IB Economics Topic 4.6.4 Relationship Between the Current Account and the Exchange Rate Revision Notes (HL)

IB Economics Topic 4.6.4 Relationship Between the Current Account and the Exchange Rate Revision Notes (HL) | RevisionDojo

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The current account has a different relationship to the different types of exchange rate systems, impacting how the exchange rate itself shifts.

We will bring up the balance of payments example table for Country A from 4.6.2 Components of Balance of Payments.

Line	Components	Figures (Millions of dollars)
1	Current Account
2	Exports of Goods	+25
3	Imports of Goods	-40
4	Balance of Trade in Goods (Line 2 - 3)	-25
5	Exports of Services	+15
6	Imports of Services	-5
7	Balance of Trade in Services (Line 5 - 6)	+10
8	Balance of Trade in Goods & Services (Line 4 + 7)	-15
9	Income (inflows - outflows)	-4
10	Current Transfers (inflows - outflows)	+1
11	Balance on Current Account (Line 8 + 9 + 10)	-18

12	Capital Account
13	Capital Transfers (inflows - outflows)	+1.1
14	Transactions non-financial assets (inflows - outflows)	+0.9
15	Balance on Capital Account (Line 13 + 14)	+2

16	Financial Account
17	Foreign Direct Investment (inflows - outflows) (FDI; inflows - outflows)	+18
18	Portfolio Investment (inflows - outflows)	-3
19	Reserve Assets (official reserves)	+2
20	Official Borrowing	-1
21	Balance of Financial Account (Line 17 + 18 + 19 + 20)	+16

22	Balance (Line 11 + 15 + 21)	0

The current account and exchange rates

Floating Exchange Rate System

At equilibrium

Recall, under a floating exchanging rate system, the market forces (demand and supply) solely determines the equilibrium exchange rate, where there is no intervention from the government or central bank.
For our example with Country A, this would mean the reserve assets would be 0, as there would be no buying or selling of currencies.

Observing the Figure A above, the initial exchange rate is at $0.34 \text{ ecocoins } = 1 \text{ dollar}$, where the supply and demand of dollars are equal (equilibrium).
Hence, the sum of credits is equal to the sum of debits in US balance of payments.
Meanwhile observing Figure B, there is equilibrium at the same exchange rate of $3 \text{ dollars } = 1 \text{ ecocoin}$, where sum of credits is equal to the sum of debits.

Change in equilibrium

The demand for the dollar increases from $D_1$ to $D_2$ if Econland's demand for imports from the US increases.
Looking back at the initial equilibrium, now there is an excess demand for dollars, which can be calculated by the horizontal distance between the initial equilibrium exchange rate A and point B.

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The current account has a different relationship to the different types of exchange rate systems, impacting how the exchange rate itself shifts.

We will bring up the balance of payments example table for Country A from 4.6.2 Components of Balance of Payments.

Line	Components	Figures (Millions of dollars)
1	Current Account
2	Exports of Goods	+25
3	Imports of Goods	-40
4	Balance of Trade in Goods (Line 2 - 3)	-25
5	Exports of Services	+15
6	Imports of Services	-5
7	Balance of Trade in Services (Line 5 - 6)	+10
8	Balance of Trade in Goods & Services (Line 4 + 7)	-15
9	Income (inflows - outflows)	-4
10	Current Transfers (inflows - outflows)	+1
11	Balance on Current Account (Line 8 + 9 + 10)	-18

12	Capital Account
13	Capital Transfers (inflows - outflows)	+1.1
14	Transactions non-financial assets (inflows - outflows)	+0.9
15	Balance on Capital Account (Line 13 + 14)	+2

16	Financial Account
17	Foreign Direct Investment (inflows - outflows) (FDI; inflows - outflows)	+18
18	Portfolio Investment (inflows - outflows)	-3
19	Reserve Assets (official reserves)	+2
20	Official Borrowing	-1
21	Balance of Financial Account (Line 17 + 18 + 19 + 20)	+16

22	Balance (Line 11 + 15 + 21)	0

The current account and exchange rates

Floating Exchange Rate System

At equilibrium

Recall, under a floating exchanging rate system, the market forces (demand and supply) solely determines the equilibrium exchange rate, where there is no intervention from the government or central bank.
For our example with Country A, this would mean the reserve assets would be 0, as there would be no buying or selling of currencies.

Observing the Figure A above, the initial exchange rate is at $0.34 \text{ ecocoins } = 1 \text{ dollar}$, where the supply and demand of dollars are equal (equilibrium).
Hence, the sum of credits is equal to the sum of debits in US balance of payments.
Meanwhile observing Figure B, there is equilibrium at the same exchange rate of $3 \text{ dollars } = 1 \text{ ecocoin}$, where sum of credits is equal to the sum of debits.

Change in equilibrium

The demand for the dollar increases from $D_1$ to $D_2$ if Econland's demand for imports from the US increases.
Looking back at the initial equilibrium, now there is an excess demand for dollars, which can be calculated by the horizontal distance between the initial equilibrium exchange rate A and point B.

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Duis aute irure dolor in reprehenderit

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Tip

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Duis aute irure dolor in reprehenderit in voluptate velit esse cillum.

1. Introduction to Economics2 subtopics

2. Microeconomics12 subtopics

3. Macroeconomics7 subtopics

4. The Global Economy10 subtopics

IB Economics 4.6.4 Relationship Between the Current Account and the Exchange Rate Notes

1. Introduction to Economics2 subtopics

2. Microeconomics12 subtopics

3. Macroeconomics7 subtopics

4. The Global Economy10 subtopics

The current account and exchange rates

Floating Exchange Rate System

At equilibrium

Change in equilibrium

anim nostrud sit dolore minim proident quis fugiat velit et eiusmod nulla quis nulla mollit dolor sunt culpa aliqua

Duis aute irure dolor in reprehenderit

Excepteur sint occaecat cupidatat non proident

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The current account and exchange rates

Floating Exchange Rate System

At equilibrium

Change in equilibrium

anim nostrud sit dolore minim proident quis fugiat velit et eiusmod nulla quis nulla mollit dolor sunt culpa aliqua

Duis aute irure dolor in reprehenderit

Excepteur sint occaecat cupidatat non proident

Unlock the rest of this chapter with a free account