PastPaperHero | Monetary fiscal and FX - Exchange rates and balance of payments

Learning Outcomes

This article explains key exchange rate and balance of payments concepts for CFA Level 1 candidates, including:

Distinguishing nominal, real, direct, and indirect exchange rate quotations and correctly identifying the base and price currency in any quote.
Computing currency appreciations and depreciations, cross‑rates, and simple real exchange rate adjustments using inflation differentials.
Comparing major FX regimes—freely floating, managed float, fixed/pegged, currency boards, dollarization, and monetary unions—and evaluating their implications for monetary policy autonomy and external stability.
Describing the structure and accounting identity of the balance of payments, with emphasis on current, capital, financial accounts, and official reserve transactions.
Interpreting how current account surpluses or deficits must be financed through capital and financial flows, reserve accumulation or depletion, or statistical discrepancies.
Assessing the interaction between fiscal and monetary policy, exchange rate arrangements, and international capital mobility within the framework of the impossible trinity.
Evaluating the mechanics and typical consequences of FX intervention and capital controls for currency stability, crisis management, and longer‑term investment conditions.
Applying these tools and relationships to simplified numerical examples and qualitative scenarios similar in style and difficulty to the CFA Level 1 exam.
Explaining how exchange rate movements affect the trade balance using the elasticities (Marshall–Lerner) approach and recognizing the J‑curve effect.
Relating a country’s current account balance to changes in its net foreign asset position and to domestic saving–investment imbalances.
Distinguishing between depreciation/appreciation (under flexible rates) and devaluation/revaluation (under fixed or pegged regimes).

CFA Level 1 Syllabus

For the CFA Level 1 exam, you are required to understand exchange rates and the balance of payments, including their interplay with fiscal and monetary policy, with a focus on the following syllabus points:

Identify and describe different exchange rate regimes and evaluate their impacts on policy autonomy and external stability.
Calculate and interpret nominal, real, and effective exchange rates.
Distinguish between direct and indirect exchange rate quotes and compute currency cross‑rates.
Define the structure, components, and identity of the balance of payments (BOP), including current, capital, financial, and official reserve accounts.
Analyze the relationship between current account and capital/financial account flows and the required financing of external imbalances.
Explain how exchange rate changes influence international trade flows, the trade balance, and the current account (elasticities and J‑curve).
Assess the effects of capital controls, FX interventions, and international capital flows on exchange rates and macroeconomic stability.
Link current account balances to national saving and investment behavior and to changes in a country’s net international investment position.
Recognize the policy constraints implied by the impossible trinity for countries with different combinations of FX regimes and capital mobility.

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

Under a fixed exchange rate regime with free capital mobility, which statement about monetary policy is most accurate?
1. The central bank can set interest rates independently of global conditions.
2. Monetary policy is largely subordinated to defending the peg.
3. Fiscal policy becomes ineffective for influencing aggregate demand.
4. The country will automatically have a balanced current account.
A country has a current account deficit of USD 40 billion. Its capital and financial account shows a surplus of USD 32 billion. Which is most likely true?
1. Official reserves increase by USD 8 billion.
2. Official reserves decrease by USD 8 billion.
3. The exchange rate must appreciate to restore balance.
4. The country’s net foreign asset position is unchanged.
All else equal, an unexpected increase in domestic interest rates in a freely floating regime is most likely to:
1. Depreciate the domestic currency because imports rise.
2. Appreciate the domestic currency due to capital inflows.
3. Depreciate the domestic currency due to capital outflows.
4. Leave the exchange rate unchanged if inflation is stable.
Which of the following is a key risk of adopting a strict currency board arrangement?
1. Excessive exchange rate volatility.
2. Frequent competitive devaluations.
3. Loss of lender‑of‑last‑resort and monetary policy flexibility.
4. Inability to participate in international trade.
Which of the following balance of payments transactions is recorded as a credit for Country X?
1. A resident of Country X buys foreign government bonds.
2. The central bank of Country X increases its holdings of foreign reserves.
3. A foreign company purchases a factory in Country X.
4. Residents of Country X import goods paid for with foreign currency deposits held abroad.

Introduction

Understanding exchange rates and the balance of payments is essential for CFA Level 1. These topics connect monetary and fiscal policy, global capital flows, and a nation’s currency. Exchange rates measure the value of one currency in terms of another—directly affecting trade, investment, inflation behavior, and external stability. The balance of payments tracks all cross‑border economic transactions, highlighting the need for every current account deficit to be financed, usually through capital inflows or reserve drawdowns. Policy choices, capital controls, and currency interventions shape a country’s exposure to volatility and macroeconomic risk.

From a macroeconomic standpoint:

The exchange rate is a key relative price in the economy: the price of foreign goods and assets in terms of domestic currency.
The balance of payments is the external accounts of an economy: it links domestic saving–investment behavior and government policies to international borrowing, lending, and asset accumulation.

