Resources for Courses
Resources for Courses
Theory Buster
Exchange rates and balance of payments – the basics
Activity 1 – deal or no deal?
Suppose that you’ve just finished your A-levels, and your parents have given you some
money with which to go on holiday. They’ve said you can go wherever you like, but on
one condition – they want as much change as possible from the money they’ve given
you. Below are three possible holiday options – which one do you choose?
1 A holiday to Ibiza for €345, with a current
exchange rate of £1 = €1.18
2 A holiday to Switzerland for 427 CHF with
an exchange rate of £1 = 1.45 CHF
3 A holiday to Denmark for 2580 DKK with
an exchange rate of £1 = 8.9 DKK
Activity 2 – types of exchange rates
Match the following key exchange rate terms with their correct definition:
Spot exchange
rate
Ratio of domestic prices between
two countries
Forward
exchange rate
The actual rate on a minute-by-minute basis
on the FOREX market
Bilateral
exchange rate
A rate at some agreed point in the future –
used by companies wanting to reduce
exchange rate uncertainty
Effective
exchange rate
index
The rate at which one currency is traded
for another
Real exchange
rate
A weighted index of a currency’s value against
a basket of currencies (weights determined
according to trade flows)
Central Bank may
intervene to prevent
large fluctuations
The exchange rate
becomes an economic
policy focus
Gov’t commitment to a
fixed price for the
currency
Revaluation/change
in target and bands rare
Value given as a target
within permitted bands
of fluctuation
The approach ised in
the EU in the run-up to
Euro adoption in 2002
Exchange rate stability
often achieved at expense
of domestic stability
Value determined mainly
by market forces of
demand and supply
The most common
exchange rate system
in the world
No target set by
government
The Bretton Woods system
with currencies tied to the US $
is a good example 1944-1972
No intervention in the
Forex market by the
Central Bank
Value determined purely
by market forces of
demand and supply
The approach used in
the UK from 1973-1990
Central Bank may have
to intervene to maintain
value within the band
Manged floating
exchange rate
Fixed
exchange rate
Floating
exchange rate
Approach used in UK
since 1992 (when the
ERM was abandoned)
Used in the UK 19901992, with band of
2.95D ± 6%
No fluctuations from the
agreed date
Semi-fixed
exchange rate
Sort the following key descriptors into their correct exchange rate regime headings.
The types of regime are: floating exchange rate, fixed exchange rate, managed floatingexchange rate and semi-fixed exchange rate:
Activity 3 – types of exchange rates
No intervention in the
Forex market by the
Central Bank
The approach used in
the EU in the run-up to
Euro adoption in 2002
The Bretton Woods system
with currencies tied to the
US $ is a good example
1944-1972
The approach used in
the UK from 1973-1990
The most common
exchange rate system
in the world
Central Bank may
intervene to prevent
large fluctuations
No fluctuations from the
agreed date
Approach used in UK
since 1992 (when the
ERM was abandoned)
Exchange rate stability
often achieved at expense
of domestic stability
Value determined mainly
by market forces of
demand and supply
Gov’t commitment to a
fixed price for the
currency
Value determined purely
by market forces of
demand and supply
No target set by
government
Managed floating
exchange rate
Fixed
exchange rate
Floating
exchange rate
Activity 3 – Answers
Used in the UK 19901992, with band of
2.95D ± 6%
The exchange rate
becomes an economic
policy focus
Revaluation/change
in target and bands rare
Central Bank may have
to intervene to maintain
value within the band
Value given as a target
within permitted bands
of fluctuation
Semi-fixed
exchange rate
Resources for Courses
Theory Buster
Exchange rates and balance of payments – the basics
Price currency
i.e. Exchange rate
S
➞
Activity 4 – determining floating exchange rates
appreciation
$1 = £0.80
depreciation
q
➞
D
Quantity of currency
Summary of factors affecting the Forex market:
Demand
• Demand for exports
• Rising domestic interest rate
(“hot money leading to shortterm capital inflow)
• Speculation
• Long-term capital inflow
(FDI, portfolio investment)
Supply
• Demand for imports
• Rising overseas interest rate
(“hot money leading to shortterm capital outflow)
• Speculation
• Long-term capital outflow
(FDI, portfolio investment)
Questions – what is the effect on the exchange of Sterling of each of the following
scenarios?
1 UK interest rates rise relative to other countries
2 Speculators anticipate an appreciation of the Euro against the £
3 UK consumers, fearing recession, stop spending on imports
4 UK manufacturers become more internationally competitive, providing a boost
to exports
5 Overseas investors increase FDI into the UK
6 UK-based investors decide to buy shares in US companies
7 Greater barriers to trade with the US reduces exports to the US market
8 Eurozone interest rates rise relative to the UK’s
Resources for Courses
Theory Buster
Exchange rates and balance of payments – the basics
Activity 5 – the importance of PED for exchange rate movements
and the effect on the current accounts
1 Suppose a country runs a current account deficit of $0.5bn, with the value of exports
being $1bn and the value of imports being $1.5bn. Explain, using a diagram, why
the country’s currency is likely to depreciate as a result.
2 Assume that this depreciation leads to a fall in the price of exports by 10% and an
increase in the price of imports by 10%, and that the PED for exports is (-)1.5 and that
the PED for imports is (-)1.0. Calculate the % change in quantity demanded of
both exports and imports.
3 State and explain the impact of the depreciation on the current account balance.
(Hint: work out the new value of exports and the new value of imports, using the
information from both questions 1 and 2).
4 Now suppose instead that the PED for exports is (-)0.2 and the PED for imports is
(-)0.6. Calculate the effect on the current account balance.
5 Why is the effect on the current account balance different in the second scenario?
What do you estimate the PED for X and M to be for the UK? Based on your answer,
how effective do you think a devaluation of the £ will be in reducing the size of the UK’s
current account deficit?
Activity 6 – the effect of uncertainty in exchange rates on trade
Suppose a US retailer signs a contract to buy 1000 pairs of shorts from a Mexican
supplier in 6 months time, at 28 000 pesos. The current market rate is $1 = 14 pesos.
Suppose the exchange rate has depreciated in 6 months time to $1 = 13 pesos?
1 Calculate the cost, in $, to the US retailer at the time of contract signing and
6 months later.
2 Assume that other costs are $2 per pair of shorts, and the market price is $5 per
pair of shorts; what is the profit that the retailer will make now, and what was
expected 6 months ago.
Resources for Courses
Theory Buster
Exchange rates and balance of payments – the basics
Current Account
Capital Account
Financial Account
Balance of Trade
• Trade in goods
• Trade in services
Capital Transfers
• Transfer of fixed
asset ownership
• Debt forgiveness
Direct Investment
Acquisition /
disposal of nonproduced nonfinancial assets
• Transfer of fixed
asset ownership
• Debt forgiveness
Financial
Derivatives
Income
• Investment
income
• Compensation
of employees
Transfers
• Short-term
Transfers
• Short-term
Portfolio
Investment
Other Investment
Reserve Assets