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Questions and Answers
Which component of the Balance of Payments records the trade of goods and services?
Which component of the Balance of Payments records the trade of goods and services?
A country with a current account surplus imports more than it exports
A country with a current account surplus imports more than it exports
False (B)
What is the term for the price of one currency in terms of another?
What is the term for the price of one currency in terms of another?
Exchange rate
In a ________ exchange rate system, currency value is determined by market forces.
In a ________ exchange rate system, currency value is determined by market forces.
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Which of the following best describes the key identity of the Balance of Payments?
Which of the following best describes the key identity of the Balance of Payments?
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A fixed exchange rate system provides more flexibility in monetary policy compared to a floating system.
A fixed exchange rate system provides more flexibility in monetary policy compared to a floating system.
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What does a current account deficit indicate?
What does a current account deficit indicate?
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Earnings from investments abroad (e.g. interest, dividends) are recorded in the BoP as _________ income.
Earnings from investments abroad (e.g. interest, dividends) are recorded in the BoP as _________ income.
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Match the following items with their component in the Balance of Payments:
Match the following items with their component in the Balance of Payments:
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Which of the following is a long-term determinant of exchange rates?
Which of the following is a long-term determinant of exchange rates?
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Which of the following is NOT a short-term factor affecting exchange rates?
Which of the following is NOT a short-term factor affecting exchange rates?
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A current account surplus indicates that a country is importing more goods and services than it is exporting.
A current account surplus indicates that a country is importing more goods and services than it is exporting.
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What does PPP stand for in the context of exchange rate theory?
What does PPP stand for in the context of exchange rate theory?
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According to the PPP theory, exchange rates adjust so that identical goods cost the same across countries when expressed in a common ______.
According to the PPP theory, exchange rates adjust so that identical goods cost the same across countries when expressed in a common ______.
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Match the exchange rate system with its description:
Match the exchange rate system with its description:
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What happens when there are higher interest rates in a country regarding its currency?
What happens when there are higher interest rates in a country regarding its currency?
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The Balance of Payments (BoP) must always balance in theory.
The Balance of Payments (BoP) must always balance in theory.
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What is adjusted in a real exchange rate?
What is adjusted in a real exchange rate?
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The relative price level, given by $\frac{P_{domestic}}{P_{foreign}}$, modifies the nominal exchange rate to find the ______ exchange rate.
The relative price level, given by $\frac{P_{domestic}}{P_{foreign}}$, modifies the nominal exchange rate to find the ______ exchange rate.
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Which of these are limitations of the Purchasing Power Parity Theory? (Select all that apply)
Which of these are limitations of the Purchasing Power Parity Theory? (Select all that apply)
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Study Notes
Balance of Payments (BoP)
- The Balance of Payments (BoP) systematically records all economic transactions between a country and the rest of the world over a specified period.
- It reflects the country's economic position in global trade and finance.
Structure of the BoP
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Current Account: Records flows of goods, services, primary income, and secondary income.
- Trade Balance: Exports minus imports of goods and services.
- Primary Income: Earnings from investments abroad (e.g., interest, dividends).
- Secondary Income: Unilateral transfers (e.g., remittances, foreign aid).
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Capital and Financial Account: Records capital transfers and financial flows.
- Capital Transfers: Debt forgiveness, asset transfers.
- Financial Account: FDI, portfolio investment, changes in reserve assets.
- Errors and Omissions: Balancing item to ensure the BoP sums to zero.
Key BoP Identity
- The BoP must always balance: Current Account + Capital and Financial Account + Errors and Omissions = 0
Current Account Deficit vs. Surplus
- Deficit: Imports exceed exports, financed by borrowing or selling assets. Implications include increased foreign debt and reduced national savings.
- Surplus: Exports exceed imports, leading to capital outflows or reserve accumulation.
Exchange Rates
- Exchange rates are the price of one currency in terms of another, determined by supply and demand.
Types of Exchange Rate Systems
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Fixed Exchange Rate System: Currency pegged to another currency or a basket of currencies.
- Pros: Stability in international trade; reduced uncertainty.
- Cons: Requires large reserves; limits monetary policy flexibility.
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Floating Exchange Rate System: Currency value determined by market forces (supply and demand).
- Pros: Automatic adjustment to trade imbalances; greater monetary policy autonomy.
- Cons: Volatility; uncertainty for traders/investors.
- Managed Float (Hybrid System): Exchange rates market-driven with occasional central bank intervention.
Determinants of Exchange Rates
- Long-Term Factors: Relative price levels (inflation), productivity differences, trade barriers, preferences(taste).
- Short-Term Factors: Interest rate differentials (higher interest rates attract capital inflows), speculation based on future exchange rate expectations.
Purchasing Power Parity (PPP) Theory
- Exchange rates adjust so identical goods cost the same across countries when expressed in a common currency.
- Formula: S1 = S0 × (Pdomestic / Pforeign)
- Limitations include transportation costs, trade barriers, and non-tradable goods.
Real Exchange Rate
- Adjusts the nominal exchange rate for differences in price levels between countries:
- RER = (Nominal Exchange Rate) × (Foreign Price Level / Domestic Price Level)
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Description
This quiz covers the Balance of Payments (BoP), detailing its structure, including the current account, capital and financial account, and key identities. Test your understanding of how economic transactions are recorded globally and the importance of maintaining balance.