Key Term: Exchange rate
The price of one currency expressed in terms of another; can refer to the nominal market rate or the real (inflation‑adjusted) rate.

Key Term: Nominal exchange rate
The observed market price at which two currencies trade; not adjusted for inflation.

Key Term: Real exchange rate
The nominal exchange rate adjusted by relative price levels between countries—indicates changes in relative purchasing power and competitiveness.

Key Term: Direct quote
An exchange rate expressed as units of the domestic currency per one unit of foreign currency.

Key Term: Indirect quote
An exchange rate expressed as units of foreign currency per one unit of the domestic currency.

Key Term: Base currency
The first currency in a quotation; the currency being priced.

Key Term: Price currency
The second currency in a quotation; the currency in which the base currency’s price is expressed.

Key Term: Appreciation
An increase in the value of a currency relative to another (it buys more of the other currency).

Key Term: Depreciation
A decrease in the value of a currency relative to another (it buys less of the other currency).

Key Term: Spot exchange rate
The current exchange rate for immediate (typically two‑business‑day) delivery of one currency against another in the FX market.

Key Term: Forward exchange rate
The agreed exchange rate today for exchanging currencies at a specified future date; used to hedge or speculate on future exchange rate movements.

Key Term: Balance of payments
Accounting record of all economic transactions between a country’s residents and the rest of the world over a specific period.

Key Term: Current account
Section of the balance of payments covering trade in goods and services, net income (investment income, wages), and current transfers.

Key Term: Capital account
Section of the balance of payments that records capital transfers and transactions in non‑produced, non‑financial assets (such as debt forgiveness or the sale of certain intangibles).

Key Term: Financial account
Section of the balance of payments that records cross‑border investment flows, including direct investment, portfolio investment, other investments (loans, deposits), and changes in reserve assets.

Key Term: Statistical discrepancy (errors and omissions)
The balancing item in the balance of payments that reconciles measured credits and debits when data from different sources do not match exactly.

Key Term: FX regime
The country's policy framework for determining or managing the value of the domestic currency in the foreign exchange market.

Key Term: Capital controls
Government‑imposed restrictions on cross‑border movement of financial capital (inflows or outflows).

Foreign exchange (FX) markets can quote exchange rates using either a direct or an indirect convention, depending on the country and market practice. It is critical to identify which currency is considered domestic in the question and then determine which is the base and which is the price currency.

FX markets operate mainly in spot and forward segments, with daily global turnover in the trillions of US dollars. The spot market determines the current nominal exchange rate, while the forward market allows economic agents to lock in future exchange rates, often to hedge transaction exposure. For Level 1, you are not required to derive forward pricing formulas in this reading, but you should understand that:

Forward rates are set now but apply to a transaction in the future.
Forwards can be used to eliminate exchange rate risk on known future foreign‑currency receipts or payments.
Forward rates are linked to interest rate differentials through no‑arbitrage conditions (covered interest parity), which is treated in more detail in the dedicated currency exchange rates reading.

Understanding this notation and the basic FX instruments is foundational for correctly computing cross‑rates, percentage appreciations/depreciations, and real exchange rates, which are all examinable at Level 1.

Exchange Rate Concepts

An exchange rate is always quoted as two currencies:

Example notation: EUR/USD = 1.10
- The base currency is EUR (first in the pair).
- The price currency is USD (second in the pair).

In this example, 1 EUR costs 1.10 USD.

From the viewpoint of a US resident:

A direct quote would be USD per unit of foreign currency, such as USD/EUR = 1.10 (domestic currency USD per EUR).
An indirect quote would be foreign currency per USD, such as EUR/USD = 0.91 (EUR per USD).

Questions will typically tell you which country’s viewpoint to adopt. Always anchor “domestic” to that country before classifying a quote as direct or indirect.

Practical tip: identify domestic, base, and price currency

In exam questions:

First, identify which country is treated as “domestic” (it is often stated explicitly).
Second, identify the base currency (first in the pair) and price currency (second in the pair).
Third, classify the quote as:
- Direct if it is domestic currency per unit of foreign currency.
- Indirect if it is foreign currency per unit of domestic currency.

Many common mistakes on exam questions arise from mixing up these three steps.

In market practice, there are also conventions such as:

Many currencies are quoted in “American terms” (USD per foreign currency).
Others are quoted in “European terms” (foreign currency per USD).

For the exam, always rely on the explicit wording rather than market slang. Carefully read whether the quote is “USD per EUR” or “EUR per USD” and treat the first currency as the base.

Key Term: Nominal effective exchange rate (NEER)
A trade‑weighted index of a currency’s nominal value against the currencies of its main trading partners.

Key Term: Real effective exchange rate (REER)
A trade‑weighted index of a currency’s real value (nominal exchange rate adjusted for relative price levels) against the currencies of its main trading partners.

