Balance of Payments and Exchange Rate
What this domain tests
Balance of Payments and Exchange Rate tests the current and capital accounts, the foreign exchange market, and fixed versus flexible and managed floating systems.
Core rules
- BoP records all economic transactions between residents and non-residents. Current account: goods, services, primary income, secondary income (transfers). Capital account: FDI, portfolio investment, loans, banking capital, and official reserve changes.
- BoP always balances in accounting terms; a current account deficit must be financed by capital inflows or reserve drawdown. Errors and omissions reconcile the two.
- Demand for foreign exchange comes from imports and outflows; supply comes from exports and inflows. The equilibrium exchange rate equates them.
- Fixed rate: central bank intervenes to maintain a peg. Flexible rate: the market determines the rate. Managed floating: market plus intervention to smooth volatility.
- Depreciation makes exports cheaper and imports dearer; appreciation does the opposite.
Worked example
Merchandise exports = 500; merchandise imports = 600; services exports = 100; services imports = 50; transfers received = 20. Current account = 500 − 600 + 100 − 50 + 20 = −30. If capital inflows are 50, the BoP surplus is 20, matched by a 20 increase in reserves. Reasoning: the current account includes goods, services, and transfers; the capital account finances the gap; reserves are the balancing item.
Traps
Putting FDI in the current account; omitting services and transfers; calling a current account deficit a BoP deficit; confusing depreciation with devaluation; and assuming fixed rates need no intervention.