Track international flows
Distinguish the current, capital and financial accounts and explain why the overall balance of payments must balance.
The Balance of Payments and Exchange Rates
This chapter links international transactions to exchange-rate policy. It develops the balance-of-payments accounts, shows how macroeconomic policies affect the current and financial accounts, measures international competitiveness, and compares fixed with floating exchange-rate systems.
Balance of paymentsCurrent accountFinancial accountReal exchange rateFixed & floatingJ-curveMarshall–Lerner
What this chapter prepares you to do
Choose a remedy
Compare expenditure-reducing, expenditure-switching and supply-side approaches to a current-account deficit.
Measure competitiveness
Distinguish nominal, real and real effective exchange rates and perform real-exchange-rate calculations.
Evaluate regimes
Analyse fixed, floating and managed exchange rates, including devaluation, revaluation, the J-curve and the Marshall–Lerner condition.
High-grade habit: keep the exchange-rate quotation clear. When discussing appreciation, depreciation, devaluation or revaluation, state what happens to the price of the domestic currency and then trace the effects on export prices, import prices, quantities and the current account.
Chapter sections
29.1
The balance of payments
The balance of payments records transactions between residents of a country and the rest of the world during a period. The overall accounts balance because every international transaction has a corresponding financing entry, but individual accounts may show large surpluses or deficits.
Current account
Records trade in goods and services plus primary and secondary income flows. A deficit means current-account debits exceed credits.
Capital account
Records capital transfers. It is often small relative to the current and financial accounts.
Financial account
Records transactions that change ownership of foreign financial assets and liabilities, including direct investment, portfolio investment, other financial assets and reserve assets.
Accounting identity:
current account + capital account + financial account + net errors/omissions = 0
current account + capital account + financial account + net errors/omissions = 0
Financial-account flows and sustainability
A current-account deficit can be financed by a financial-account surplus: the country may borrow from abroad or sell domestic assets to overseas investors. This permits current spending to exceed current receipts, but it can create future outflows of interest, profits or debt repayments. A persistent current-account surplus can also involve a trade-off if resources are directed towards exports rather than domestic consumption.
Flow versus stock: the balance of payments records flows during a period. The accumulated stock of external assets and liabilities is the country's international investment position.
How macroeconomic policy affects the balance of payments
| Policy/change | Main transmission | Likely balance-of-payments effect |
|---|---|---|
| Expansionary fiscal policy | AD rises → prices/incomes may rise → imports rise and competitiveness may weaken | Current account may move towards deficit |
| Lower interest rates | AD may rise; lower returns may discourage foreign financial inflows | Current account may weaken while the financial account may also face outflow pressure |
| Supply-side improvement | Productivity and quality improve; LRAS rises | Export competitiveness can improve and the current account may strengthen |
Why a current-account deficit may arise
Weak competitiveness
Low productivity or poor quality reduces foreign demand for exports and can encourage purchases of imports.
Higher domestic inflation
If domestic prices and labour costs rise faster than abroad, exports become less competitive while imports become relatively attractive.
Rapid economic growth
Rising incomes can increase imports, especially when the marginal propensity to import is high.
Policies to reduce a current-account deficit
| Approach | How it works | Evaluation |
|---|---|---|
| Expenditure reducing | Reduce aggregate demand, for example through higher taxation, so import spending falls and resources may be released for export. | Can slow economic growth and raise unemployment. |
| Expenditure switching | Switch domestic spending from imports to home-produced goods, for example through tariffs, non-tariff barriers or campaigns to buy domestic output. | Can reduce consumer welfare, distort resource allocation and provoke retaliation. |
| Supply-side measures | Improve productivity, quality and innovation so domestic firms become more internationally competitive. | Targets the underlying weakness but usually takes time. |
Current-account deficit
→identify cause
→reduce total spending?
orswitch spending?
orraise competitiveness?
evaluate growth, jobs, inflation and retaliation
29.2
Measuring the exchange rate
The nominal exchange rate is the price of one currency in terms of another. For international competitiveness, however, the nominal rate is only part of the story because relative inflation can reinforce or offset an exchange-rate movement.
Nominal exchange rate
The observed currency price, such as dollars per unit of domestic currency or domestic currency per dollar.
Real exchange rate
The nominal exchange rate adjusted for relative price levels between two countries.
Real effective exchange rate
A trade-weighted measure of the real exchange rate against multiple trading partners, giving greater weight to more important partners.
