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 the United States: a Canadian tourist spends $\$2,000$ on vacation in Orlando, a US firm buys German machinery, a Japanese fund buys shares in a US bank, and an American working in Germany sends money to her family in the United States.

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

1. a) Read the equilibrium exchange rate from the graph.
2. b) Explain who demands dollars 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 explain 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 dollars; 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 European 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 European 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 dollars: 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 European 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 dollars 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 vacation in Spain for British tourists and the cost of a vacation 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 dollars 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 Secretary of the Treasury 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 companies' 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.

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.