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?

Currency Appreciation and Depreciation
Related Articles
  1. Financial Advisors

    Tips on Passing the CFA Level I on Your First Attempt

    Obtain valuable tips and helpful study instructions that can help you pass the Level 1 Chartered Financial Analyst exam on your first attempt.
  2. Financial Advisors

    Putting Your CFA Level I on Your Resume

    Learn techniques for emphasizing your CFA Level I status in the Skills and Certifications or Professional Development section of your resume.
  3. Professionals

    Investment Analyst: Career Path and Qualifications

    Learn how to prepare for a career as an investment analyst, and read more about how many professionals in the field progress during their careers.
  4. Professionals

    CAIA Vs. CFA: How Are They Different?

    Find out how the CAIA and CFA designations differ, including which professionals should seek either title based on their career ambitions.
  5. Professionals

    Equity Investments: CFA Level II Tutorial

    Chapter 1: Equity Valuation: Its Applications and Processes Chapter 2: Return Concepts for Equity Valuation Chapter 3: Industry Analysis With Porter's 5 Forces
  6. Professionals

    What To Expect On The CFA Level III Exam

    The Chartered Financial Analyst Level III exam, which is only offered in June, is the last in the series of three tests that CFA candidates must pass.
  7. Professionals

    What To Expect On The CFA Level I Exam

    Becoming a chartered financial analyst requires the passing of three grueling exams covering an array of topics.
  8. Options & Futures

    The Alphabet Soup of Financial Certifications

    We decode the meaning of the many letters that can follow the names of financial professionals.
  9. Professionals

    How to Ace the CFA Level I Exam

    Prepare to ace the CFA Level 1 exam by studying systematically.
  10. Personal Finance

    How To Choose A Financial Advisor

    Many advisors display similar skillsets that can make distinguishing between them difficult. The following guidelines can help you better understand their qualifications and services.
  1. Personal Financial Advisor

    Professionals who help individuals manage their finances by providing ...
  2. CFA Institute

    Formerly known as the Association for Investment Management and ...
  3. Chartered Financial Analyst - CFA

    A professional designation given by the CFA Institute (formerly ...
  4. Security Analyst

    A financial professional who studies various industries and companies, ...
  1. What are the differences between a Chartered Financial Analyst (CFA) and a Certified ...

    The differences between a Chartered Financial Analyst (CFA) and a Certified Financial Planner (CFP) are many, but comes down ... Read Full Answer >>
  2. How do I become a Chartered Financial Analyst (CFA)?

    According to the CFA Institute, a person who holds a CFA charter is not a chartered financial analyst. The CFA Institute ... Read Full Answer >>
  3. What types of positions might a Chartered Financial Analyst (CFA) hold?

    The types of positions that a Chartered Financial Analyst (CFA) is likely to hold include any position that deals with large ... Read Full Answer >>
  4. Who benefits the most from prepaid expenses?

    Prepaid expenses benefit both businesses and individuals. Prepaid expenses are the types of expenses that are bought or paid ... Read Full Answer >>
  5. If I am looking to get an Investment Banking job. What education do employers prefer? ...

    If you are looking specifically for an investment banking position, an MBA may be marginally preferable over the CFA. The ... Read Full Answer >>
  6. Can I still pass the CFA Level I if I do poorly in the ethics section?

    You may still pass the Chartered Financial Analysis (CFA) Level I even if you fare poorly in the ethics section, but don't ... Read Full Answer >>
Hot Definitions
  1. Black Friday

    1. A day of stock market catastrophe. Originally, September 24, 1869, was deemed Black Friday. The crash was sparked by gold ...
  2. Turkey

    Slang for an investment that yields disappointing results or turns out worse than expected. Failed business deals, securities ...
  3. Barefoot Pilgrim

    A slang term for an unsophisticated investor who loses all of his or her wealth by trading equities in the stock market. ...
  4. Quick Ratio

    The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet ...
  5. Black Tuesday

    October 29, 1929, when the DJIA fell 12% - one of the largest one-day drops in stock market history. More than 16 million ...
  6. Black Monday

    October 19, 1987, when the Dow Jones Industrial Average (DJIA) lost almost 22% in a single day. That event marked the beginning ...
Trading Center