Balance of Payments & Exchange Rates

How a country pays its way in the world, and how the price of its currency is set. This sub-theme links the balance of payments, exchange rates and international competitiveness — three ideas that constantly feed into one another.

🎯 Learning objectives — by the end of 4.3 you can…

- describe the components of the balance of payments and how to correct an imbalance; - explain fixed, managed and floating exchange rates and what moves them; - analyse the effect of a depreciation using the Marshall-Lerner condition and the J-curve; - explain and assess international competitiveness.

4.3.1 The balance of payments

Spec: 4.3.1

The balance of payments records all transactions between a country and the rest of the world. It has two main parts:

The accounts must balance overall: a current account deficit is financed by a surplus on the financial account (inflows of investment). Current account deficits and surpluses are driven by competitiveness, the exchange rate and relative incomes/growth.

Key terms

Correcting a current account deficit

- Expenditure-switching — a lower exchange rate or tariffs switch spending toward domestic goods; - Expenditure-reducing — deflationary fiscal/monetary policy lowers demand for imports; - Supply-side — raising competitiveness is the long-run fix.

4.3.2 Exchange rates

Spec: 4.3.2

An exchange rate can be fixed (pegged to another currency), floating (set by market demand and supply), or managed (mostly floating but with intervention). Governments and central banks intervene through foreign-currency transactions (buying/selling using reserves), interest rates, and quantitative easing. In a floating system the rate is set where the demand for and supply of the currency meet:

Key terms

What moves a floating rate — and the key terms

- Influences: relative interest rates, relative inflation (PPP theory), the current account, the strength of the economy, capital flight, speculation and global factors (e.g. commodity prices). - Revaluation/devaluation = a deliberate change in a fixed system; appreciation/depreciation = a market-driven change in a floating system.

4.3.3 Marshall-Lerner & the J-curve

Spec: 4.3.3

A depreciation makes exports cheaper abroad and imports dearer at home. But it only improves the current account if the Marshall-Lerner condition holds: the combined price elasticities of demand for exports and imports must be greater than one (PEDx + PEDm > 1).

In the short run demand is inelastic (contracts and habits are slow to change), so the condition often fails at first: the country pays more for the same volume of imports while export volumes lag. The current account therefore worsens before it improves — the J-curve:

Evaluation

Other effects & evaluation

A depreciation can also raise growth and employment (net exports rise) but cause imported inflation (dearer imports and inputs). Competitive devaluations ("currency wars") are beggar-thy-neighbour and invite retaliation. The size and timing of all these effects depend on elasticities and the state of the global economy.

4.3.4 International competitiveness

Spec: 4.3.4

International competitiveness is the ability of a country's firms to compete in global markets. It is measured by relative unit labour costs, relative export prices and relative productivity.

A competitive economy enjoys strong exports, growth, employment and FDI; an uncompetitive one tends to run current account deficits and suffer structural unemployment.

4.3 Recap — nail these

Balance of payments = current account (trade + income) + capital/financial; it must balance.
Exchange rates: fixed/managed/floating; floating set by demand & supply; appreciation vs depreciation.
Depreciation improves the current account only if PEDx + PEDm > 1 (Marshall-Lerner); the J-curve means it worsens first.
Competitiveness = unit labour costs, export prices, productivity; improved by supply-side policy.