CFA Level 1

Global Economic Analysis - Foreign Exchange Parity Relations


How Exchange Rates are Determined
With a flexible or floating exchange rate system, the value of a currency, as related to other currencies, is determined by the market forces of supply and demand. Suppose that the current exchange rate between the U.S. dollar and British pound is $1.50 = 1 British pound and that Americans then increase their purchases of British goods, while the purchase of U.S. goods by the British stays the same.

We would then expect that at that exchange rate, more U.S. dollars are available than are demanded. The exchange rate of the U.S. dollar would be expected to go down until a new equilibrium is achieved. Shifts in supply and demand for a nation's currency will cause the nation's currency to appreciate or depreciate.

One advantage of a floating exchange rate system is that it reflects existing economic fundamentals. Another advantage is that governments are not forced to defend some particular exchange rate (or range of rates), and are free to adopt fiscal or monetary policies that are independent of the exchange rate.

If you are baffled by exchange rates, or if you are just curious about why some currencies fluctuate while others don't, the following article has the answers:
Floating and Fixed Exchange Rates

The Balance of Payments

The balance of payments measures all financial flows that cross a country's border during a given period of time, typically a quarter or a year. It renders an account of all payments and liabilities to foreigners, and all payments and obligations received from foreigners. For example, when a U.S. company sells a product overseas, that export creates a financial inflow to the U.S., while an American citizen purchasing an imported item creates a negative financial inflow (an outflow). By definition, the sum of all the components of the balance of payments must be equal to zero.

With regard to balance-of-payments accounts, there are three major types of accounts:

1.The Current Account - This type of account records transactions with foreign countries for all current transactions that take place as part of normal business. The current account is specifically made up of:

·Imports and exports, which is also called the trade balance or balance of merchandise trade
·Services, such as accounting and insurance
·Factor payments, such as interest and dividends paid
·Current transfers such as gifts, which do not have an associated exchange factor

2.The Financial Account - Also known as a balance-on-capital account, this account covers changes in ownership of financial and real investments. Parts of this account include:

·Net foreign purchases of long-term domestic assets, such as bonds, stock, real estate and other business assets, netted against similar purchases of foreign assets made by the country's citizens
·Private transfers of financial assets such as cash and other forms of payments made by domestic entities to foreigners in order to settle balances owed to the foreigners, netted with similar transfers of financial assets from foreigner to domestic entities.

3.The Official Reserve Account - This account keeps track of all transactions made by monetary authorities. The sum of the current and financial accounts, which is called the overall balance, should be equal to zero. The central bank can use some of its reserves when the overall balance is negative. If the overall balance is positive, the central bank can choose to add to its reserves.

Look Out!
Know these components well - they are critical to understanding later sections.

The following page will prime you for the topics discussed in this section:
What is the Balance of Payments?


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