Instead of watching dozens of bilateral rates, policymakers and analysts often track NEER and REER indices to summarize the overall strength or weakness of a currency against a basket of trading‑partner currencies.

Measuring Appreciation and Depreciation

Suppose EUR/USD changes from 1.10 to 1.20.

In EUR/USD terms (USD price of 1 EUR):
- The EUR has appreciated against the USD (it now buys more USD).
- The USD has depreciated against the EUR.

The percentage change of the base currency is:

\%\Delta_{\text{EUR}} = \frac{\text{New rate} - \text{Old rate}}{\text{Old rate}} = \frac{1.20 - 1.10}{1.10} \approx 9.1\% \ \text{appreciation}.

The percentage change of the price currency is equal in magnitude but with opposite sign when measured using the inverted quote:

Initially, USD/EUR = 1 / 1.10 ≈ 0.9091.
Finally, USD/EUR = 1 / 1.20 ≈ 0.8333.

Percentage change of USD (now the base currency) is:

\%\Delta_{\text{USD}} = \frac{0.8333 - 0.9091}{0.9091} \approx -8.3\% \ \text{depreciation}.

The difference between 9.1% and 8.3% arises from compounding (multiplicative inversion). In the exam, you usually compute the percentage change for the base currency as given.

A useful shortcut:

If the quote is DC/FC (domestic per foreign) and the number rises, the foreign currency appreciates and the domestic currency depreciates.
If the quote is DC/FC and the number falls, the foreign currency depreciates and the domestic currency appreciates.

Always state clearly which currency you are analyzing.

Worked Example 1.1

A country’s currency moves from 0.80 USD/LCU (USD per local currency unit) to 0.60 USD/LCU. From the local country’s viewpoint, by what percentage has its currency changed against the USD?

Answer:
The quote is USD per LCU, so the LCU is the base currency.
Percentage change = (0.60 − 0.80) / 0.80 = −0.20 / 0.80 = −25%.
The local currency has depreciated by 25% against the USD.

You can check the USD’s change using the inverse quotes:

- Initially: LCU/USD = 1 / 0.80 = 1.25. - Finally: LCU/USD = 1 / 0.60 ≈ 1.6667.

For small changes (say 1–2%), the percentage appreciation of one currency is approximately the same magnitude as the percentage depreciation of the other. For very large moves (as here, 25–30%), the difference between the two percentages becomes more noticeable.

Nominal and Real Exchange Rates

Most exchange rates you see (spot and forward) are nominal. However, to understand changes in international competitiveness, you must adjust for relative price levels (inflation). This gives the real exchange rate.

Conceptually:

The nominal rate tells you how many units of one currency exchange for another today.
The real rate adjusts the nominal rate by relative price levels to show how many units of foreign goods you can buy compared with domestic goods.

If the nominal exchange rate is quoted as DC/FC (domestic currency per unit of foreign currency), a common form of the real exchange rate is:

\text{Real exchange rate} = S \times \frac{P_F}{P_D}

where:

$S$ = nominal exchange rate (DC per 1 FC),
$P_F$ = foreign price level,
$P_D$ = domestic price level.

Interpretation:

A higher real exchange rate (real appreciation) means foreign goods become cheaper relative to domestic goods; domestic producers are less competitive.
A lower real exchange rate (real depreciation) means foreign goods become more expensive relative to domestic goods; domestic producers are more competitive.

A simple numerical illustration:

Suppose the nominal rate is 120 JPY/USD (domestic: Japan, foreign: US), so $S = 120$ JPY per USD.
The Japanese price level index is $P_D = 100$ and the US price level index is $P_F = 125$ .
The real exchange rate is: $\text{Real} = 120 \times \frac{125}{100} = 150.$ Compared with a benchmark of, say, 120, the real rate of 150 indicates a real depreciation of the JPY (US goods are more expensive in yen terms), improving Japanese exporters’ competitiveness.

For a domestic investor, a simple approximate formula for the percentage change in the real exchange rate is:

\%\Delta \text{Real} \approx \%\Delta \text{Nominal} - (\pi_{\text{domestic}} - \pi_{\text{foreign}}),

where $\pi$ denotes inflation.

If the domestic currency’s nominal value falls (depreciates), but domestic inflation is much higher than foreign inflation, domestic goods may still become relatively more expensive in real terms.

Key Term: Purchasing power parity (PPP)
The theory that identical goods should cost the same in different countries when prices are expressed in a common currency, under free trade and no transaction costs. In its relative form, PPP links expected exchange rate changes to inflation differentials.

Relative PPP suggests that, over the long run:

\%\Delta S \approx \pi_{\text{domestic}} - \pi_{\text{foreign}},

when $S$ is the domestic‑currency price of foreign currency. A country with higher inflation than its trading partners should see its currency depreciate in nominal terms over time.

