified period
- includes international trade and capital flows
What is the double-entry system in accounting? (2)
- Records every transaction with a corresponding credit and debit entry
- reflecting inflows and outflows
What are the components of the current account in the BoP? (3)
Includes the balance of trade, factor income and transfer payments
What is recorded in the Capital Account of the BoP?
Records transfer between governments and with the IMF
What is recorded in the Financial Account of the BoP?
The flow of funds resulting from the sale of assets between countries
Give examples of instruments recorded in the Financial Account of the BoP? (2)
- Foreign Direct Investment
- Portfolio Investment
What is the relationship between the Current Account (CA) and the Financial Account (FA) in the BoP?
The BoP is approximately zero, meaning that a deficit in the current account is offset by a surplus in the financial account and vice versa
What does a deficit in the current account indicate? (2)
- An excess of imports over exports
- May be financed by inward investment or borrowing
How can devaluing a currency affect the current account of the BoP? (2)
- Increases the cost imports and decreases the cost of exports
- Can improve the current account if the price elasticity of demand for imports and exports is favourable
What is the problem with a weak home currency in improving the current account? (2)
May not be effective if:
- demand for imports and exports is inelastic
- foreign competitors lower their prices to remain competitive
How do income growth rates affect the demand for a currency? (2)
- Increased income growth in one country (e.g. the US) leads to higher demand for imports
- Increases demand for the currency of the trading partner (e.g. GBP)
What is the difference between the Balance of Trade approach and the Monetary approach to exchange rates? (2)
- BoT - focuses on trade flows as the main determinant of exchange rates
- Monetary - emphasises the role of money supply and demand
How do changes in interest rates impact exchange rates? (2)
- An increase in interest rates in one country makes its financial assets more attractive
- Causes a surge in capital inflows and the currency to appreciate
How do quotas and uncertainty impact exchange rates? (2)
- Quotas can limit foreign trade
- Uncertainty leads to volatility in exchange rates due to reduced investor confidence
How do expectations influence exchange rates? (3)
- If market participants expect a currency to appreciate, they will buy it in anticipation
- Causes an increase in demand and the value of the currency to rise
- This can happen even if expectations are not based on fundamental factors
What role does the IMF and World Bank play in international financial flows? (2)
IMF - provides surveillance, technical assistance and financing to promote global economic stability
World Bank - offers loans to enhance economic development in countries
What is the purpose of the World Bank’s structural adjustment loans (SALs)?
Designed to promote long-term economic growth by supporting reforms in borrowing countries
What is the balance of payments formula?
BoP = Current Account (CA) + Capital Account (KA) + Financial Account (FA)
How do you calculate the current account?
CA = Balance of Trade + Net Factor Income + Net Transfers
How do you calculate the Financial Account (FA)?
FA = Financial Capital Inflows - Financial Capital Outflows
Explain the argument for developed countries operating a CA in surplus and a FA in deficit. (2)
- Mature economy should be able to generate surplus goods and savings
- The net demand for home currency on the CA is met by a net supply of home currency for foreign currency to invest abroad
Explain the argument for developing countries operating with a CA deficit and an FA surplus. (2)
- CA deficit due to imports of machinery
- This importing is financed through international borrowing resulting in a surplus on the financial account
How do developed countries tend to find themselves with a current account deficit? (2)
- High interest payments on loans or import of relatively unproductive goods
- financed by inward investment which created a demand by foreign currency for home currency to invest
