Balance of Payments and Exchange Rates: practice questions

Question 1

A country's economy has many cross-border transactions in a single year, including the sale of goods abroad, migrant workers sending money home to relatives, and multinational companies moving profits between countries.

Which of the following is recorded as secondary income in the current account of the balance of payments?

Accepted Answer

B

Question 2

Kelmora's national statistics agency has published the following current account data for last year (all figures in US$ million). A negative figure indicates a net outflow of income (more paid abroad than received); a positive figure indicates a net inflow. Component US$ million…

Accepted Answer

((a)) Balance of trade in goods =8200-9650=-1450, i.e. a deficit of US$1,450 million; balance of trade in services =3100-2400=+700, i.e. a surplus of US$700 million  ((b)) Balance of trade in goods and services =-1450+700=-750, i.e. a deficit of US$750 million  ((c)) Current account balance =-750+(-450)+180=-1020, i.e. Kelmora's current account is in a deficit of US$1,020 million  ((d)) One possible cause is that Kelmora's imports of goods substantially exceed its exports of goods (for example because rising domestic incomes are pulling in more imported goods, or domestically produced goods are less price-competitive than foreign alternatives), and this large g…

Question 3

Rivandia operates a freely floating exchange rate for its currency, the riven, against the US dollar. Rivandia's main export is a specialty coffee bean. After a successful international marketing campaign, global demand for Rivandia's coffee exports rises sharply. (a) Explain, u…

Accepted Answer

((a)) The rise in foreign demand for Rivandia's coffee exports raises the demand for rivens in the foreign exchange market, since foreign buyers need rivens to pay Rivandian exporters, shifting the demand curve for rivens to the right; with the supply of rivens unchanged, the equilibr…  ((b)) The riven has appreciated  ((c)) Before the change, 200 ÷ 5 = 40, i.e. $40; after the change, 200 ÷ 4 = 50, i.e. $50  ((d)) Before the change, 10 × 5 = 50 rivens; after the change, 10 × 4 = 40 rivens  ((e)) Rivandia's textile export has become more expensive to foreign buyers, rising from $40 to $50, making Rivandia's exports less price-competitive abroad, while the imported machine component has become cheaper in riven terms, falling from 50 to 40 rivens, making imports more attra…

Question 4

Doverna operates a freely floating exchange rate. Over the past year, its currency, the dovar, has depreciated significantly against the currencies of its major trading partners. Doverna's current account has been in deficit for several years, and the government hopes that this…

Accepted Answer

((a)) The depreciation lowers the value of the dovar, so Doverna's exports become cheaper in foreign-currency terms and more price-competitive abroad, while its imports become more expensive in dovars and less attractively priced for domestic buyers  ((b)) Cheaper exports and dearer imports tend to raise export revenue and reduce import spending, so net exports (X-M) rise, shifting aggregate demand to the right; in the short run this is likely to raise Doverna's real output and lower unemployment, but it also raises the domestic p…  ((c)) Depreciation should help by making exports more competitive and imports more expensive, but it may not be sufficient alone, since it can take time for trade volumes to respond, it raises domestic costs and prices in a way that could offset some of the benefit, and if the deficit…

Question 5

A country operates a freely floating exchange rate for its currency. Which of the following changes is most likely to cause an appreciation of the country's currency?

Accepted Answer

C

Question 6

A country has been running a current account deficit for several consecutive years. To keep financing this gap, it has had to attract funds from abroad, for example by selling government bonds to foreign investors, and by drawing on its official reserves of foreign currency.

Which of the following is most likely to be a consequence of this persistent current account deficit?

Accepted Answer

C

Question 7

Meridia has run a current account deficit for the past three years. Last year, Meridia's current account balance was a deficit of $27 billion, while its nominal GDP was $450 billion. (a) Calculate Meridia's current account deficit as a percentage of its GDP. [2] (b) Many economi…

Accepted Answer

((a)) Deficit as a percentage of GDP =27/450×100=6%  ((b)) Meridia's deficit of 6% is above the 5% threshold, since 6>5, so by this measure Meridia's deficit would be regarded as a warning sign of possible unsustainability  ((c)) A persistent deficit has to be financed from abroad, most likely through greater borrowing (raising Meridia's external debt over time) and/or by running down its official reserves of foreign currency  ((d)) Since more currency flows out to pay for imports and finance the deficit than flows in, there is a tendency toward depreciation of Meridia's currency, or the authorities may need to keep interest rates relatively high to attract capital inflows and support its value

Question 8

Wexford operates a freely floating exchange rate for its currency, the wex. Wexford's central bank unexpectedly raises its main policy interest rate from 2.5% to 5.5%, while interest rates in Wexford's major trading partners remain unchanged. (a) Explain, using demand and supply…

Accepted Answer

((a)) A higher interest rate in Wexford relative to its trading partners makes wex-denominated deposits and bonds more attractive to foreign savers and investors seeking a better return, so foreign investors want to acquire more wex to invest in Wexford, shifting the demand curve for…  ((b)) The wex has appreciated  ((c)) The appreciation makes Wexford's exports more expensive in foreign-currency terms, reducing their price competitiveness abroad, so if foreign buyers respond to this by switching towards competitors, Wexford's export volumes and revenue are likely to fall, particularly for export…

Question 9

A country's currency appreciates significantly against the currencies of its main trading partners. The prices of the goods and services this country buys and sells internationally, measured in the seller's own currency, remain unchanged.

Assuming buyers respond to the resulting change in prices, which of the following is the most likely direct effect of this appreciation on the country's current account balance, other things equal?

Accepted Answer

B

Question 10

Bregantia has a persistent current account deficit. Rather than relying on a depreciation of its currency, Bregantia's government is considering imposing tariffs on imported manufactured goods as a way of correcting the deficit. (a) Explain how imposing tariffs on imported manuf…

Accepted Answer

((a)) A tariff is a tax on imported goods, so it raises the domestic price of the targeted imported manufactured goods, and if consumers respond by buying fewer of these now relatively more expensive imports and switching towards domestically produced substitutes, import spending fall…  ((b)) A depreciation is a market-determined, economy-wide change in the price of all of Bregantia's exports and imports at once, whereas a tariff is a policy tool set directly by the government at a rate and scope it chooses, and can be targeted narrowly at specific imported goods, he…  ((c)) Tariffs may reduce spending on the targeted imports and provide some improvement, but their effectiveness is limited because trading partners may retaliate with tariffs of their own on Bregantia's exports, offsetting the gain, protectionism may breach trade agreement commitments…

Component	US$ million
Exports of goods	8,200
Imports of goods	9,650
Exports of services	3,100
Imports of services	2,400
Net primary income	-450
Net secondary income	+180

Balance of Payments and Exchange Rates: Economics 9708 (Cambridge International AS & A Level)

Syllabus coverage

Question 1

Question 2

Question 3

Question 4

Question 5

Question 6

Question 7

Question 8

Question 9

Question 10