Exercises: The balance of payments and the exchange rate

Explain what a country's balance of payments records and name its three main accounts (current, capital, and financial), indicating in one sentence what each one records.

Indicate in which account of the balance of payments each transaction is recorded and whether it is a credit (inflow) or a debit (outflow) for Spain: a British tourist spends $2.000\ \text{€}$ on holiday in Valencia, a Spanish firm buys German machinery, a US fund buys shares in a Spanish bank, and a Spanish emigrant sends money to her family from Germany.

The figure shows the euro market against the dollar: on the vertical axis, the exchange rate (dollars per euro) and, on the horizontal axis, the quantity of euros traded.

1. a) Read the equilibrium exchange rate from the graph.
2. b) Explain who demands euros and who supplies them in this market (think about exporters, importers, and tourists).

The exchange rate of the euro against the dollar is $1,15$ dollars per euro.

1. a) A Spanish tourist changes $200\ \text{€}$ for their trip to New York: how many dollars do they receive?
2. b) Explain in your own words what it means for the euro to "appreciate" against the dollar and how that tourist would notice it.

Explain what the trade balance is and how it differs from the services balance. Spain usually has a deficit in the first (it imports more goods than it exports) and a surplus in the second (thanks to tourism): reason how one can offset the other within the current account.

Explain the difference between a fixed exchange rate and a flexible exchange rate, and give an example of each system (the euro floats against the dollar; some countries peg their currency to the dollar and their central bank intervenes to keep it there).

Explain the difference between foreign direct investment and portfolio investment, both recorded in the financial account. Give an example of each and reason which of the two is usually considered more stable and why.

Central banks hold reserves of foreign currencies (dollars, gold and other assets). Explain what those reserves can be used for: intervening in the currency market to defend the value of the currency, and meeting payments abroad in times of crisis.

The exchange rate of the euro against the dollar is $1,10$ dollars per euro.

1. a) How many dollars do you get when changing $500\ \text{€}$?
2. b) How many euros do you get when changing $770$ dollars?
3. c) If the rate changes to $1,20$ dollars per euro, has the euro appreciated or depreciated? Explain what this change means.

A winery in Briga sells wine to the United States at $10.000$ dollars per container. With the exchange rate at $1,00$ dollar per euro, each container yields $10.000\ \text{€}$; but the rate rises to $1,25$ dollars per euro.

1. a) Calculate how many euros it earns now per container.
2. b) Explain why the appreciation of the euro harms exporters and name two groups that benefit from it instead.

Arta's current account balance in one year: exports of goods, $40.000$ million euros; imports of goods, $55.000$ million; receipts from services (mainly tourism), $25.000$ million; payments for services, $10.000$ million; and net primary and secondary income (rents and transfers), $-2.000$ million.

1. a) Calculate the current account balance and state whether there is a surplus or deficit.
2. b) Explain what this result means and reason how it is financed (what happens in the financial account?).

The exchange rate of the euro against the dollar is $1,08$ dollars per euro.

1. a) A Spanish furniture maker sells a piece of furniture in the United States for $1.080$ dollars: how many euros is that revenue worth?
2. b) A Spanish importer buys a television costing $540$ dollars: how many euros does it pay?
3. c) If the exchange rate moves to $1,20$ dollars per euro, recalculate what it pays for the same television and explain the effect on imports.

Meridia's current account balance in one year, in billions of euros: exports of goods, $90.000$; imports of goods, $110.000$; receipts from services, $45.000$; payments for services, $25.000$; net primary income, $-5.000$; and net transfers, $-3.000$.

1. a) Calculate the current account balance and state whether there is a surplus or deficit.
2. b) Which sub-account partly offsets the deficit in the goods trade balance? Relate it to tourism.
3. c) Explain how that balance is financed (what should we expect in the financial account?).

A Spanish company sells boxes of razor blades in the United States at $50\ \text{€}$ per box.

1. a) How many dollars does each box sell for if the exchange rate is $1,25$ dollars per euro? And if the euro depreciates to $1,05$ dollars per euro?
2. b) Explain why the depreciation improves the company's competitiveness in the American market.
3. c) Reason what happens, at the same time, to the cost in euros of the fuel the company imports and pays for in dollars.

