IB Economics SL

Exchange Rates & the Balance of Payments | The Global Economy | IB Economics SL

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Unit 4: The Global Economy - Exchange Rates & the Balance of Payments

Understanding International Finance! Exchange rates and the balance of payments are fundamental to understanding how countries interact economically in the global marketplace. Exchange rates determine the price of currencies and affect everything from the cost of foreign holidays to a nation's competitiveness in international trade. The balance of payments records all economic transactions between a country and the rest of the world, providing crucial insights into economic health and international financial flows. This unit explores different exchange rate systems, how currency markets function, what determines exchange rates, and how to interpret the balance of payments accounts.

1. Introduction to Exchange Rates

Exchange Rate: The price of one currency expressed in terms of another currency. It indicates how much of one currency must be given up to purchase one unit of another currency.
Exchange Rate Notation:

Example: USD/EUR = 1.10 means:
1 euro = 1.10 US dollars
or
1 US dollar = 0.91 euros

Alternative notation:
£1 = $1.25 (one pound equals 1.25 dollars)

Why Exchange Rates Matter

Importance of Exchange Rates:
  • International trade: Determine competitiveness of exports and cost of imports
  • Foreign investment: Affect returns on international investments
  • Tourism: Influence cost of foreign travel
  • Inflation: Exchange rate changes affect domestic price levels
  • Economic policy: Key variable for monetary and fiscal policy
  • Living standards: Affect purchasing power of domestic currency abroad

2. Types of Exchange Rate Systems

1. Freely Floating Exchange Rate (Flexible)

Floating Exchange Rate: The exchange rate is determined entirely by market forces of supply and demand for currencies, with no government intervention. The rate fluctuates continuously based on market conditions.
How It Works:
  • Currency values determined by foreign exchange (forex) market
  • Supply and demand for currency constantly changing
  • Rate adjusts automatically to equilibrium
  • Government and central bank do not intervene
  • Most major currencies operate under this system (USD, EUR, GBP, JPY)
Advantages of Floating Rates:

1. Automatic Adjustment Mechanism:
  • Exchange rate automatically adjusts to restore equilibrium
  • Trade imbalances correct themselves
  • Deficit → currency depreciates → exports cheaper, imports expensive → deficit reduces
  • No need for government intervention

2. Independent Monetary Policy:
  • Central bank free to pursue domestic objectives (inflation, employment)
  • Not constrained by need to maintain fixed rate
  • Can use interest rates for domestic goals

3. No Need for Foreign Reserves:
  • Government doesn't need large foreign currency reserves
  • Resources can be used elsewhere
  • No risk of running out of reserves

4. Insulation from External Shocks:
  • Exchange rate absorbs external economic shocks
  • Protects domestic economy from foreign disturbances
Disadvantages of Floating Rates:

1. Exchange Rate Volatility and Uncertainty:
  • Rates fluctuate unpredictably
  • Creates uncertainty for businesses (export/import planning difficult)
  • Investment and trade may be discouraged
  • Hedging costs (forward contracts, currency options)

2. Speculation and Instability:
  • Speculators can cause large currency swings
  • Destabilizing "hot money" flows
  • Exchange rate may overshoot equilibrium

3. Lack of Discipline:
  • Government may pursue irresponsible policies
  • Inflation discipline reduced (no fixed rate constraint)
  • May allow currency to depreciate rather than address underlying problems

4. Imported Inflation:
  • Depreciation makes imports more expensive
  • Can trigger cost-push inflation
  • Especially problematic for countries dependent on imports

2. Fixed Exchange Rate (Pegged)

Fixed Exchange Rate: The exchange rate is set and maintained at a specific level by the government or central bank. The rate is "pegged" to another currency (usually US dollar) or basket of currencies.
How It Works:
  • Government announces official exchange rate
  • Central bank intervenes in forex market to maintain rate
  • If currency under pressure to depreciate: Central bank buys own currency (sells foreign reserves)
  • If currency under pressure to appreciate: Central bank sells own currency (accumulates foreign reserves)
  • Requires substantial foreign currency reserves
Examples of Fixed Rates:
  • Hong Kong Dollar: Pegged to US dollar at HK$7.8 = US$1
  • Saudi Riyal: Pegged to US dollar at 3.75 riyals = $1
  • Danish Krone: Pegged to euro
  • Historical: Bretton Woods system (1944-1971) - currencies pegged to US dollar
Advantages of Fixed Rates:

