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Balance of Payments and Exchange Rates: Question 9

Syllabus 6.3, 6.4

Multiple choice AS 1 mark

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?

Choose an answer to check it, then compare with the worked solution below.
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Worked solution

Step 1: Recall how appreciation changes relative prices

When a currency appreciates, a good priced in that currency becomes more expensive to foreign buyers (who now need more of their own currency to buy it), while a good priced in a foreign currency becomes cheaper to domestic buyers (who now need less domestic currency to buy it). This changes the price competitiveness of the country’s exports and imports, even though the underlying seller’s-currency prices have not moved.

Step 2: Check option B

The country’s exports become more expensive to foreign buyers, making them less price-competitive abroad, while imports become cheaper in domestic-currency terms, making them more price-competitive at home. Assuming buyers respond to these price changes, export volumes are likely to fall and import volumes are likely to rise, so the current account balance is most likely to worsen. This is exactly what option B describes.

Step 3: Rule out options A, C and D

  • Option A: appreciation makes exports less attractively priced abroad, not more, so this describes the opposite effect.
  • Option C: the exchange rate and the level of official reserves are different things; a change in the exchange rate does not, by itself, directly alter the stock of reserves held.
  • Option D: net secondary income (such as remittances) is a separate current account component not directly caused to rise by an appreciation’s effect on trade prices.

Final answer

Option B. An appreciation makes exports less price-competitive abroad and imports more price-competitive at home, so, assuming buyers respond to these price changes, the current account balance is most likely to worsen; A, C and D each mischaracterise the effect.