Balance of Payments and Exchange Rate
Balance of Payments and Exchange Rate
This domain explains a country's transactions with the rest of the world and how the exchange rate is determined. The exam tests the structure of the balance of payments, current and capital accounts, fixed and floating rates, and depreciation versus devaluation.
Core rules
- The balance of payments records all economic transactions between residents and non-residents in a year. It has a current account and a capital account; the two together balance in accounting terms.
- Current account: exports and imports of goods (trade balance), services, primary income and secondary income transfers. A trade deficit is not the same as a current account deficit.
- Capital account: foreign investment, loans, banking capital and changes in reserves. A current account deficit is financed by a capital account surplus or by drawing down reserves.
- Under a floating exchange rate, the rate is determined by demand and supply of foreign exchange. Under a fixed rate, the central bank intervenes to maintain a peg.
- Depreciation is a fall in a currency's value under floating rates; devaluation is a deliberate fall under a fixed rate. Appreciation and revaluation are the opposite.
- A rise in demand for imports raises demand for foreign currency and tends to depreciate the domestic currency.
Worked example
A country's merchandise exports are $200 billion, imports $260 billion, services exports $60 billion, services imports $40 billion, and transfers inflow $10 billion. Trade balance = 200 − 260 = −$60 billion. Current account balance = (200 − 260) + (60 − 40) + 10 = −$30 billion. If the capital account has a net inflow of $20 billion, the overall balance is −$30 + 20 = −$10 billion, which is met by a $10 billion fall in reserves. The current account is in deficit even though services and transfers are in surplus.
Traps
Do not call a trade deficit a balance of payments deficit. Do not treat depreciation as bad for all sectors; it helps exporters and hurts importers. Do not confuse devaluation with depreciation. Remember that the BoP always balances in accounting terms; a deficit refers to a specific account or to the need for financing.