PPP is a long‑run relationship. In the short run, exchange rates can deviate substantially from PPP due to capital flows, changes in interest rates, risk premia, and speculative forces. For Level 1, you should understand PPP qualitatively and be able to use simple percentage approximations.

Worked Example 1.2

A domestic currency depreciates 20% against trading partners in nominal terms, but inflation in the domestic country is 15% higher than abroad. What happens to the real exchange rate and competitiveness?

Answer:
Approximate real change ≈ 20% nominal depreciation − 15% inflation differential = +5%.
The real exchange rate appreciates by about 5%, meaning domestic goods become relatively more expensive than foreign goods despite the nominal depreciation. Domestic competitiveness worsens.

Real exchange rate concepts can also be extended to a real effective exchange rate (REER), which is a trade‑weighted average of bilateral real rates.

A higher REER generally means a real appreciation (lower external competitiveness).
A lower REER generally means a real depreciation (higher external competitiveness).

A nominal effective exchange rate (NEER) is analogous but uses nominal rates without adjusting for inflation. NEER and REER indices are widely used in practice to summarize a country’s overall currency strength against multiple partners.

Depreciation/appreciation vs devaluation/revaluation

Under flexible (floating) exchange rates, we usually speak of:

Depreciation: a market‑driven fall in the value of a currency.
Appreciation: a market‑driven rise in the value of a currency.

Under a fixed or pegged regime, the authorities announce and maintain a parity. A discrete change in that official parity is called:

Devaluation: an official reduction in the peg; the domestic currency is made cheaper relative to the anchor.
Revaluation: an official increase in the peg; the domestic currency is made more expensive relative to the anchor.

In both cases, the economic effects are similar (cheaper or more expensive currency), but the terminology reflects whether the change is market‑driven (depreciation/appreciation) or policy‑driven (devaluation/revaluation).

Exchange Rate Regimes

Countries choose among various FX regimes, each with distinct implications for monetary policy and external stability.

Freely floating: Market forces primarily determine the exchange rate; central bank intervention is rare and not rule‑based.
Managed float (dirty float): Market forces dominate, but the central bank intervenes episodically to smooth volatility or lean against undesirable moves, without a fixed target.
Fixed/Pegged: The central bank targets a specific parity (for example, 7.80 HKD/USD) or a narrow band around it, and actively buys/sells its own currency and reserves to maintain the peg.
Currency board/dollarization/monetary union: Extreme forms of fixity or adoption of a foreign/common currency; monetary policy autonomy is largely or completely lost.

Key Term: Freely floating exchange rate
An FX regime in which the currency’s value is determined mainly by supply and demand in the FX market, with limited discretionary intervention.

Key Term: Managed float
An FX regime where the currency is mostly market‑determined, but the central bank occasionally intervenes to influence the exchange rate, without a pre‑announced path.

Key Term: Fixed/pegged exchange rate
An FX regime in which the monetary authority commits to keep the currency’s value fixed (or within a narrow band) against another currency or a basket of currencies.

Key Term: Currency board
An FX regime where the domestic currency is fully (or almost fully) backed by foreign reserves at a fixed rate; the monetary base is rigidly linked to reserve holdings, greatly limiting policy discretion.

Key Term: Dollarization
Use of another country’s currency (often USD or EUR) as legal tender, replacing the domestic currency.

Key Term: Monetary union
Adoption of a common currency by two or more countries, with a shared central bank (for example, euro area).

Key Term: Devaluation
An official reduction in the par value of a currency under a fixed or pegged exchange rate system, making the domestic currency cheaper relative to the anchor currency.

Key Term: Revaluation
An official increase in the par value of a currency under a fixed or pegged system, making the domestic currency more expensive relative to the anchor currency.

Under flexible rates, exchange rate changes are typically described as depreciation and appreciation. Under fixed or pegged regimes, discrete policy changes in the fixed parity are called devaluations or revaluations.

In practice, there are many variations and hybrids of these basic regimes:

Conventional fixed peg: The currency is pegged to a single anchor currency or a basket, with very narrow fluctuation bands.
Crawling peg: The peg is adjusted periodically in small steps (for example, to offset inflation differentials).
Pegged within bands (target zone): The currency is allowed to fluctuate within a wider band around a central parity; the central bank intervenes when the rate approaches the band’s edges.
No separate legal tender: The country uses another economy’s currency (dollarization) or participates in a monetary union.

The IMF classifies countries by their de facto exchange arrangements, ranging from “no separate legal tender” to “independently floating.”

Trade‑offs across regimes

Each regime involves trade‑offs across monetary policy autonomy, exchange rate stability, and the need for FX reserves.

