Balance of Payments Overview

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Questions and Answers

What does the Current Account primarily record?

Long-term investments and portfolio investments

Capital transfers and financial investments

Trade in goods and services, income flows, and unilateral transfers (correct)

Exchange rate fluctuations

A surplus in the trade balance occurs when imports exceed exports.

False

What are unilateral transfers?

Remittances, foreign aid, and gifts

The _____ records long-term investments in foreign enterprises.

Foreign direct investment (FDI) Signup and view all the answers

Which of the following is a disadvantage of a fixed exchange rate system?

Requires large reserves Signup and view all the answers

Match the following components of the Balance of Payments with their descriptions:

Trade Balance = The difference between exports and imports Primary Income = Earnings from investments abroad Portfolio Investment = Short-term investments in stocks or bonds Capital Transfers = Debt forgiveness or transfers for asset purchases Signup and view all the answers

In a floating exchange rate system, the value of a currency is pegged to another currency.

False Signup and view all the answers

What is the BoP accounting identity?

Current Account Balance + Capital and Financial Account Balance + Errors and Omissions = 0 Signup and view all the answers

Which of the following factors does NOT directly influence exchange rates?

Color of the currency Signup and view all the answers

A currency crisis can occur when a country maintains a flexible exchange rate.

False Signup and view all the answers

What is the Purchasing Power Parity (PPP) theory?

The PPP theory states that exchange rates adjust so that identical goods cost the same across countries when expressed in a common currency. Signup and view all the answers

In the Interest Rate Parity (IRP) formula, F is the ______ exchange rate.

forward Signup and view all the answers

Match the following events with their corresponding currency crises:

Asian Financial Crisis = Speculative attacks on currencies like the Thai baht Argentine Crisis = Overvalued currency peg to the U.S. dollar Signup and view all the answers

Which of the following statements about trade balances is true?

Deficits can weaken a currency. Signup and view all the answers

Lower inflation rates strengthen a currency's purchasing power.

True Signup and view all the answers

Explain the limitations of Purchasing Power Parity (PPP).

PPP holds better over long periods than short periods due to factors like transportation costs and trade barriers. Signup and view all the answers

Study Notes

Balance of Payments (BoP)

The Balance of Payments (BoP) is a record of a country's economic transactions with the rest of the world over a specified period.
It has two main accounts:
- Current Account: Records trade in goods, services, income, and unilateral transfers.
- Capital and Financial Account: Tracks capital transfers, FDI, portfolio investment, and changes in reserve assets.

Current Account Components

Trade Balance: Difference between exports and imports of goods and services.
- Surplus: Exports exceed imports.
- Deficit: Imports exceed exports.
Primary Income: Earnings from foreign investments (e.g., dividends, interest).
Secondary Income (Unilateral Transfers): Remittances, foreign aid, and gifts.

Capital and Financial Account Components

Capital Transfers: Debt forgiveness, asset transfers.
Financial Account:
- Foreign Direct Investment (FDI): Long-term investment in foreign enterprises.
- Portfolio Investment: Short-term investments in stocks or bonds.
- Reserve Assets: Changes in central bank holdings of foreign currencies or gold.

BoP Accounting Identity

The BoP must always balance.
Current Account Balance + Capital and Financial Account Balance + Errors and Omissions = 0
A deficit in one account must be offset by a surplus in another account.

Exchange Rate Systems

Fixed Exchange Rate: Currency value is pegged to another currency (or a basket).
- Central banks intervene in the foreign exchange market to maintain the fixed rate.
- Pros: Stable international trade, reduced exchange rate risk.
- Cons: Requires large reserves, limits monetary policy flexibility.
Floating Exchange Rate: Currency values are determined by supply and demand in foreign exchange markets.
- Pros: Automatic adjustment to trade imbalances, increased monetary policy flexibility.
- Cons: Volatility, uncertainty for traders and investors.
Managed Float (Hybrid System): Primarily market-driven exchange rates with occasional central bank intervention.

Determinants of Exchange Rates

Interest Rate Differentials: Higher domestic interest rates attract foreign capital, appreciating the currency.
Inflation Rates: Lower inflation strengthens a currency's purchasing power.
Trade Balances: Persistent deficits can weaken a currency.
Political Stability: Stable economies attract investment, strengthening the currency.

Currency Crises

Occur when a country struggles to maintain a fixed exchange rate due to insufficient reserves or loss of investor confidence.
Examples include the Asian Financial Crisis (1997) and the Argentine Crisis (2001).

Purchasing Power Parity (PPP)

Exchange rates adjust so identical goods cost the same across countries (expressed in a common currency), but not always accurate over short periods.
Formula: E = (Domestic Price Level) / (Foreign Price Level)

Limitations of PPP:

Transportation costs and trade barriers influence goods prices between countries.

Interest Rate Parity (IRP)

Explains the relationship between interest rates and exchange rates under arbitrage conditions.
Formula: Forward Exchange Rate = Spot Exchange Rate × (1 + Domestic Interest Rate) / (1 + Foreign Interest Rate)

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Description

This quiz covers the essential components of the Balance of Payments, including the Current Account and Capital and Financial Account. Learn about trade balances, primary and secondary income, and the significance of foreign direct investment. Test your understanding of how these accounts reflect a country's economic transactions with the world.