Exchange rates and the current account of the balance of payments

Last time

Before we start: last time, in Poverty, you learned these points. Here they are again on one card. Keep them in mind, because today builds on them.

The price of a currency

When a Pakistani firm imports machinery from Germany, it must pay in euros, so it buys euros with rupees. The price of one currency in terms of another is the exchange rate. In this lesson: what moves it, what it does to trade, and how a country's trade with the world is recorded.

Floating and fixed

A floating exchange rate is set by the demand for and supply of the currency on the foreign exchange market. A fixed exchange rate is set by the government or central bank, which buys and sells currency to hold it at that level. When a floating rate rises, the currency appreciates. When it falls, it depreciates.

What raises a currency

Foreigners must buy a country's currency to pay for its exports, so rising exports raise demand for it. Higher interest rates attract foreign savers, and foreign firms investing in the country also buy its currency. Tourists visiting, and speculators expecting the currency to rise, add to demand too.

What lowers a currency

When a country imports more, it sells its own currency to buy foreign currency, so supply rises and the rate falls. Lower interest rates, money leaving the country, and inflation higher than in other countries can all lower it. So can speculators selling the currency because they expect it to fall.

Effects of a fall

Exports become cheaper for foreigners, so exports may rise. Imports become dearer, so imports may fall, but imported raw materials and fuel cost more, which can cause cost-push inflation. Whether the current account improves depends on how price-elastic the demand for exports and imports is.

Effects of a rise

Exports become dearer for foreigners, so they may fall, and exporters may cut jobs. Imports become cheaper, which helps consumers and lowers costs for firms using imported materials, reducing inflation. The current account may worsen as exports fall and imports rise.

The current account

The balance of payments records all money flowing into and out of a country. Its current account has four parts.

Adding it up

In one question, a country had a trade in goods and services balance of minus 3 billion dollars. Its primary and secondary income balance was plus 0.6 billion. The current account balance is minus 3 plus 0.6, which is minus 2.4 billion. A negative balance is a current account deficit: more money flows out than in.

Causes of a deficit

Strong demand for imports, often when incomes rise quickly. Exports that are not competitive, because of high costs, low productivity, or a high exchange rate. A long deficit must be paid for by borrowing or selling assets, and it can push the currency down.

Productivity and the current account

When labour productivity rises, each worker makes more, so average costs fall. Lower costs allow lower prices, so exports become more competitive and sell more abroad. Domestic goods also compete better with imports, so a surplus on the current account can grow.

Correcting a deficit

Expenditure-reducing: higher taxes or interest rates cut spending, including on imports. Expenditure-switching: protection, or a lower exchange rate, makes imports dearer and exports cheaper. Supply-side: raise productivity and quality, so exports compete better in the long run.

Mistakes that lose marks

Mistake one: saying a rise in the exchange rate makes exports cheaper. It makes them dearer. Mistake two: confusing the current account with the government budget. Mistake three: saying a depreciation always cures a deficit, without mentioning PED. The fix: direction of the currency, effect on export and import prices, then PED.

The full-marks tip

The full-marks tip: for an exchange rate change, say what happens to the price of exports and of imports, then to their quantities. For the current account, name the part that changes, and whether it moves towards deficit or surplus.

On one card

So, on one card: exchange rates and the current account. Keep it for revision.