Freely floating
- Advantages:
  - High monetary policy autonomy; the central bank can focus on domestic objectives (inflation, output).
  - Automatic adjustment of external imbalances via exchange rate movements; persistent current account deficits tend to be associated with depreciation, which can correct them over time.
- Disadvantages:
  - Higher FX volatility; can increase uncertainty for trade and investment.
  - Possible pass‑through of depreciation to inflation (import prices rise).
  - Potential for overshooting and misalignment due to speculative flows.
Managed float
- Advantages:
  - Some smoothing of excessive short‑term volatility.
  - Some room for independent monetary policy, as the central bank is not strictly committed to a parity.
- Disadvantages:
  - Policy may be less transparent; uncertainty about the authorities’ reaction function.
  - Risk of a “one‑way bet” if markets perceive that the authorities defend certain levels asymmetrically.
Fixed/pegged
- Advantages:
  - Greater nominal and FX stability; can help anchor inflation expectations.
  - May support trade and investment with the anchor country by reducing exchange rate risk.
- Disadvantages:
  - Loss of independent monetary policy (especially with open capital markets).
  - Vulnerability to speculative attacks if the peg is misaligned or reserves are inadequate.
  - Need to accumulate and manage large FX reserves to credibly defend the peg.
Currency board/dollarization/monetary union
- Advantages:
  - Strong credibility in disinflation; imported monetary policy discipline from the anchor or union.
  - Virtually eliminates domestic currency risk within the union or vis‑à‑vis the anchor currency.
- Disadvantages:
  - Almost no monetary policy flexibility; the central bank cannot freely adjust interest rates or act as a traditional lender of last resort.
  - Internal adjustment to shocks occurs mainly via wages, prices, and fiscal policy; unemployment and output volatility may rise if these are rigid.
  - Under dollarization, the country forfeits seigniorage (profit from issuing money) to the provider of the anchor currency.

Regime choice is closely linked to the impossible trinity, discussed later.

Balance of Payments (BOP)

The balance of payments is a double‑entry accounting system: every international transaction generates both a credit and a debit entry of equal value.

Key Term: Balance of payments
Accounting record of all economic transactions between a country’s residents and the rest of the world over a specific period (usually a year or quarter).

The BOP is divided into major accounts.

Current account

The current account summarizes flows of goods, services, income, and current transfers.

Trade in goods (merchandise exports and imports).
Trade in services (tourism, transportation, financial services, IT services, consulting, etc.).
Primary income (investment income such as interest and dividends, and compensation of employees).
Secondary income or current transfers (remittances, foreign aid for consumption, pension payments, gifts).

A positive current account balance (surplus) means a country is a net lender to the rest of the world during that period; a negative balance (deficit) means it is a net borrower.

Capital account

The capital account is typically small for most economies and records:

Capital transfers (for example, debt forgiveness, migrants’ transfers of assets).
Transactions in non‑produced, non‑financial assets (for example, rights to natural resources, certain licenses, trademarks, or patents).

These items change the stock of assets without being payment for current production.

Financial account

The financial account records cross‑border investment flows and changes in financial claims and liabilities:

Direct investment (FDI): acquisition of a lasting interest and significant influence or control (typically ≥10% of voting shares).
Portfolio investment: cross‑border purchases of equity and debt securities below the control threshold.
Other investment: loans, trade credits, bank deposits, and other accounts receivable/payable.
Official reserve assets: FX reserves, SDRs (Special Drawing Rights), monetary gold, and reserve positions at the IMF held by the central bank.

Key Term: Official reserve assets
Foreign currency assets and other reserve assets (such as gold and SDRs) held by the central bank that can be used to finance balance‑of‑payments imbalances or intervene in FX markets.

Key Term: Trade balance
The difference between exports and imports of goods and services; a component of the current account.

Financial account items record how a current account surplus or deficit is financed: through changes in private or official holdings of foreign assets and liabilities.

Double‑entry logic and the BOP identity

The BOP must satisfy an accounting identity (using the modern IMF terminology and including errors and omissions):

\text{Current account} + \text{Capital account} + \text{Financial account} + \text{Errors and omissions} = 0.

This identity reflects the double‑entry nature of the BOP: every transaction gives rise to equal credits and debits.

In the double‑entry convention:

Credit entries usually reflect:
- Exports of goods and services.
- Income received from abroad.
- Capital inflows (foreign purchases of domestic assets; increases in liabilities to foreigners).
- Reductions in official reserves (central bank selling foreign assets; decrease in foreign assets).
Debit entries usually reflect:
- Imports of goods and services.
- Income paid abroad.
- Capital outflows (domestic purchases of foreign assets; increases in foreign assets).
- Increases in official reserves (central bank buying foreign assets).

Key Term: Statistical discrepancy (errors and omissions)
A balancing item that captures measurement errors and timing differences in recorded BOP transactions so that the accounts sum to zero.

In practice, data are collected from many different sources (customs, banks, surveys) and will not match perfectly. The statistical discrepancy reconciles these differences.