1. Certainty and Reduced Risk:
  • Businesses know exact exchange rate
  • Easier to plan international trade and investment
  • No hedging costs
  • Encourages trade and FDI

2. Price Stability and Anti-Inflation Discipline:
  • Forces government to maintain low inflation (to keep rate fixed)
  • Imported discipline on economic policy
  • Inflation cannot be higher than anchor currency country

3. Reduced Speculation:
  • Less opportunity for currency speculation
  • More stable currency markets
  • Avoids destabilizing capital flows
Disadvantages of Fixed Rates:

1. Loss of Independent Monetary Policy:
  • Interest rates must be set to maintain exchange rate, not for domestic needs
  • Cannot use monetary policy to fight recession or inflation
  • Domestic objectives sacrificed for exchange rate stability

2. Requires Large Foreign Reserves:
  • Central bank needs substantial reserves to defend currency
  • Costly to maintain (opportunity cost)
  • Risk of running out of reserves (speculative attack)

3. No Automatic Adjustment Mechanism:
  • Trade imbalances don't self-correct
  • Persistent deficits/surpluses can build up
  • Eventually may force devaluation

4. Vulnerability to Speculative Attacks:
  • If market believes currency overvalued, speculators attack
  • Massive selling pressure forces devaluation or abandonment
  • Can trigger currency crisis
  • Example: Asian Financial Crisis 1997 (Thailand, Indonesia, South Korea)

5. Wrong Rate Risk:
  • Pegged rate may not be equilibrium rate
  • If overvalued: Persistent trade deficit, reserve depletion
  • If undervalued: Persistent surplus, inflationary pressure

3. Managed Float (Dirty Float)

Managed Float: A hybrid system where the exchange rate is generally determined by market forces, but the government or central bank occasionally intervenes to influence the rate. Combines elements of both floating and fixed systems.
How It Works:
  • Usually floats freely based on supply and demand
  • Government intervenes when rate moves too much
  • Central bank buys/sells currency to smooth volatility
  • No announced target rate (unlike fixed)
  • Most common system in practice today

Examples: China (managed float since 2005), India, Singapore, many emerging markets

Advantages:
  • Combines flexibility of floating with some stability
  • Can smooth excessive volatility
  • Retains some monetary policy independence

Disadvantages:
  • Requires reserves (though less than fixed)
  • Still creates some uncertainty
  • Intervention may be ineffective or counterproductive

3. Currency Appreciation and Depreciation

Currency Appreciation: An increase in the value of a currency relative to another currency in a floating exchange rate system. The currency becomes stronger—one unit buys more foreign currency.
Currency Depreciation: A decrease in the value of a currency relative to another currency in a floating exchange rate system. The currency becomes weaker—one unit buys less foreign currency.
Terminology Note:
  • Floating rates: Use "appreciation" and "depreciation"
  • Fixed rates: Use "revaluation" (increase) and "devaluation" (decrease) when government officially changes the rate
Example of Appreciation:
Initially: £1 = $1.20
Later: £1 = $1.30

The pound has appreciated (strengthened):
  • One pound now buys more dollars ($1.30 instead of $1.20)
  • Equivalently, the dollar has depreciated (weakened)
  • Percentage appreciation: (1.30 - 1.20) / 1.20 × 100% = 8.33%
Example of Depreciation:
Initially: £1 = $1.40
Later: £1 = $1.25

The pound has depreciated (weakened):
  • One pound now buys fewer dollars ($1.25 instead of $1.40)
  • Equivalently, the dollar has appreciated (strengthened)
  • Percentage depreciation: (1.25 - 1.40) / 1.40 × 100% = -10.71%

4. Determinants of Exchange Rates

In a floating exchange rate system, exchange rates are determined by supply and demand for currencies in the foreign exchange (forex) market.

