Reading 17: The Exchange Rate and the Balance of Payments-LOS 2011, accounts, payments, balance, likely

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Session 4: Economics for Valuation
Reading 17: The Exchange Rate and the Balance of Payments

LOS e: Describe the balance of payments accounts.

 

 

In 2005, Tunisia’s merchandise imports exceeded the value of its merchandise exports. In this case, Tunisia would most likely have which of the following?

A) Balance of trade surplus.

B) Capital account surplus.

C) Current account surplus.

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The capital account includes investment in real assets and financial securities. If a country is running a current account deficit, as in the case of Tunisia, a way to make up the difference in the current account is to be a net borrower creating a surplus in the capital account.

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In response to exchange rate volatility, a central bank intervenes in the currency market by buying foreign currencies. What effect will this intervention most likely have on the foreign exchange value of the domestic currency and on the country’s official reserves, respectively?

A) Only one will increase.

B) Both will decrease.

C) Both will increase.

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If the central bank intervenes by buying foreign currencies, then it is selling its domestic currency, which will decrease the domestic currency’s foreign exchange value. Official reserves consist of a government’s foreign currency holdings. Buying foreign currencies will increase official reserves.

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Which of these statements about international finance is most accurate?

A) Purchasing power parity implies that exchange rates should adjust so that investments in any country offer the same risk-adjusted return.

B) Exchange rates tend to be more volatile than the quantity of a currency traded because the factors that affect the supply of a currency are independent of the factors that affect the demand for a currency.

C) Investments in a country by foreign citizens and foreign investments by that country’s own citizens will be reflected in the capital account.

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The capital account measures the principal value of inward investments by foreign citizens and outward investments by domestic citizens. The idea that investments in any country with the same amount of risk should offer the same return is an implication of interest rate parity, not purchasing power parity. Volatility in exchange rates that is large compared to changes in trading volume arises from the fact that the same factors (domestic interest rates and expected future exchange rates) affect both supply and demand for a currency.

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At an International Trade forum in Shanghai, China, a special panel of leaders advocating free trade was discussing the balance of payments in their respective countries. During the forum the following statements were made:

China’s Delegate: 2006 was a wonderful year for China economically speaking. However, the U.S. has experienced greater difficulties because of its widening trade deficit. The U.S. is running a trade deficit because it is spending more on public services than it is raising in tax revenues.

Uruguay’s Delegate: Since 1997 the U.S. has run a current account deficit and a smaller surplus in its capital account. This has led to a small surplus in the country’s official reserve account in order to balance the balance-of-payments account.

With respect to these statements:

A) only one is correct.

B) both are correct.

C) both are incorrect.

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If the U.S. is spending more on public services than it is collecting in tax revenues, it is experiencing a budget deficit, not a trade deficit. If the U.S. is experiencing a current account deficit that is larger than its capital account surplus there will be a surplus in the country’s official reserve account so that its balance-of-payments will net to zero.