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 Mexico: a British tourist spends $\$40\,000$ on vacation in Cancún, a Mexican firm buys German machinery, a US fund buys shares in a Mexican bank, and a Mexican emigrant sends money to her family from Germany.

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

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

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 Valle de Guadalupe 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.

Mexico's current account balance in one year: exports of goods, $800\,000$ million pesos; imports of goods, $1\,100\,000$ million; receipts from services (mainly tourism), $500\,000$ million; payments for services, $200\,000$ million; and net primary and secondary income (rents and transfers), $-40\,000$ 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 how it is financed (what happens in the financial account?).

An analyst states during a televised debate: "A $10\ \%$ depreciation of the pesos 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.