Briga records, in one year, a current account surplus of $10.000$ million euros and a positive balance of $1.000$ million in the capital account.

1. a) Bearing in mind that the sum of the three accounts (current, capital and financial) must be zero except for errors and omissions, what must the balance of the financial account be?
2. b) Interpret that result: does Briga receive foreign capital or, on the contrary, does it accumulate assets in the rest of the world (buying companies, bonds or deposits abroad)?
3. c) Relate the case to a strongly exporting economy such as Germany.

The euro appreciates by $15\ \%$ against the pound sterling over two years.

1. a) Explain how that appreciation affects the cost of a holiday in Spain for British tourists and the cost of a holiday in London for Spanish tourists.
2. b) Reason what net effect can be expected on Spain's services balance.
3. c) Qualify your answer: why does tourism not depend only on price? Mention two other factors.

An analyst states during a televised debate: "A $10\ \%$ depreciation of the euro against the dollar is excellent news for the entire Spanish economy: our exports will soar immediately, and we will correct our trade deficit without any adverse effects".

1. a) Analytically refute this statement by assessing the disparate impact of this depreciation on two companies: a La Rioja winery that produces using local grapes and sells to the United States, versus a Spanish shipping company whose vessels consume fuel priced in dollars and which has acquired its fleet through bank loans denominated in US currency.
2. b) Based on the price elasticity of demand for imports and exports, justify why in the short term Spain's trade balance usually deteriorates after a depreciation instead of improving ("J-curve" effect).
3. c) Predict the effect of this depreciation on the domestic general price level (cost-push or imported inflation) and explain what interest rate policy dilemma the European Central Bank would face if the depreciation coincides with GDP stagnation in the eurozone.

To control rising inflation, the central bank of Briga raises its interest rates to $5\ \%$, while its trading partners keep theirs at $1,5\ \%$. This differential triggers a heavy inflow of foreign financial capital into Brigan public debt.

1. a) Model the functioning of the foreign exchange market: predict how this flow affects the supply and demand curves for Briga's currency and deduce the resulting change in its nominal exchange rate.
2. b) Analyze the transmission of this exchange rate change to two key sectors: the Brigan automobile industry (which sells $60\ \%$ of its output abroad) and the domestic hospitality sector catering to foreign travelers.
3. c) Justify why Briga's Minister of Economy warns that a "too strong" currency can cause deindustrialization and unemployment, even though it makes imports of consumer goods and energy cheaper.

The Government of Meridia maintains that an ongoing current account deficit of $4\ \%$ of GDP over a decade is not a cause for concern, arguing that it "reflects the country's attractiveness in drawing funds from the rest of the world". However, the net international investment position (net external debt) already exceeds $75\ \%$ of its GDP.

1. a) Use the macroeconomic identity of the external balance ($Saving - Investment = Current\ account\ balance$) to refute the official view and explain what this structural deficit reveals about public and private saving patterns in Meridia.
2. b) Predict what financial and real consequences the country would suffer if an episode of global risk aversion is triggered and international markets abruptly cut off external financing (sudden stop).
3. c) Design a combination of two economic policy measures (one demand-side fiscal measure and one supply-side structural measure) to balance the external accounts in the medium term, justifying the adjustment costs and sacrifices that each will impose on the population.

Meridia imports $70\ \%$ of the energy it consumes and pays for it in dollars. In one year, the euro depreciates against the dollar from $1,20$ to $1,05$ dollars per euro.

1. a) Calculate how an annual energy bill of $12.000$ million dollars changes in euros.
2. b) Explain the knock-on effect of that depreciation on firms' costs and on the country's inflation.
3. c) Reason why, in a country so dependent on imported energy, a depreciation can improve exports and, at the same time, worsen the trade balance for a while.

Arta's public treasury is running a high fiscal deficit and finances its budgets by issuing sovereign bonds. Currently, $60\ \%$ of this debt is held by non-resident investment funds. Prompted by rumors of budget instability, credit rating agencies downgrade the country's creditworthiness.