Textbook form of the real exchange rate:
real exchange rate = nominal exchange rate × (domestic CPI ÷ foreign CPI)
real exchange rate = nominal exchange rate × (domestic CPI ÷ foreign CPI)
Worked example: suppose the nominal rate is 0.020 foreign-currency units per unit of domestic currency, the domestic CPI is 150 and the foreign CPI is 120. The real exchange rate is 0.020 × (150 ÷ 120) = 0.025. Domestic inflation has made the domestic currency's real value higher than the nominal quotation alone would suggest.
Quotation matters: the numerical direction of an exchange-rate change depends on how the rate is quoted. In the textbook's foreign-currency-per-domestic-currency examples, a fall in the rate represents a weaker domestic currency and, other things equal, improved price competitiveness.
Why use a trade-weighted rate?
A bilateral exchange rate against one country can give a misleading picture if that country represents only a small share of total trade. The real effective exchange rate combines several bilateral rates using trade weights, so it gives a broader indication of a country's international price competitiveness.
Textbook context: Pakistan
The book compares Pakistan's rupee with the US dollar to show why the nominal exchange rate can be misleading. A nominal depreciation may appear to improve competitiveness, but if domestic prices rise faster than prices abroad, that gain can be partly or completely offset. This is why the real exchange rate and the trade-weighted real effective exchange rate are useful.
Nominal and real exchange rates
A nominal depreciation does not guarantee an improvement in international competitiveness. If domestic inflation is faster than foreign inflation, the real exchange rate may move in the opposite direction from the nominal rate.
Adapted from the Cambridge International AS & A Level Economics book by Peter Smith (Second Edition, with Adam Wilby and Mila Zasheva).
29.3
The determination of exchange rates
Floating exchange rates
Under a floating exchange rate system, market demand and supply determine the currency's value. If demand for the currency changes, the exchange rate adjusts towards a new market equilibrium. The authorities do not promise to maintain a particular official rate.
Fixed exchange rates
Under a fixed exchange rate system, the authorities commit to an official currency value against another currency or standard. If the market equilibrium differs from the official rate, the central bank must intervene.
Textbook example: Malaysia
The book uses the Malaysian ringgit to illustrate a fixed exchange rate. If the official rate is above the market-clearing rate, there is an excess supply of ringgits. The Malaysian authorities must buy that excess domestic currency by selling foreign-exchange reserves. If demand for ringgits is instead stronger than supply at the official rate, the authorities buy foreign currency and reserves accumulate.
Maintaining a fixed exchange rate
At the official rate ef, supply of ringgits exceeds demand: Qs > Qd. The authorities defend the fixed rate by buying the excess ringgits and paying with foreign-exchange reserves.
Adapted from the Cambridge International AS & A Level Economics book by Peter Smith (Second Edition, with Adam Wilby and Mila Zasheva).
Excess supply of domestic currency
The central bank sells foreign currency reserves and buys domestic currency. Persistent intervention can run reserves down.
Excess demand for domestic currency
The central bank supplies additional domestic currency in return for foreign currency, so reserves accumulate.
Maintaining a fixed exchange rate in the face of changing demand
At D1, the official rate ef is the market equilibrium. If demand is lower at D0, reserves must be sold to absorb excess domestic currency; if demand rises to D2, the authorities supply more domestic currency and accumulate foreign reserves.
Adapted from the Cambridge International AS & A Level Economics book by Peter Smith (Second Edition, with Adam Wilby and Mila Zasheva).
Policy constraint: because foreign-exchange intervention changes domestic liquidity and money supply, a country maintaining a fixed rate cannot freely set monetary policy independently of its exchange-rate commitment.
Devaluation and revaluation
Devaluation
An official reduction in the price of the domestic currency under a fixed-rate system.
Revaluation
An official increase in the price of the domestic currency under a fixed-rate system.
Depreciation
A market-driven fall in the value of the currency under a floating system.
Appreciation
A market-driven rise in the value of the currency under a floating system.
Effects of a devaluation
A devaluation makes exports cheaper to overseas buyers and imports more expensive to domestic residents, so export quantity demanded should rise and import quantity demanded should fall, ceteris paribus. This tends to increase aggregate demand. However, the current account does not necessarily improve immediately.
The speed of adjustment matters. In the short run, contracts are already in place and domestic firms may not be able to expand export supply immediately. Import and export demand can therefore be relatively inelastic at first. Over time, buyers can switch suppliers and producers can change output, so quantity responses are likely to become larger.
The J-curve effect of a devaluation
After devaluation at A, the current account can initially worsen because prices change before export and import quantities fully respond. As firms and consumers adjust, the current account improves and may move into surplus after B.
Adapted from the Cambridge International AS & A Level Economics book by Peter Smith (Second Edition, with Adam Wilby and Mila Zasheva).
