Unit 4: The Global Economy - Exchange Rates & Balance of Payments
Understanding Currency Markets and International Financial Flows
Introduction: The International Financial System
When countries trade goods, services, and assets internationally, they need a mechanism to exchange currencies and record these transactions. This involves two key concepts:
- Exchange rates: The price of one currency in terms of another
- Balance of Payments: Record of all economic transactions between a country and the rest of the world
These are interconnected: Exchange rates affect trade flows, which affect the balance of payments, which in turn affects exchange rates.
1. Exchange Rates
What is an Exchange Rate?
Exchange rate is the price of one currency expressed in terms of another currency.
Example: If the exchange rate is £1 = $1.30, this means:
- 1 British pound can be exchanged for 1.30 US dollars
- Or, $1 = £0.77 (reciprocal: 1 ÷ 1.30)
Exchange Rate Notation
Direct quotation: Domestic currency per unit of foreign currency
Example (from US perspective): $1.30/£ means $1.30 per British pound
Indirect quotation: Foreign currency per unit of domestic currency
Example (from US perspective): £0.77/$ means £0.77 per US dollar
Appreciation vs. Depreciation
Currency Appreciation
Definition: Increase in value of a currency relative to another currency
Example:
- Before: £1 = $1.30
- After: £1 = $1.40
- The pound appreciated (now buys more dollars)
- The dollar depreciated (now buys fewer pounds)
Effects:
- Exports become more expensive (less competitive)
- Imports become cheaper
- Inflation decreases (cheaper imports)
Currency Depreciation
Definition: Decrease in value of a currency relative to another currency
Example:
- Before: £1 = $1.30
- After: £1 = $1.20
- The pound depreciated (now buys fewer dollars)
- The dollar appreciated (now buys more pounds)
Effects:
- Exports become cheaper (more competitive)
- Imports become more expensive
- Inflation increases (expensive imports)
Important Terminology Note
Floating exchange rate systems: Use appreciation/depreciation
Fixed exchange rate systems: Use revaluation (official increase) / devaluation (official decrease)
2. Types of Exchange Rate Systems
A. Floating (Flexible) Exchange Rates
Definition: Exchange rate determined by market forces of supply and demand without government intervention.
How it works:
- Currency traded freely in foreign exchange (forex) market
- Rate fluctuates continuously based on supply and demand
- No government commitment to maintain specific rate
Examples: US dollar, British pound, Japanese yen, Australian dollar (most major currencies)
Supply and Demand in Currency Markets
Demand for a Currency
Who demands a currency? Foreigners who want to:
- Buy exports: Need domestic currency to pay for goods/services
- Invest: Buy domestic assets (stocks, bonds, real estate)
- Speculate: Bet on currency appreciation
- Tourism: Visit the country
Demand curve: Downward sloping
- Higher exchange rate (expensive currency) → Lower quantity demanded
- Lower exchange rate (cheap currency) → Higher quantity demanded
Supply of a Currency
Who supplies a currency? Domestic residents who want to:
- Buy imports: Need foreign currency, so supply domestic currency
- Invest abroad: Buy foreign assets
- Speculate: Bet on currency depreciation
- Tourism abroad: Travel internationally
Supply curve: Upward sloping
- Higher exchange rate → Higher quantity supplied
- Lower exchange rate → Lower quantity supplied
Factors Affecting Exchange Rates (Shifters)
Factors Increasing Demand (Currency Appreciates)
1. Higher interest rates:
- Attracts foreign investment (hot money flows)
- Investors want higher returns
- Demand for currency increases
2. Lower inflation:
- Exports more competitive (prices stable)
- Foreign demand for goods increases
- Currency demand increases
3. Strong economic growth:
- Attracts foreign investment
- Confidence in economy
4. Current account surplus:
- Exports > Imports
- High foreign demand for currency
5. Speculation:
- Investors expect appreciation
- Buy now to profit later
- Self-fulfilling prophecy
Factors Decreasing Demand / Increasing Supply (Currency Depreciates)
- Lower interest rates (capital outflows)
- Higher inflation (exports less competitive)
- Weak economic growth
- Current account deficit (imports > exports)
- Political instability or uncertainty
- Negative speculation
Advantages of Floating Exchange Rates
- Automatic adjustment: BOP imbalances correct themselves (deficit → depreciation → exports increase)
- Independent monetary policy: Central bank free to set interest rates for domestic goals
- No need for reserves: Government doesn't maintain large foreign currency reserves
- Market efficiency: Reflects economic fundamentals
- Insulation from external shocks: Exchange rate absorbs impact
Disadvantages of Floating Exchange Rates
- Uncertainty: Fluctuations create risk for traders and investors
- Speculation: Short-term capital flows cause volatility
- Inflation from depreciation: Import prices rise
- May not correct imbalances: Depreciation worsens deficit if demand inelastic (J-curve effect)
B. Fixed (Pegged) Exchange Rates
Definition: Exchange rate set and maintained by government/central bank at a specific level.
