How is an exchange rate determined, what records a country's transactions with the rest of the world, and how do they interact?
Exchange rates and the balance of payments: the structure of the balance of payments, floating and fixed exchange rate systems, how a floating rate is determined and what causes appreciation and depreciation, and the effects of a changing exchange rate on the current account.
An SQA Advanced Higher Economics answer on exchange rates and the balance of payments: the structure of the balance of payments, fixed and floating exchange rate systems, how a floating rate is determined and the causes of appreciation and depreciation, and how a changing exchange rate affects the current account, including the Marshall-Lerner condition and the J-curve.
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What this key area is asking
Exchange rates and the balance of payments are the financial side of the global economy. You must explain the structure of the balance of payments, distinguish fixed and floating exchange rate systems, show how a floating rate is determined by currency demand and supply and what causes appreciation and depreciation, and analyse how a changing exchange rate affects the current account, including the Marshall-Lerner condition and the J-curve. These ideas connect trade theory to real macroeconomic outcomes and feature heavily in data-response questions.
The structure of the balance of payments
The accounts must balance overall (any imbalance is matched by reserve and financial flows): a current-account deficit (importing more than exporting in the broadest sense) is financed by a surplus on the financial account, for example by inward investment or borrowing.
Exchange rate systems
- A floating exchange rate is set freely by demand and supply on the foreign exchange market, with no central-bank target. It adjusts automatically to shocks but can be volatile.
- A fixed exchange rate is pegged by the central bank to another currency or to gold, maintained by buying or selling reserves and adjusting interest rates. It gives certainty for trade and investment but removes monetary-policy independence and can come under speculative attack.
- Managed (dirty) floats sit between the two: mostly market-determined, with occasional intervention.
How a floating rate is determined
An appreciation (rise) follows higher demand or lower supply, for example higher interest rates, stronger export demand or positive speculation. A depreciation (fall) follows the reverse, for example lower interest rates, weaker exports, more imports or speculation against the currency.
Effects of a changing exchange rate on the current account
A depreciation makes exports cheaper in foreign currency and imports dearer in domestic currency. The effect on the current account is summed up as WIDEC / SPICED logic but, more rigorously, depends on elasticities:
A depreciation also raises imported inflation (dearer imports feed into prices), which is the main cost to weigh against the competitiveness gain.
Causes and consequences of a deficit
A persistent current-account deficit can reflect strong domestic demand sucking in imports, poor competitiveness, or an overvalued exchange rate. It is financed by the financial account (inward investment or borrowing), which is sustainable if it funds productive investment but risky if it builds up external debt. Policy responses include allowing depreciation, demand restraint (deflationary fiscal or monetary policy to cut imports), or supply-side measures to raise competitiveness, the most durable but slowest cure.
Worked example: will a depreciation help?
Why this matters
Exchange rates and the balance of payments turn the trade theory of the previous topic into measurable macroeconomic outcomes, and they are a favourite for data-response questions because they demand a labelled currency diagram and careful, elasticity-conditioned reasoning. The current account is one of the government's four macroeconomic aims, and exchange-rate movements (and Brexit-related trade shifts) are constantly in the news, making this a strong project area too.
Try this
Q1. State what causes a floating currency to appreciate. [2 marks]
- Cue. A rise in demand for the currency or a fall in its supply, for example higher interest rates, stronger demand for exports, or positive speculation, raising the equilibrium exchange rate.
Q2. State the Marshall-Lerner condition and what it tells us. [2 marks]
- Cue. A depreciation improves the current account only if the sum of the price elasticities of demand for exports and imports exceeds one; otherwise the dearer imports can outweigh the volume gains.
Exam-style practice questions
Practice questions written in the style of SQA exam questions on this dot point, with worked answer explainers. The year tag is the paper they imitate, not the source.
SQA AH (style)10 marksUsing a demand and supply diagram for a currency, explain how a floating exchange rate is determined and what could cause the currency to depreciate.Show worked answer →
Worth 10 marks: the determination (about 5 marks) and the causes of depreciation (about 5 marks).
Determination (about 5 marks). A floating exchange rate is set by the demand for and supply of the currency on the foreign exchange market. Demand for the pound comes from foreigners buying UK exports, investing in the UK, or speculating that the pound will rise; supply comes from UK residents buying imports, investing abroad, or selling pounds. The equilibrium exchange rate is where demand equals supply, with no central-bank intervention.
Causes of depreciation (about 5 marks). A currency depreciates (falls in value) when demand for it falls or supply rises: lower interest rates (less attractive to investors), lower demand for exports, higher demand for imports, falling confidence or speculation against the currency, or a worsening current account. On the diagram this is a leftward shift of demand or a rightward shift of supply, lowering the equilibrium rate. A clear, labelled diagram is expected.
SQA AH (style)12 marksExplain the structure of the balance of payments, and analyse how a depreciation of the currency affects the current account.Show worked answer →
Worth 12 marks: the structure (about 5 marks) and the effect of depreciation (about 7 marks).
Structure (about 5 marks). The balance of payments records all transactions between a country and the rest of the world. The current account covers trade in goods and services, primary income (investment income and wages) and secondary income (transfers); the capital and financial account covers flows of investment and assets. The accounts must balance overall: a current-account deficit is matched by a surplus on the financial account.
Effect of depreciation (about 7 marks). A depreciation makes exports cheaper in foreign currency and imports dearer in domestic currency. This should raise export volumes and cut import volumes, improving the current account, provided demand is sufficiently price elastic (the Marshall-Lerner condition: the sum of the price elasticities of demand for exports and imports exceeds one). In the short run, before volumes adjust, the higher import prices can worsen the current account first, the J-curve effect, before it improves. Evaluation should note that depreciation also raises imported inflation.
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Sources & how we know this
- Advanced Higher Economics Course Specification — SQA (Qualifications Scotland) (2024)