Financing current account imbalances

Interpretation:

A current account deficit implies the country is a net borrower from the rest of the world in that period. It must be financed by:
- Net capital/financial inflows (FDI, portfolio inflows, borrowing from abroad), and/or
- A decrease in official reserves (central bank selling reserves; a credit entry in the financial account), and/or
- A positive statistical discrepancy.
A current account surplus implies the country is a net lender; it must correspond to:
- Net capital/financial outflows (domestic residents acquiring foreign assets or repaying foreign debts), and/or
- An increase in official reserves (reserve accumulation; a debit entry), and/or
- A negative statistical discrepancy.

From an economic standpoint, a country that runs a current account deficit is absorbing more than it produces and must finance this by either selling assets to foreigners or borrowing from them. A country with a current account surplus is doing the opposite: it is accumulating foreign assets or reducing its foreign liabilities.

BOP, saving, and investment

The BOP also connects to macroeconomic saving and investment behavior. Starting from the open‑economy national income identity (ignoring statistical discrepancy):

Y = C + I + G + (X - M),

where $Y$ is national income, $C$ private consumption, $I$ investment, $G$ government spending, and $(X - M)$ net exports (exports minus imports). Abstracting from net income and transfers, we treat net exports as the current account.

Define national saving $S$ as:

S = Y - C - G.

Substituting for $Y$ :

S = (C + I + G + (X - M)) - C - G = I + (X - M).

Rearranging:

\text{Current account} \approx (X - M) = S - I.

Thus:

A current account deficit indicates that domestic investment exceeds national saving; the gap is financed by foreign saving (capital inflows).
A current account surplus indicates that national saving exceeds domestic investment; the excess saving is invested abroad (capital outflows).

This identity is conceptually important for interpreting why some economies consistently borrow from the rest of the world (low saving relative to investment) while others consistently lend (high saving relative to investment).

Key Term: Net foreign asset position (net international investment position)
The stock of residents’ foreign assets minus their foreign liabilities at a point in time; it changes mainly due to current account balances and valuation effects.

Over time, repeated current account deficits will reduce a country’s net foreign asset position (making it more of a net debtor), while repeated surpluses will increase it (making it a net creditor). In practice, valuation changes (for example, exchange rate movements affecting the domestic‑currency value of foreign assets) also affect the net foreign asset position, but Level 1 focuses on the link through the current account.

Classifying typical BOP transactions

For exam questions, you should be comfortable classifying common transactions. From the domestic country’s point of view:

A domestic firm exports goods and is paid in foreign currency:
- Credit to current account (exports).
- Debit to financial account (increase in foreign bank deposits—an asset).
A resident buys foreign government bonds:
- Debit to financial account (portfolio investment abroad).
A foreign company builds a factory domestically:
- Credit to financial account (FDI inflow; increase in liabilities to foreigners).
The central bank sells foreign reserves to support the domestic currency:
- Credit to financial account (reduction in reserve assets).
Migrant workers send remittances home:
- Credit to current account (secondary income—current transfer).

Being able to think through “Who is paying whom, and is this an asset or a liability?” will help you get the sign and the account correct.

Worked Example 1.3

If a country’s current account balance is –USD 50 billion and the combined capital and financial account is +USD 43 billion, what must be true of the balance of payments?

Answer:
The BOP must still sum to zero. The –50 current account deficit is mainly financed by +43 of net capital/financial inflows. The remaining –7 billion must be offset by either:

- a USD 7 billion decrease in official reserves (a positive credit in the financial account), or - a combination of reserve changes and statistical discrepancies amounting to +7.
In practice, we say that official reserves decrease or "errors and omissions" account for the USD 7 billion difference.

Worked Example 1.4

A domestic firm exports USD 5 million of goods to a foreign buyer on credit. Later, the buyer pays cash. How are these flows recorded in the exporter’s country’s BOP?

Answer:
At the time of shipment (on credit):

- Credit (current account): +5 million for goods exports. - Debit (financial account): +5 million increase in foreign assets (trade credit/receivable).

When the payment is received:

- Debit (financial account): –5 million reduction in foreign receivable. - Credit (financial account): +5 million increase in foreign currency bank deposits (another foreign asset).
The BOP remains balanced at each step.

This example illustrates how trade in goods is often accompanied by offsetting financial transactions (changes in claims and liabilities) in the financial account.

Exchange Rates, Trade Balance, and the Elasticities Approach

Exchange rate changes affect a country’s trade balance (exports minus imports) via their impact on export and import prices and quantities.

A depreciation of the domestic currency:
- Makes exports cheaper in foreign currency (tends to increase export volumes).
- Makes imports more expensive in domestic currency (tends to reduce import volumes).
An appreciation has the opposite effects.

Whether the trade balance improves after a depreciation depends on how responsive quantities demanded are to price changes (demand elasticities).

Key Term: Marshall–Lerner condition
The condition that a currency depreciation will improve the trade balance if the sum (or weighted sum) of the absolute values of export and import demand elasticities is sufficiently high (demand is elastic enough).

Recall the definition of price elasticity of demand:

\varepsilon = \frac{\%\Delta Q}{\%\Delta P}.

