Chapter Twenty-Two: The Balance of Payments and Exchange Rates

Table of Contents

1. Chapter Twenty-Two: The Balance of Payments and Exchange Rates

Chapter Twenty-Two: The Balance of Payments and Exchange Rates

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Question 1 Which of the following statements about the balance of payments is not correct? a) Payments that lead to demands for foreign currency are measured as debits while payments that lead to supplies of foreign exchange are measured as credits. b) The current account balance plus the capital and financial account balances add up to zero. c) A current account deficit is a sign of a weak economy while a current account surplus is a sign of a strong economy. d) A current account surplus implies that domestic residents are increasing their net foreign assets. e) The capital and financial accounts of the balance of payments measure the net change in ownership of foreign and domestic assets by domestic and overseas residents. Correct.Incorrect. The answer is c) A current account deficit is a sign of a weak economy while a current account surplus is a sign of a strong economy.Your answer has been saved.

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Question 2 Which of the following statements about the balance of payments is not correct? a) The current account balance is made up of the balance of trade in goods and services, net overseas income of employees, investment income and net transfers. b) The capital and financial accounts consist of cross-border transactions is assets and liabilities. c) Ignoring measurement errors, a current account surplus must be matched by a deficit on the capital and financial account. d) A change in official reserves does not appear in the balance of payments accounts. e) A capital gain on net overseas assets would not appear in the balance of payments accounts. Correct.Incorrect. The answer is d) A change in official reserves does not appear in the balance of payments accounts.Your answer has been saved.

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Question 3 Trade in 'invisibles' relates to: a) Illegal trade in drugs. b) Trade in goods that fly rather than coming by ship. c) Trade in shares in companies where the shares are registered overseas. d) Trade in services, such as insurance and banking. e) Trade in financial assets. Correct.Incorrect. The answer is d) Trade in services, such as insurance and banking.Your answer has been saved.

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Question 4 'Direct investment' in the context of balance of payments relates to: a) Lending to a foreign government. b) Lending to a government by the IMF. c) Aid to a developing country. d) Investment in shares of overseas companies. e) The building of a new production facility overseas or the takeover of a foreign company. Correct.Incorrect. The answer is e) The building of a new production facility overseas or the takeover of a foreign company.Your answer has been saved.

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Question 5 'Portfolio investment' in the context of balance of payments relates to: a) Purchase of overseas real estate. b) Takeover of foreign companies. c) Purchase of shares in a foreign company. d) Interest income on overseas assets. e) Transfers of money from domestic residents to their relatives overseas. Correct.Incorrect. The answer is c) Purchase of shares in a foreign company.Your answer has been saved.

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Question 6 If exchange rates are determined according to purchasing power parity (PPP) which of the following will not be true? a) The prices of goods will be the same in all countries when converted at the going exchange rate. b) The rate of exchange rate change between any two currencies will be equal to the inflation differential between the two countries concerned. c) The country with the higher inflation rate will have a depreciating currency. d) Overshooting of exchange rates will occur in response to a monetary shock. e) If any two countries both have zero inflation, their bilateral exchange rate will be constant. Correct.Incorrect. The answer is d) Overshooting of exchange rates will occur in response to a monetary shock.Your answer has been saved.

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Question 7 A government that wishes to operate a pegged exchange rate must: a) Set the currency price by law. b) Use its foreign exchange reserves to intervene in the foreign exchange market, such that foreign currency is sold when the domestic currency is in excess supply and foreign currency is bought when domestic currency is in excess demand. c) Use its foreign exchange reserves to intervene in the foreign exchange market, such that foreign currency is bought when the domestic currency is in excess supply and foreign currency is sold when domestic currency is in excess demand. d) Have an independent central bank. e) Keep its current account in balance at all times. Correct.Incorrect. The answer is b) Use its foreign exchange reserves to intervene in the foreign exchange market, such that foreign currency is sold when the domestic currency is in excess supply and foreign currency is bought when domestic currency is in excess demand.Your answer has been saved.

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Question 8 In a floating exchange rate system: a) The current account deficit of the balance of payments must always be zero. b) The government must hold no foreign exchange reserves. c) The exchange rate must not overshoot. d) The exchange rate will adjust to keep the current account surplus (or deficit) just equal to the capital and financial account deficit (or surplus). e) The home country must have more foreign assets than liabilities. Correct.Incorrect. The answer is d) The exchange rate will adjust to keep the current account surplus (or deficit) just equal to the capital and financial account deficit (or surplus).Your answer has been saved.

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Question 9 Why, in theory, should the current account and capital and financial account balances sum to zero? Hint: re-read 'The meaning of payments balances and imbalances' pp 500-01. If you need to remind yourself of the definitions of the current account and capital account, you may wish to also read 'Balance of payments accounts' pp 498-500.

10	Question 10 Who 'gains' and who 'loses' if a country is running a balance of trade surplus? Hint: re-read 'Does the balance of payments matter?' pp 501-03. Also consider Box 22.1: Trade and modern mercantilism (p501).

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Question 11 Make a list of the factors that will influence (a) the demand for pounds and (b) the supply of pounds in the market for foreign exchange. Hint: re-read 'Demand for and supply of pounds', pp504-06. You should also ensure that you understand why the demand and supply curves for a currency (in terms of another currency) are downwards sloping and upward sloping respectively.

12	Question 12 Draw a diagram to show why a system of fixed exchange rates involves keeping the exchange rate of a currency within a band either side of a given rate. Hint: re-read 'Fixed exchange rates' pp507-08. You should compare your diagram with Figure 22.2 (p507).

13	Question 13 What will happen if a government is operating within a system of fixed exchange rates but it has over-valued its own currency? Hint: re-read 'Fixed exchange rates' pp507-08. .

14	Question 14 What factors will cause exchange rate fluctuations within a flexible regime of exchange rates? Hint: re-read 'Changes in exchange rates' pp508-10.

15	Question 15 What is meant by the term 'Purchasing Power Parity'? What will happen if country A's price level rises faster than that of country B? Hint: re-read 'Purchasing power parity' pp510-11.

16	Question 16 Does the volatility of exchange rates mean that foreign exchange markets are inefficient? Hint: re-read 'Box 22.4: News and the exchange rate' p513.

17	Question 17 What are the implications for the rate of exchange between currencies if countries' interest rates differ? Hint: re-read 'Exchange rate overshooting' pp511-15.

18	Question 18 Draw a flow chart to show how the 1990-92 recession in the UK was made worse by an over-valued exchange rate. Hint: re-read 'Implications of overshooting' pp514-15.