Supply and Demand for Currency

Demand for a Currency (e.g., US dollars):
  • Foreigners buying US exports: Need dollars to pay US exporters
  • Foreign investment in US: Need dollars to buy US assets (stocks, bonds, property)
  • Tourism to US: Need dollars for travel expenses
  • Speculation: Expect dollar to appreciate → buy dollars now

Supply of a Currency (e.g., US dollars):
  • Americans buying imports: Supply dollars to get foreign currency
  • Americans investing abroad: Supply dollars to buy foreign assets
  • Americans traveling abroad: Supply dollars for foreign currency
  • Speculation: Expect dollar to depreciate → sell dollars now

Factors Affecting Exchange Rates

1. Interest Rates

Mechanism:
  • Higher interest rates: Attract foreign investment ("hot money")
  • Demand for currency increases → appreciation
  • Example: If US raises rates, foreign investors buy US bonds → demand for dollars ↑ → dollar appreciates

Lower interest rates:
  • Less attractive for investment
  • Demand falls, supply may increase (capital outflow) → depreciation

Important: It's the relative interest rate that matters (compared to other countries)
2. Inflation Rates

Higher inflation:
  • Exports less competitive (prices rising)
  • Demand for exports falls → demand for currency falls
  • Imports more attractive (relatively cheaper)
  • Supply of currency increases (buy imports)
  • Result: Currency depreciates

Lower inflation:
  • Exports more competitive
  • Demand for currency increases
  • Result: Currency appreciates

Purchasing Power Parity (PPP) Theory: Currencies adjust to equalize purchasing power across countries
3. Current Account Balance (Trade Balance)

Trade surplus (X > M):
  • High demand for currency (foreigners buying exports)
  • Low supply of currency (fewer imports)
  • Currency appreciates

Trade deficit (M > X):
  • Low demand for currency (fewer exports)
  • High supply of currency (buying imports)
  • Currency depreciates
4. Speculation

If speculators expect appreciation:
  • Buy currency now to profit later
  • Demand increases → appreciation
  • Self-fulfilling prophecy

If speculators expect depreciation:
  • Sell currency now
  • Supply increases → depreciation
  • Can create extreme volatility
5. Government/Central Bank Intervention
  • Buying own currency → increased demand → appreciation
  • Selling own currency → increased supply → depreciation
  • Interest rate changes affect exchange rate indirectly
6. Foreign Direct Investment (FDI)
  • High FDI inflows → demand for currency increases → appreciation
  • FDI outflows → supply increases → depreciation
7. Political Stability and Economic Performance
  • Stable, well-governed countries → confidence → demand for currency ↑
  • Strong economic growth → attracts investment → appreciation
  • Political instability, corruption → capital flight → depreciation

5. Effects of Exchange Rate Changes

Effects of Currency Depreciation

On Exports:
  • Exports cheaper in foreign currency terms
  • More competitive internationally
  • Export volume likely increases (if demand elastic)
  • Export revenue may increase

On Imports:
  • Imports more expensive in domestic currency
  • Less competitive vs. domestic goods
  • Import volume likely decreases (if demand elastic)
  • Import expenditure may decrease

On Current Account:
  • Exports ↑, Imports ↓ → current account balance improves
  • May eliminate deficit or increase surplus
  • BUT: J-curve effect (short-run deterioration before improvement)

On Aggregate Demand:
  • Net exports (X-M) increase → AD shifts right
  • Economic growth increases
  • Unemployment may decrease
  • Inflation may increase

On Inflation:
  • Imported goods more expensive → cost-push inflation
  • Especially significant if import-dependent
  • Raw materials, oil, components all more expensive

On Living Standards:
  • Reduced purchasing power abroad
  • Foreign travel more expensive
  • Imported goods more expensive
  • May reduce real incomes if inflation rises

On Foreign Debt:
  • If debt denominated in foreign currency, burden increases
  • More expensive to repay
  • Problem for developing countries

Effects of Currency Appreciation

On Exports:
  • Exports more expensive in foreign currency
  • Less competitive
  • Export volume likely decreases
  • Harm to export industries

On Imports:
  • Imports cheaper in domestic currency
  • More competitive vs. domestic goods
  • Import volume likely increases

On Current Account:
  • Exports ↓, Imports ↑ → current account balance worsens
  • Deficit may increase or surplus decrease

On Aggregate Demand:
  • Net exports (X-M) decrease → AD shifts left
  • Economic growth slows
  • Unemployment may increase
  • Inflationary pressure decreases

On Inflation:
  • Imported goods cheaper → reduces inflation
  • Helps control price level
  • Positive for price stability

On Living Standards:
  • Increased purchasing power abroad
  • Foreign travel cheaper
  • Imported goods cheaper
  • Real incomes may increase

On Foreign Debt:
  • If debt in foreign currency, burden decreases
  • Cheaper to repay