How it works:
- Government declares official exchange rate
- Central bank intervenes to maintain this rate
- If currency under pressure to depreciate: Central bank buys domestic currency with foreign reserves
- If currency under pressure to appreciate: Central bank sells domestic currency, buys foreign currency
Examples: Many developing countries peg to USD or euro, Hong Kong dollar pegged to USD
Advantages of Fixed Exchange Rates
- Certainty: Businesses can plan without exchange rate risk
- Encourages trade and investment: Removes currency risk
- Discipline on government: Cannot use inflation to solve problems
- Low inflation: If pegged to low-inflation currency
Disadvantages of Fixed Exchange Rates
- Loss of independent monetary policy: Interest rates must support exchange rate, not domestic economy
- Requires large reserves: Must have foreign currency to intervene
- No automatic adjustment: BOP imbalances persist
- Vulnerable to speculation: If market thinks peg unsustainable, massive attack possible
- Wrong rate: Fixed rate may not reflect economic fundamentals (overvalued or undervalued)
C. Managed Float (Dirty Float)
Definition: Hybrid system where currency mostly floats but government occasionally intervenes.
How it works:
- Exchange rate determined by market most of the time
- Central bank intervenes to smooth excessive volatility
- No official target rate, but implicit range
Examples: China (managed against basket of currencies), India, many emerging markets
Goal: Combine flexibility with stability
Comparison of Exchange Rate Systems
| Aspect | Floating | Fixed | Managed Float |
|---|---|---|---|
| Determination | Market forces | Government | Mostly market, some intervention |
| Flexibility | High | None | Moderate |
| BOP Adjustment | Automatic | Requires policy changes | Gradual |
| Monetary Policy Independence | Full | None | Partial |
| Reserve Requirements | Low | High | Moderate |
| Uncertainty | High | Low | Moderate |
3. The Balance of Payments (BOP)
Definition and Purpose
Balance of Payments (BOP) is 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).
Purpose:
- Track international financial flows
- Monitor country's economic relationships
- Inform policy decisions
- Assess economic health
Key principle: Double-entry bookkeeping - every transaction recorded twice (credit and debit)
Structure of the Balance of Payments
Main Components
\[ \text{BOP} = \text{Current Account} + \text{Capital Account} + \text{Financial Account} \]In theory: BOP should equal zero (credits = debits)
In practice: Statistical discrepancy due to measurement errors
1. Current Account
Definition: Records trade in goods and services, investment income, and transfers.
Four sub-accounts:
A. Balance of Trade in Goods (Visible Trade)
- Exports of goods: Credit (+)
- Imports of goods: Debit (-)
Examples: Cars, electronics, food, machinery
Surplus: Exports > Imports (positive)
Deficit: Imports > Exports (negative)
B. Balance of Trade in Services (Invisible Trade)
- Exports of services: Credit (+)
- Imports of services: Debit (-)
Examples: Tourism, financial services, shipping, insurance, legal services, education
C. Primary Income (Investment Income)
- Income received from abroad: Credit (+) - Profits, interest, dividends from foreign investments
- Income paid abroad: Debit (-) - Payments to foreign investors
Examples: UK company earns dividends from US stocks (credit for UK)
D. Secondary Income (Transfers)
- Received: Credit (+)
- Paid: Debit (-)
Examples:
- Remittances (workers sending money home)
- Foreign aid
- Gifts
- Pensions
Current Account Balance Formula
\[ \text{CA} = (X - M) + \text{Net Primary Income} + \text{Net Secondary Income} \]Where:
- • \(X\) = Exports of goods and services
- • \(M\) = Imports of goods and services
Current Account Surplus: CA > 0 (credits > debits)
Current Account Deficit: CA < 0 (debits > credits)
2. Capital Account
Definition: Records capital transfers and non-produced, non-financial assets.