1. a) Explain how the panic selling of bonds by non-residents to repatriate their capital is recorded in Arta's balance of payments (sub-account, column, and effect on the net creditor or debtor position).
2. b) Predict the immediate impact of this mass sell-off on the secondary bond market: justify the inverse relationship between the market price of bonds and their effective interest rate (yield), and deduce how this affects the sovereign risk premium.
3. c) Refute the statement of a public official who claims that "public debt is just an internal figure and it makes no difference whether it is held by local or foreign savers." Present two specific risks (capital flight and currency vulnerability or economic sovereignty) associated with high external debt.

Following the outbreak of a deep recession, a country with a central bank and a sovereign currency depreciates its currency by $20\ \%$, while a Eurozone member state, faced with a shock of similar magnitude, is forced to undertake an "internal devaluation" process.

1. a) Compare the transmission mechanisms of both processes: predict which macroeconomic variables bear the immediate adjustment in each country (relative external prices versus nominal wages, domestic employment, and aggregate demand).
2. b) Justify why internal devaluation often worsens the indebtedness of domestic households and businesses ("debt deflation" phenomenon), whereas currency depreciation spreads the loss of purchasing power through an across-the-board increase in import prices.
3. c) Based on the trade-off between exchange rate policy autonomy and economic integration, critically assess what structural conditions (such as labor mobility or the existence of a common budget with fiscal transfers) a monetary union would require to prevent peripheral countries from enduring such painful adjustments.

The economic authorities of Briga proudly claim that their current account surplus has continuously exceeded $5\ \%$ of GDP over the last fifteen years, asserting that this is unequivocal proof of the success of their export-led model and advising all their trading partners to emulate their wage restraint and austerity policies.

1. a) Using the double-entry bookkeeping principle of the balance of payments ($CA + KA + FA = 0$, with $FA$ measured as the net capital inflow) and the national income identity, interpret the necessary counterpart in Briga's financial account and refute the mathematical possibility of all trading partners simultaneously adopting a similar mercantilist strategy.
2. b) Justify why this chronic surplus may be a symptom of concerning domestic imbalances in Briga (in relation to household underconsumption, insufficient public investment, and accumulated savings not reinvested in the domestic economy).
3. c) If Briga were using its own floating currency instead of sharing a common currency with its deficit-running neighbors, predict how this imbalance would tend to correct itself through the exchange rate mechanism, and explain why the lack of exchange rate adjustment fuels geopolitical tensions among partners.

International financial markets anticipate severe instability in Arta and trigger a massive sell-off of debt securities and listed equities, converting their proceeds into hard currencies to exit the country. Arta operates under a fixed exchange rate regime pegged to the benchmark currency.

1. a) Explain the pressure experienced by the domestic foreign exchange market and detail how this capital drain is reflected in the financial account's sub-balances and in the central bank's foreign exchange reserve position.
2. b) Evaluate the two orthodox intervention alternatives available to the central bank to keep the exchange rate pegged in the face of this speculative attack, identifying the critical operational limit of the first and the severe recessionary cost to the real economy of the second.
3. c) Predict the scenario in which the central bank is forced to give in and allow an abrupt devaluation: justify how this outcome would impact the solvency of Arta's banking system and corporate sector if they held liabilities denominated in foreign currency and assets in domestic currency (currency mismatch).

Unit challenge. Imagine that you are an economic analyst and you must advise a Spanish SME planning to import electronic components from the US and expand its sales outside the EU. Design a one-page executive report following these phases:

1. Real data: Go to the Banco de España website (bde.es) and note down the current official EUR/USD exchange rate and the latest published trade balance.

2. Exchange rate and balance: Calculate the cost in euros of importing goods worth $10.000$ USD today compared to a scenario where the euro experiences a $5,0\,\%$ depreciation. Explain which sub-balance the purchase is recorded in and whether this depreciation favors or harms its future exports.

3. Money and financing: The SME applies for a bank loan for the purchase. Explain how banks create bank money through the reserve ratio when granting the loan and how an ECB interest rate hike would affect its decision.

4. Proposal: Summarize your conclusions in a table and argue whether the firm should take on debt and import now.

Evaluation criteria:

• Accurate extraction of real data from the Banco de España and application of the exchange rate.

• Correct classification in the balance of payments and understanding of currency effects.

• Conceptual rigor when explaining money creation and interest rates.

• Analytical coherence and quality of argumentation in the final report.