The Marshall-Lerner Condition and J-Curve

Marshall-Lerner Condition: For a currency depreciation to improve the trade balance (current account), the sum of the price elasticities of demand for exports and imports must be greater than 1.
Marshall-Lerner Condition: \[ |PED_X| + |PED_M| > 1 \]

Where:
  • • \( PED_X \) = Price elasticity of demand for exports
  • • \( PED_M \) = Price elasticity of demand for imports


Interpretation:
  • • If condition met: Depreciation improves trade balance
  • • If condition not met: Depreciation worsens trade balance
J-Curve Effect:

After a depreciation, the trade balance follows a J-shaped pattern over time:

Short Run (Worsening):
  • Quantities of exports and imports don't adjust immediately (contracts, habits)
  • But prices change immediately
  • Pay more for same volume of imports → import bill rises
  • Receive same for exports but in depreciated currency
  • Result: Trade balance initially worsens

Long Run (Improvement):
  • Quantities eventually adjust
  • Export volume increases (cheaper abroad)
  • Import volume decreases (more expensive)
  • Marshall-Lerner condition satisfied
  • Result: Trade balance improves

Time lag: Typically 6-18 months

6. The Balance of Payments (BOP)

Balance of Payments (BOP): A record of all economic transactions between residents of a country and the rest of the world over a specific time period (usually one year). It shows all money flows in and out of the country.
Three Main Accounts:
  1. Current Account: Trade in goods and services, income, transfers
  2. Capital Account: Capital transfers and non-produced, non-financial assets (small, often ignored)
  3. Financial Account: Investment flows, changes in foreign ownership of assets

1. Current Account

Current Account: Records trade in goods and services, income flows (wages, dividends, interest), and current transfers (foreign aid, remittances).
Components of Current Account:

A. Balance of Trade in Goods (Visible Trade):
  • Exports of goods (credit, +)
  • Imports of goods (debit, -)
  • Merchandise trade (physical products)
  • Examples: Cars, food, machinery, oil, electronics

B. Balance of Trade in Services (Invisible Trade):
  • Exports of services (credit, +)
  • Imports of services (debit, -)
  • Examples: Tourism, financial services, shipping, insurance, consulting

C. Income (Primary Income):
  • Investment income: Profits, dividends, interest from foreign investments
  • Compensation of employees: Wages earned abroad
  • Income flows in (credit, +): Foreign pays dividends to domestic investors
  • Income flows out (debit, -): Domestic pays dividends to foreign investors

D. Current Transfers (Secondary Income):
  • One-way transfers (no quid pro quo)
  • Foreign aid (government grants)
  • Remittances (workers sending money home)
  • Pensions
  • Received (credit, +); Sent (debit, -)
Current Account Balance: \[ \text{CA} = (X - M) + \text{Net Income} + \text{Net Transfers} \]

Where:
  • • \( X \) = Exports of goods and services
  • • \( M \) = Imports of goods and services
  • • Net Income = Income received - Income paid abroad
  • • Net Transfers = Transfers received - Transfers sent
Current Account Balance Interpretation:
  • Current Account Surplus (CA > 0): Country earning more from abroad than spending abroad
  • Current Account Deficit (CA < 0): Country spending more abroad than earning
  • Balanced Current Account (CA = 0): Earnings equal spending

2. Financial Account

Financial Account: Records transactions involving financial assets and liabilities—essentially investment flows and changes in ownership of assets between countries.
Components of Financial Account:

A. Foreign Direct Investment (FDI):
  • Long-term investment in physical capital (factories, buildings)
  • Ownership stake ≥ 10%
  • Inward FDI: Foreign companies invest in domestic economy (credit, +)
  • Outward FDI: Domestic companies invest abroad (debit, -)
  • Example: Toyota building factory in US

B. Portfolio Investment:
  • Investment in financial assets (stocks, bonds)
  • Ownership < 10% (no control)
  • Inflows: Foreigners buy domestic stocks/bonds (credit, +)
  • Outflows: Domestic residents buy foreign stocks/bonds (debit, -)

C. Reserve Assets:
  • Central bank holdings of foreign currency and gold
  • Used for intervention in forex markets
  • Increase (accumulation) recorded as debit (-)
  • Decrease (using reserves) recorded as credit (+)

D. Other Investment:
  • Bank loans, trade credits
  • Short-term capital flows

3. Capital Account

Capital Account (Small, Often Ignored):
  • Capital transfers (debt forgiveness, migrant transfers)
  • Transactions in non-produced, non-financial assets (patents, copyrights, trademarks)
  • Usually very small relative to current and financial accounts