Usually very small, includes:
- Debt forgiveness
- Migrants' transfers (when people move permanently)
- Sale of patents, copyrights, trademarks
- Transfer of fixed assets
Note: Often combined with Financial Account in simplified presentations
3. Financial Account
Definition: Records transactions in financial assets and liabilities (investments).
Three types:
A. Foreign Direct Investment (FDI)
- Inward FDI: Foreign companies invest in domestic country (build factories, acquire firms) - Credit (+)
- Outward FDI: Domestic companies invest abroad - Debit (-)
Characteristic: Long-term, involves control/management
B. Portfolio Investment
- Inward: Foreigners buy domestic stocks/bonds - Credit (+)
- Outward: Domestic residents buy foreign securities - Debit (-)
Characteristic: Financial investment without control
C. Reserve Assets
- Changes in central bank's foreign currency reserves
- Gold, foreign currencies, SDRs
- Used to intervene in currency markets (fixed/managed systems)
Financial Account Balance
\[ \text{FA} = \text{Net FDI} + \text{Net Portfolio Investment} + \text{Net Other Investment} + \Delta \text{Reserves} \]Financial Account Surplus: Net capital inflows (foreigners invest more in our country)
Financial Account Deficit: Net capital outflows (we invest more abroad)
BOP Equilibrium
Fundamental BOP Identity
\[ \text{Current Account} + \text{Capital Account} + \text{Financial Account} = 0 \]Or, simplifying:
\[ \text{Current Account Balance} = -(\text{Capital + Financial Account Balance}) \]This means:
- Current account deficit must be financed by capital/financial account surplus (borrowing or selling assets to foreigners)
- Current account surplus means capital/financial account deficit (lending or buying foreign assets)
Example: Understanding BOP Relationships
Country A has:
- Current Account: -$50 billion (deficit)
- This means imports > exports by $50 billion
How is this financed?
- Financial Account: +$50 billion (surplus)
- Options: Foreign investment flows in, country borrows, sells assets, uses reserves
Interpretation: Country consuming more than producing, financed by foreign capital
4. Current Account Deficits and Surpluses
What Causes Current Account Imbalances?
Causes of Current Account Deficit
- Strong domestic growth: High income → More imports
- Overvalued currency: Exports expensive, imports cheap
- Low savings rate: High consumption → More imports
- High government spending: Budget deficit often linked to current account deficit ("twin deficits")
- Low competitiveness: Uncompetitive products, low productivity
- Discovery of natural resources: Currency appreciation (Dutch disease)
Causes of Current Account Surplus
- High competitiveness: Strong export industries
- High savings rate: Low consumption → Fewer imports
- Weak domestic demand: Slow growth → Low import demand
- Undervalued currency: Exports cheap, imports expensive
- Export-oriented policies: Government support for exporters
Impact of Current Account Deficits
Potential Problems
1. Increasing Foreign Debt:
- Deficit financed by borrowing
- Debt accumulates over time
- Interest payments increase (burden on future generations)
- May become unsustainable
2. Currency Depreciation:
- Deficit → Excess supply of domestic currency
- Pressure for depreciation (floating rates)
- Import prices rise → Inflation
- Lower living standards
3. Reduced National Sovereignty:
- Heavy foreign borrowing → Dependence on foreign creditors
- May need to adopt policies dictated by lenders
- Loss of economic independence
4. Unsustainable Consumption:
- Living beyond means
- Eventually must adjust (painful)
5. Crowding Out Domestic Industry:
- Imports replace domestic production
- Job losses in import-competing sectors
- Deindustrialization
When Deficits Might NOT Be Problematic
- Short-term deficit: Temporary, self-correcting
- Investment-driven: If imports are capital goods for productive investment
- Growing economy: High imports due to strong growth (will generate future exports)
- Funded by FDI: Not creating debt, building productive capacity
- Small relative to GDP: Large economy can sustain moderate deficit
- Reserve currency country: US can run deficits more easily (dollar demand globally)
Methods to Reduce Current Account Deficit
1. Expenditure-Switching Policies
Goal: Switch spending from imports to domestic goods
A. Currency Depreciation:
- Makes exports cheaper, imports more expensive
- Encourages exports, discourages imports
- Improves current account
B. Trade Protection:
- Tariffs, quotas on imports
- Makes imports expensive
- Problem: Retaliation, inefficiency
2. Expenditure-Reducing Policies
Goal: Reduce overall spending (including imports)
A. Contractionary Fiscal Policy:
- Cut government spending, raise taxes
- Reduces aggregate demand
- Imports fall
- Problem: Recession, unemployment