Marshall–Lerner condition
The textbook states that a devaluation improves the current account only when the sum of the price elasticities of demand for exports and imports is numerically greater than 1. The logic is that the favourable quantity response must be strong enough to outweigh the adverse price effect.
Marshall–Lerner condition:
|PEDexports| + |PEDimports| > 1
|PEDexports| + |PEDimports| > 1
Quantity effect
Export volumes rise and import volumes fall after the currency becomes more competitive.
Price effect
Export prices expressed in foreign currency fall while import prices in domestic currency rise. If quantity responses are weak, the current account may worsen.
Competitive devaluation and managed floating
If one country deliberately devalues to gain competitiveness, other countries may retaliate with their own devaluations, reducing the original advantage and potentially depressing world trade. A managed float is a floating system in which authorities occasionally intervene to smooth excessive short-run fluctuations.
29.4
Fixed or floating exchange rates?
Neither system is automatically superior in every circumstance. The textbook evaluates them mainly through adjustment to shocks, stability and the discipline they impose on macroeconomic policy.
| Issue | Floating exchange rate | Fixed exchange rate |
|---|---|---|
| Adjustment to external shocks | Exchange rate can change automatically, carrying much of the adjustment burden. | Real output, employment, wages and domestic demand may have to adjust because the rate itself is defended. |
| Monetary-policy independence | Greater scope to use interest rates for domestic stabilisation. | Monetary policy is constrained by the need to maintain the peg. |
| Trading stability | Potential volatility creates exchange-rate risk. | Known official rate can make future contracts and planning easier. |
| Policy discipline | Governments may be tempted to rely on depreciation to restore competitiveness after inflationary policy. | The commitment to the peg can impose financial discipline. |
| Reserve requirement | No commitment to continuously defend one level, although intervention may occur. | Foreign-exchange reserves are needed to defend the official rate. |
Adjustment after an inflation shock
If domestic inflation rises faster than abroad, a floating currency can depreciate and help restore competitiveness. Under a fixed system, the exchange rate cannot perform this adjustment, so policy may have to deflate the domestic economy. That can reduce inflation but may temporarily raise unemployment and slow growth.
Fixed-rate discipline: if a country repeatedly runs an overall deficit while defending an overvalued rate, foreign-exchange reserves can be depleted. A fixed system is therefore most sustainable when the chosen rate is reasonably close to the average market-equilibrium rate over time.
Exchange-rate stability and hedging
Floating rates create uncertainty for international traders and investors. Firms can reduce this risk through forward or futures contracts, a process known as hedging, but hedging itself can be costly. A fixed system reduces day-to-day currency uncertainty, although an occasional official realignment can still create large changes.
Macroeconomic policy and spillovers
Under floating rates, a country can use monetary policy more independently, but changes in interest rates affect capital flows and the exchange rate. For example, higher interest rates can attract short-term capital, cause appreciation and weaken the current account. Policy changes can also spill over to trading partners through bilateral exchange-rate movements.
Do not confuse overall balance with current-account balance: under a floating system the overall balance of payments is automatically reconciled through market adjustment, but the current account can still remain in persistent deficit if it is financed by a financial-account surplus.
Evaluation framework: for any exchange-rate regime, ask how it handles external shocks, whether it stabilises trade and investment, how much monetary-policy independence it allows, whether reserves are adequate, and whether the current/financial-account pattern is sustainable.
Chapter 29 revision checklist
□ Distinguish the current, capital and financial accounts.
□ Explain why the overall balance of payments must balance.
□ Identify foreign direct investment, portfolio investment, other financial assets and reserve assets.
□ Explain how a current-account deficit may be financed and why this matters for future income flows.
□ Explain how fiscal, monetary and supply-side policies can affect the balance of payments.
□ Explain causes of a current-account deficit.
□ Distinguish expenditure-reducing from expenditure-switching policies.
□ Evaluate supply-side measures for correcting a current-account deficit.
□ Define the nominal exchange rate.
□ Calculate and interpret the real exchange rate.
□ Explain the real effective exchange rate and trade weighting.
□ Explain how a fixed exchange rate is maintained using reserves.
□ Distinguish devaluation, depreciation, revaluation and appreciation.
□ Explain why a fixed exchange rate constrains independent monetary policy.
□ Explain the expected effects of a devaluation.
□ Explain the J-curve effect.
□ State and apply the Marshall–Lerner condition.
□ Explain competitive devaluation and managed floating.
□ Compare fixed and floating rates in adjusting to shocks and providing stability.
□ Evaluate exchange-rate regimes using policy discipline, reserves, trade risk and current/financial-account sustainability.
20 questions. Each answer is marked immediately with a short explanation of why it is correct or incorrect.