Demand is:

Elastic if $\varepsilon > 1$ (quantity responds more than proportionally to price).
Inelastic if $\varepsilon < 1$ .

Because expenditure $R$ equals price multiplied by quantity ( $R = P \times Q$ ), we can combine changes in price and quantity. Using $\%\Delta R = \%\Delta P + \%\Delta Q$ and substituting $\%\Delta Q = \varepsilon \cdot \%\Delta P$ , we get:

\%\Delta R = (1 - \varepsilon) \%\Delta P.

From this:

If demand is elastic ( $\varepsilon > 1$ ), an increase in price reduces expenditure.
If demand is inelastic ( $\varepsilon < 1$ ), an increase in price increases expenditure.

This behavior is central to the Marshall–Lerner condition.

Generalized Marshall–Lerner condition

The generalized Marshall–Lerner condition (allowing for an initial trade imbalance) can be written as:

\omega_X \varepsilon_X + \omega_M (\varepsilon_M - 1) > 0,

where:

$\omega_X$ = export share in total trade (exports + imports),
$\omega_M$ = import share in total trade (with $\omega_X + \omega_M = 1$ ),
$\varepsilon_X$ = foreign demand elasticity for exports,
$\varepsilon_M$ = domestic demand elasticity for imports.

If this condition holds, a depreciation of the domestic currency will move the trade balance toward surplus.

Intuition:

Depreciation makes exports cheaper in foreign currency; if export demand is price‑sensitive ( $\varepsilon_X$ large enough), export volumes and export revenues in domestic currency rise.
Depreciation makes imports more expensive in domestic currency; if import demand is elastic ( $\varepsilon_M > 1$ ), the percentage drop in import volumes more than offsets the price increase, so total import expenditure in domestic currency falls.

In the special case of initially balanced trade (exports = imports, so $\omega_X = \omega_M = 0.5$ ), the condition reduces to the classic form:

\varepsilon_X + \varepsilon_M > 1.

You should understand qualitatively:

The more price‑sensitive (elastic) import and export demand are, the more likely depreciation improves the trade balance.
If import demand is very inelastic (low $\varepsilon_M$ ), higher domestic‑currency import prices may increase import expenditure despite lower import volumes, making the trade balance worse.
As the initial trade deficit becomes larger (imports > exports, so $\omega_M$ rises), the elasticity of import demand becomes especially important.

A simple illustration using import demand:

Suppose a depreciation raises domestic‑currency import prices by 10%.
If $\varepsilon_M = 0.6$ (inelastic), import volumes fall by only 6%; import expenditure rises by about 4% (10% − 6%).
If $\varepsilon_M = 1.4$ (elastic), import volumes fall by 14%; import expenditure falls by about 4% (10% − 14%).

Key Term: J‑curve effect
The observed pattern whereby a currency depreciation initially worsens the trade balance (due to existing contracts and quantity adjustment lags) before improving it in the medium term as volumes respond to new relative prices.

Immediately after a depreciation:

Many trade contracts are denominated in foreign currency and fixed in the short term.
Quantities of exports and imports adjust slowly because of delivery lags and the time needed for firms and consumers to change suppliers and consumption patterns.

As a result:

Import prices in domestic currency jump quickly, raising the domestic‑currency value of imports.
Export prices in foreign currency fall, but export volumes do not yet fully respond.

The trade balance (in domestic currency) can therefore worsen initially, then gradually improve as export and import quantities adjust to the new relative prices—tracing out a J‑shaped path over time.

Worked Example 1.5

A country with an initially balanced trade account experiences a depreciation of its currency. Export demand elasticity is 0.4 and import demand elasticity is 0.9. Based on the Marshall–Lerner condition, what is the likely effect on the trade balance in the long run?

Answer:
Sum of elasticities = 0.4 + 0.9 = 1.3 > 1.
With initially balanced trade, the Marshall–Lerner condition is satisfied.
Therefore, a currency depreciation is likely to improve the trade balance in the long run, after quantities have time to adjust.

Short‑run trade flows may still follow a J‑curve: the trade balance can deteriorate immediately after depreciation because:

- Contract prices are fixed in the short term. - Quantities adjust slowly. - The higher domestic‑currency price of imports dominates before import volumes decline.

In contrast, if $\varepsilon_X + \varepsilon_M < 1$ , a depreciation is unlikely to improve the trade balance even in the long run; expenditure effects dominate volume effects.

Policy, Capital Flows, and the Impossible Trinity

Trade‑offs between FX regime, capital mobility, and monetary policy independence are central for CFA candidates.

Key Term: Impossible trinity (trilemma)
The concept that a country cannot simultaneously have:

- a fixed (or tightly managed) exchange rate, - independent monetary policy, and - perfect capital mobility.
Only two of the three can be achieved at any one time.