BOP Accounting Identity

Balance of Payments Identity: \[ \text{Current Account} + \text{Financial Account} + \text{Capital Account} = 0 \]

Or more simply (ignoring small capital account): \[ \text{Current Account} + \text{Financial Account} = 0 \]

Interpretation:
  • • Current account deficit must be financed by financial account surplus (capital inflows)
  • • Current account surplus matched by financial account deficit (capital outflows)
  • • Every debit must have corresponding credit
Example:
Country has current account deficit of $50 billion

Must be financed by:
  • Financial account surplus of $50 billion
  • This means: Foreign investment inflows, borrowing from abroad, or using foreign reserves
  • Country is net borrower from rest of world

Interpreting BOP Data

Current Account Deficit:

Meaning:
  • Spending more abroad than earning
  • Importing more than exporting (broadly)
  • Living beyond production means

Financed by:
  • Borrowing from abroad
  • Selling assets to foreigners
  • Using foreign reserves

Is it bad?
  • Not necessarily: If financing productive investment (importing capital goods for growth)
  • Potentially problematic: If financing consumption, persistent, or very large
  • Concerns: Rising foreign debt, dependency on foreign capital, vulnerability to capital flight
Current Account Surplus:

Meaning:
  • Earning more from abroad than spending
  • Exporting more than importing (broadly)
  • Producing more than consuming

Matched by:
  • Lending to foreigners
  • Acquiring foreign assets
  • Accumulating foreign reserves

Is it good?
  • Not necessarily: May indicate weak domestic demand, underinvestment
  • Potentially good: Building national wealth, strong competitiveness
  • Concerns: May cause currency appreciation, reduce export competitiveness; can create imbalances

7. Causes of Current Account Deficits/Surpluses

Causes of Current Account Deficit:
  • High consumer spending: High marginal propensity to import
  • Strong currency: Appreciation makes imports cheap, exports expensive
  • High inflation: Reduces export competitiveness
  • Low productivity: Uncompetitive industries
  • Rapid economic growth: Sucks in imports
  • Low savings rate: Consumption exceeds production
  • Declining export industries: Structural problems

Causes of Current Account Surplus:
  • High savings rate: Production exceeds consumption
  • Weak currency: Depreciation makes exports cheap, imports expensive
  • Low inflation: Maintains competitiveness
  • High productivity: Competitive export industries
  • Strong export sectors: Comparative advantages
  • Weak domestic demand: Imports low

8. Policies to Correct Current Account Imbalances

Correcting a Current Account Deficit

1. Expenditure-Reducing Policies:

Contractionary Fiscal/Monetary Policy:
  • Reduce aggregate demand → reduce imports
  • Higher taxes, lower government spending, higher interest rates
  • Problem: Causes recession, unemployment
2. Expenditure-Switching Policies:

A. Currency Depreciation/Devaluation:
  • Makes exports cheaper, imports more expensive
  • Switches expenditure from imports to domestic goods
  • Improves current account (if Marshall-Lerner condition met)
  • Problems: J-curve effect, imported inflation, may not work if inelastic demand

B. Protectionism:
  • Tariffs, quotas reduce imports directly
  • Problems: Retaliation, inefficiency, consumer welfare loss
3. Supply-Side Policies:
  • Improve productivity and competitiveness
  • Make exports more attractive
  • Education, infrastructure, R&D, deregulation
  • Advantage: Sustainable long-term solution
  • Disadvantage: Very long time lag (years/decades)

9. IB Economics Exam Skills

Key Exam Question Types

Question Type 1: Explain Exchange Rate Changes [6 marks]
Example: "Explain how an increase in interest rates can lead to an appreciation of a country's currency."

Answer Structure:
  • Define appreciation (currency value increases)
  • Mechanism: Higher interest rates → attract foreign investment ("hot money flows")
  • Foreign investors need domestic currency to buy bonds/deposits
  • Demand for currency increases
  • Draw supply-demand diagram showing demand shift right
  • Exchange rate rises → appreciation
  • Example: If US raises rates, foreigners buy US bonds → demand for dollars ↑
Question Type 2: Calculate Exchange Rate Changes [4 marks]
Example: "The exchange rate changes from £1 = $1.50 to £1 = $1.35. Calculate the percentage change and state whether the pound has appreciated or depreciated."

