What does the balance of payments record, and how are exchange rates determined and managed?
The structure of the balance of payments, the causes and consequences of a current account imbalance, exchange rate systems, and exchange rate determination and effects.
A focused CCEA A-Level Economics answer on the balance of payments and exchange rates, covering the current and capital and financial accounts, the causes and consequences of a current account deficit, floating, fixed and managed exchange rate systems, how a floating rate is determined, and the effects of currency changes, with worked depreciation analysis.
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What this dot point is asking
CCEA wants you to explain the structure of the balance of payments (the current account and the capital and financial account), the causes and consequences of a current account imbalance, the main exchange rate systems, how a floating exchange rate is determined by supply and demand, and the effects of a change in the exchange rate on trade, inflation and growth.
The structure of the balance of payments
The current account has four parts: trade in goods (visible trade, such as cars and oil), trade in services (invisible trade, such as tourism and banking), primary income (net interest, profits and dividends from abroad), and secondary income (current transfers with no return, such as aid and remittances). The capital and financial account records flows of investment and assets - foreign direct investment, portfolio investment and changes in reserves. In principle the overall balance of payments balances, because a current account deficit is financed by inflows on the financial account.
Current account imbalances
Exchange rate systems
In a floating system, the currency appreciates (rises) when demand for it increases - for example, higher demand for exports, higher interest rates attracting capital, or speculation - and depreciates (falls) when supply increases or demand falls.
Try this
Q1. State the four components of the current account. [4 marks]
- Cue. Trade in goods, trade in services, primary income (investment income) and secondary income (transfers).
Q2. Explain the difference between a floating and a fixed exchange rate. [3 marks]
- Cue. A floating rate is set by market supply and demand; a fixed rate is pegged by the central bank and defended using reserves.
Q3. Explain why a depreciation might not improve the current account in the short run. [4 marks]
- Cue. In the short run demand for exports and imports is often inelastic (Marshall-Lerner not met), so the J-curve means the balance can worsen before it improves.
Exam-style practice questions
Practice questions written in the style of CCEA exam questions on this dot point, with worked answer explainers. The year tag is the paper they imitate, not the source.
CCEA A2 26 marksExplain the main components of the current account of the balance of payments.Show worked answer →
Worth 6 marks. Markers reward each component named and explained.
Trade in goods (visible trade): exports and imports of physical goods such as cars, oil and food. The difference is the balance of trade in goods.
Trade in services (invisible trade): exports and imports of services such as tourism, banking, insurance and shipping.
Primary income: net income from abroad, mainly interest, profits and dividends earned on overseas investments, plus wages of workers abroad.
Secondary income (current transfers): transfers with no return, such as government contributions to international bodies and remittances.
Conclusion: the current account balance is the sum of these four; a deficit means the country is spending more on imports and outflows than it earns from exports and inflows.
CCEA A2 28 marksExamine the effects of a depreciation of a country's currency on its economy.Show worked answer →
Worth 8 marks. A strong answer traces the effects on trade, inflation and growth, and conditions them on elasticities.
Exports and imports: a depreciation makes exports cheaper in foreign currency and imports dearer in domestic currency, so exports should rise and imports fall, improving the current account.
Marshall-Lerner condition: this improvement only occurs if the combined price elasticities of demand for exports and imports are greater than one. In the short run demand is often inelastic, so the current account may worsen first before improving, the J-curve effect.
Inflation and growth: dearer imports raise the cost of imported raw materials and goods, adding to cost-push inflation, while higher net exports raise aggregate demand and growth.
Judgement: a depreciation can improve competitiveness and the current account and support growth, but at the cost of higher inflation, and only if demand is sufficiently elastic, so the net effect depends on elasticities and the time period.
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Sources & how we know this
- CCEA GCE Economics specification — CCEA (2016)