Balance of Payments and Foreign Exchange

The balance of payments (BOP) is used to track transactions between a country and its international trading partners. It can be viewed as an accounting statement that captures all payments made to foreigners and liabilities incurred by them. BOP also shows all payments and obligations received from foreigners.

A country’s balance of payments consists of its current account as well as its capital
and financial account.

The current account measures the exchange of goods, services, investment income, and unilateral gifts.

$$ \text{Current account surplus – Exports > Imports} $$

$$ \text{Current account deficit – Imports > Exports} $$

The financial account (capital account) measures the flow of funds for debt and equity investment into and out of a country.

Influence of the Current Account on Exchange Rates

A country’s current account trend influences the path taken by exchange rates over time through the following mechanisms:

$$ {\begin{array}{l|l} \text{The flow supply or demand channel} & {\text{A country that exports more than} \\ \text{it imports will see an increased}\\ \text{demand for its currency, resulting}\\ \text{in currency appreciation.}}\\ \hline \text{The portfolio balance channel} & {\text{A country operating at a trade } \\ \text{surplus will have more of a deficit}\\ \text{ country’s currency than it wants,}\\ \text{resulting in downward pressure on}\\ \text{the deficit country’s currency.}} \\ \hline \text{The debt sustainability channel} & {\text{If a country runs persistent deficits,} \\ \text{it will be indebted to foreigners}\\ \text{and its currency will be depreciated}\\ \text{so that the current account deficit} \\ \text{narrows.}} \\ \end{array}}$$

Influence of the Capital Account on Exchange Rates

Capital account balances have a more immediate effect on exchange rates relative to current account balances.

Excessive capital inflows in Emerging Markets (EM) catalyze boom-like conditions such as:

1. Appreciation of emerging market currencies.
2. A great buildup of external debt by emerging market governments and businesses.
3. Overinvestment in risky projects.
4. Market bubbles.

Question

Current account surplus is most likely a result of:

1. Exports exceeding imports.
2. Imports exceeding exports.
3. Exports being equal to imports.

Solution

The correct answer is A.

The current account measures the exchange of goods, services, investment income, and unilateral gifts.

A current account surplus occurs when exports are greater than imports. On the other hand, a current account deficit is a result of imports being greater than exports.

Reading 8: Currency Exchange Rates: Understanding Equilibrium Value

LOS 8 (j) Explain how flows in the balance of payment accounts affect currency exchange rates.