B. Contractionary Monetary Policy:
- Raise interest rates
- Reduces consumption and investment
- Imports fall
- Problem: Slows growth
3. Supply-Side Policies
Goal: Improve competitiveness and productivity
- Education and training (human capital)
- Infrastructure investment
- R&D support
- Reduce business regulations
- Makes exports more competitive
- Problem: Takes many years
The J-Curve Effect
Short-Run Worsening Before Improvement
Scenario: Currency depreciates to reduce current account deficit
Short run (first few months):
- Quantities of imports/exports don't change much (contracts already signed)
- But import prices rise immediately
- Current account deficit worsens
Long run (after 6-12 months):
- Export volumes increase (cheaper abroad)
- Import volumes decrease (expensive at home)
- Current account deficit improves
Graph shape: Looks like letter "J" - dips down first, then rises
Condition: Marshall-Lerner condition must hold:
\[ PED_X + PED_M > 1 \](Sum of price elasticities of demand for exports and imports must exceed 1)
Impact of Current Account Surpluses
Potential Benefits
- Increases national wealth: Accumulating foreign assets
- Strong currency: High demand for currency
- Investment income: Returns from foreign investments
- Economic security: Not dependent on foreign funding
- Export competitiveness: Strong industries
Potential Problems
- Currency appreciation: Makes exports less competitive over time
- Low domestic consumption: High savings = lower living standards now
- Trade tensions: Other countries may accuse of currency manipulation
- Resource misallocation: Over-investment in exports at expense of domestic needs
- Inflationary pressure: If surplus due to undervalued currency
IB Economics Exam Tips
Key Formulas and Definitions
- Current Account: \(CA = (X - M) + \text{Net Primary Income} + \text{Net Secondary Income}\)
- BOP Identity: \(CA + \text{Capital Account} + \text{Financial Account} = 0\)
- Appreciation: Currency increases in value (buys more foreign currency)
- Depreciation: Currency decreases in value (buys less foreign currency)
Exchange Rate Diagrams
Must show:
- Currency on axes (e.g., price of £ on Y-axis, quantity of £ on X-axis)
- Downward-sloping demand curve
- Upward-sloping supply curve
- Original equilibrium (E₁) and new equilibrium (E₂)
- Shift of curve (demand or supply)
- Clear labels showing appreciation or depreciation
Common Mistakes to Avoid
- Confusing appreciation/depreciation direction: Higher exchange rate = appreciation
- Wrong BOP components: Know what goes in current vs. financial account
- Saying deficit is always bad: Context matters (investment-driven vs. consumption)
- Forgetting J-curve: Depreciation worsens deficit initially
- Not explaining Marshall-Lerner condition: Elasticities must be sufficient
- Ignoring interdependence: Exchange rates affect BOP, BOP affects exchange rates
Essay Structure for BOP/Exchange Rate Questions
Introduction:
- Define key terms (exchange rate system, current account, etc.)
- Provide context
Body - Explaining the Issue:
- How exchange rate system works
- Factors affecting exchange rates (with diagram)
- Impact on BOP components
Body - Analyzing Consequences:
- Effects on current account (exports, imports)
- Effects on economy (inflation, growth, employment)
- Financial account implications
Evaluation:
- Time lags (J-curve)
- Elasticities matter (Marshall-Lerner)
- Depends on cause of imbalance
- Trade-offs (floating vs. fixed)
- Real-world examples
Real-World Examples to Use
- US: Persistent current account deficit, reserve currency status
- China: Large current account surplus, managed float, accused of currency manipulation
- Germany: Current account surplus in Eurozone
- UK: Brexit impact on pound (depreciation), current account deficit
- Asian Financial Crisis (1997-98): Fixed exchange rates collapse
✓ Exchange Rates & BOP Checkpoint
You should now understand the three main exchange rate systems (floating, fixed, managed) with their advantages and disadvantages; how currency markets work through supply and demand with factors causing appreciation/depreciation; the structure of the Balance of Payments with current account (trade in goods/services, investment income, transfers), capital account, and financial account; and the causes and impacts of current account deficits including debt accumulation, currency pressure, and policy options. Remember the BOP identity (current + capital + financial = 0), the J-curve effect showing short-run worsening before improvement after depreciation, and the Marshall-Lerner condition for successful devaluation. Always use properly labeled exchange rate diagrams and explain the interconnections between exchange rates and BOP. These concepts are crucial for IB Economics SL global economy analysis.