Balance of Payments and Exchange Rate
What the domain tests
Balance of Payments and Exchange Rate tests the structure of the BoP, current and capital accounts, autonomous and accommodating transactions, and exchange-rate determination under fixed and floating systems.
Core rules
- Current account: exports and imports of goods, services, primary income, and secondary income or transfers.
- Capital account: foreign investment, loans, banking capital, and changes in reserves.
- BoP identity: the current account balance plus the capital account balance plus errors and omissions equals zero ex post; the BoP always balances in accounting terms.
- Exchange rate: price of foreign currency in terms of domestic currency. Demand and supply of foreign exchange determine it under floating rates.
- Depreciation vs devaluation: depreciation is a market fall under floating rates; devaluation is a deliberate official fall under a fixed rate.
Worked example
A country has a current account deficit of $80 billion and a capital account surplus of $80 billion. The BoP balances: −80 + 80 = 0. If export demand rises, the supply of foreign currency increases and the domestic currency appreciates under floating rates, making imports cheaper and exports relatively dearer.
Traps that cost marks
Do not say a BoP deficit means the accounts do not balance; look at the current account or overall balance. Do not omit transfers from the current account. Do not confuse appreciation with revaluation: revaluation is a policy change under a fixed rate. Capital inflows can appreciate the currency. A current account deficit is not automatically a crisis if it is financed by stable long-term inflows.