Answer:
  • Percentage change = (1.35 - 1.50) / 1.50 × 100% = -10%
  • The pound has depreciated by 10%
  • One pound now buys fewer dollars ($1.35 vs. $1.50)
Question Type 3: Analyze Effects [8 marks]
Example: "Analyze the effects of a currency depreciation on a country's economy."

Answer Structure:
  • Define depreciation
  • On exports: Cheaper abroad → volume increases → export revenue may rise
  • On imports: More expensive → volume decreases → may reduce spending on imports
  • On current account: (X-M) likely improves (if Marshall-Lerner condition met)
  • But: J-curve effect means short-run deterioration first
  • On AD: Net exports increase → AD shifts right → GDP ↑, unemployment ↓
  • On inflation: Imported goods more expensive → cost-push inflation
  • On living standards: Reduced purchasing power, foreign goods/travel expensive
  • On foreign debt: If denominated in foreign currency, real burden increases
Question Type 4: Evaluate Exchange Rate Systems [10 marks]
Example: "Evaluate the use of a fixed exchange rate system."

Answer Structure:
  • Introduction: Define fixed exchange rate
  • Advantages:
    • Certainty for trade/investment
    • Anti-inflation discipline
    • Reduced speculation
    • Example: Hong Kong peg stability
  • Disadvantages:
    • Loss of independent monetary policy
    • Requires large reserves
    • No automatic adjustment
    • Vulnerable to speculative attacks
    • Example: Asian Financial Crisis 1997
  • Evaluation:
    • Suitable for: Small, open economies; countries with inflation problems; high trade integration with anchor currency country
    • Not suitable for: Large economies needing policy flexibility; countries facing asymmetric shocks
    • Trade-off between stability and flexibility
  • Judgment: Appropriate for some countries but not universally optimal
Question Type 5: Interpret BOP Data [6 marks]
Example: Given BOP data, explain what it shows about the country's economy.

Answer Structure:
  • Identify current account balance (deficit/surplus, size)
  • Identify main contributors (goods, services, income, transfers)
  • Explain financial account (how deficit financed or surplus invested)
  • Assess sustainability and implications
  • Consider whether deficit/surplus is problematic

Conclusion

Exchange rates and the balance of payments are fundamental to understanding international economics. Exchange rates—whether floating, fixed, or managed—determine currency values and profoundly affect trade competitiveness, investment flows, inflation, and economic growth. Currency appreciation and depreciation create winners and losers, affecting exporters, importers, consumers, and the overall current account balance. The balance of payments comprehensively records all economic transactions with the rest of the world, with the current account tracking trade and income flows, and the financial account recording investment and capital flows. Understanding these concepts is essential for analyzing how countries interact in the global economy and evaluating the effectiveness of exchange rate policies and international economic integration.

Key Takeaways for IB Success:

  • Know three exchange rate systems: floating, fixed, managed float—advantages and disadvantages of each
  • Understand appreciation vs. depreciation: calculate percentage changes, identify direction
  • Master determinants of exchange rates: interest rates, inflation, trade balance, speculation, FDI
  • Analyze effects of exchange rate changes on exports, imports, current account, AD, inflation, living standards
  • Know Marshall-Lerner condition and J-curve effect
  • Understand BOP structure: current account (goods, services, income, transfers) and financial account (FDI, portfolio investment)
  • Interpret current account deficits and surpluses: causes, consequences, sustainability
  • Know BOP accounting identity: CA + FA = 0
  • Evaluate policies to correct imbalances: expenditure-reducing, expenditure-switching, supply-side
  • Use real examples: Hong Kong peg, Asian Financial Crisis, Eurozone imbalances
Exam Success Checklist:
  • ✓ For exchange rate calculations: Show all steps, use formula, interpret result
  • ✓ For appreciation/depreciation: State which currency strengthened/weakened and explain meaning
  • ✓ For effects questions: Cover multiple impacts (exports, imports, CA, AD, inflation, living standards)
  • ✓ Always mention Marshall-Lerner condition when discussing depreciation and trade balance
  • ✓ Distinguish short-run (J-curve) from long-run effects
  • ✓ For BOP questions: Identify both current and financial account components
  • ✓ Remember BOP identity: deficit in one account means surplus in other
  • ✓ Evaluate whether deficit/surplus is problematic (context-dependent)
  • ✓ For system evaluation: balanced argument with advantages, disadvantages, and judgment
  • ✓ Use specific examples: countries, crisis events, policy changes
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