Study Notes
Exchange rates influence the balance of payments (BOP) by affecting the current and financial accounts. A floating exchange rate allows automatic correction of current account imbalances, while managed and fixed exchange rates involve government intervention.
- Floating Exchange Rate — the currency value is determined by market forces without direct government control. Example: A deficit in the current account leads to currency depreciation, increasing export demand and reducing import demand.
- Managed Exchange Rate — the currency is primarily market-driven but with occasional government intervention to stabilize it. Example: The central bank buys domestic currency to prevent depreciation during a current account deficit.
- Fixed Exchange Rate — the currency value is pegged to another currency or a basket of currencies. Example: The central bank sells foreign currency to maintain the exchange rate during a current account deficit.
- Current Account — records a country's transactions with the rest of the world, including trade balance, net income, and direct payments. Example: A surplus indicates more exports than imports.
- Financial Account — records capital transactions, including investments and loans, between a country and the rest of the world. Example: A surplus in the financial account can offset a current account deficit.
Exam Tips
Key Definitions to Remember
- Floating Exchange Rate
- Managed Exchange Rate
- Fixed Exchange Rate
- Current Account
- Financial Account
Common Confusions
- Confusing the self-correcting nature of floating exchange rates with managed or fixed systems
- Misunderstanding the role of central banks in managed and fixed exchange rate systems
Typical Exam Questions
- How does a floating exchange rate correct a current account deficit? It leads to currency depreciation, increasing export demand and reducing import demand.
- What role does the central bank play in a managed exchange rate system? It intervenes to stabilize the currency by buying or selling domestic or foreign currency.
- How does a fixed exchange rate system maintain currency value? The central bank uses foreign reserves to buy or sell currency to maintain the pegged rate.
What Examiners Usually Test
- Understanding of how different exchange rate systems affect the balance of payments
- Ability to explain the relationship between the current account and exchange rates
- Knowledge of central bank interventions in managed and fixed exchange rate systems