Typical combinations:

Fixed rate + free capital mobility
- Monetary policy must align with the anchor country’s policy; interest rates cannot diverge significantly.
- Example: Classical gold standard; modern currency boards and hard pegs in financially open economies.
Independent monetary policy + free capital mobility
- Exchange rate must be flexible; central bank sets rates to target domestic objectives, and the currency adjusts.
- Example: Most major advanced economies today (for example, US, UK, Canada, Japan).
Fixed rate + independent monetary policy
- Achieved only with meaningful capital controls, limiting cross‑border financial flows.
- Example: Some emerging economies with pegged regimes and capital controls.

Under a fixed rate with high capital mobility, domestic interest rates cannot be set independently. If they diverge from foreign rates, capital flows will pressure the exchange rate and force the central bank to intervene.

Interaction with fiscal and monetary policy

Expansionary or contractionary fiscal and monetary policies interact differently with exchange rate regimes:

Under a fixed exchange rate with free capital mobility:
- Expansionary fiscal policy (higher government spending or lower taxes) tends to raise domestic interest rates and attract capital inflows.
- To maintain the peg, the central bank must intervene (buy foreign currency, sell domestic currency). If this intervention is not fully sterilized, the money supply expands, reinforcing the fiscal stimulus.
- Monetary policy is largely subordinated to preserving the peg.
Under a floating regime:
- The central bank can set interest rates to target inflation and output.
- Expansionary fiscal policy may raise interest rates and cause currency appreciation, which can partially offset the fiscal expansion by reducing net exports (sometimes linked to the idea of “twin deficits”—fiscal and current account deficits).

Capital flows respond quickly to changes in interest differentials, expected exchange rate movements, and perceived risk. For example:

An unexpected increase in domestic policy rates in a floating regime tends to attract short‑term capital inflows, causing the currency to appreciate in the short run.
A loss of confidence in fiscal sustainability or banking system health can trigger capital outflows, putting downward pressure on the currency even if interest rates are high.

Worked Example 1.6

Country A pegs its currency to the USD but wants to lower domestic interest rates to stimulate growth while maintaining free capital mobility. What happens?

Answer:
Lowering domestic rates below US rates makes domestic assets less attractive. Investors shift funds into USD assets:

- Capital outflows increase. - The domestic currency comes under downward pressure. - To defend the peg, the central bank must sell foreign reserves and buy domestic currency.
If this continues, reserves may be depleted, forcing: - abandonment of the peg (sharp devaluation), or - reversal of the interest rate cut.
The country cannot simultaneously maintain the peg, free capital mobility, and independent monetary policy.

This mechanism is a typical pattern in currency crises: a country with a fixed exchange rate and open capital account attempts to conduct policy inconsistent with the peg, leading to speculative attacks and reserve losses.

FX Interventions and Capital Controls

Countries may intervene in FX markets to smooth volatility or maintain a peg.

Buying domestic currency (selling reserves) to support a weak currency.
Selling domestic currency (buying reserves) to prevent excessive appreciation.

Interventions can be:

Unsterilized: The central bank does not offset the impact on the domestic money supply; FX intervention directly affects liquidity and interest rates.
Sterilized: The central bank conducts open market operations (buying or selling domestic bonds) to neutralize the monetary impact of FX intervention.

Key Term: Unsterilized intervention
FX market intervention in which the central bank allows the associated change in the monetary base to affect domestic liquidity and interest rates.

Key Term: Sterilized intervention
FX market intervention accompanied by offsetting open market operations so that the domestic money supply (and short‑term interest rates) are largely unchanged.

For example, to support its currency (which is under downward pressure), a central bank sells foreign reserves and buys its own currency:

Unsterilized:
- Domestic money supply contracts.
- Short‑term interest rates may rise, making domestic assets more attractive and reinforcing currency support.
Sterilized:
- The central bank simultaneously buys domestic government bonds (injecting domestic liquidity).
- The net effect on the money supply is offset, and short‑term interest rates may remain unchanged.

In practice, sterilized intervention may have limited and temporary effects when capital is freely mobile and markets are deep, because investors focus on interest rate differentials and expectations rather than short‑term changes in supply and demand. Nevertheless, many central banks still conduct sterilized interventions to signal their views or to smooth abrupt movements.

Key Term: Capital controls
Legal restrictions on the movement of capital across borders, such as limits on foreign investment, minimum holding periods, approval requirements, or taxes on inflows/outflows.

Controls can:

Reduce short‑term speculative flows and relieve pressure on a peg.
Provide temporary space for independent monetary policy under an otherwise constrained regime.
But often at the cost of:
- Lower long‑term foreign investment.
- Weaker financial market depth and efficiency.
- Distortions, evasion, and potential misallocation of capital.

Worked Example 1.7

If Country X experiences rapid capital outflows and tries to maintain its fixed FX rate but reserves run out, what are likely implications?

Answer:
Once reserves are exhausted, the central bank cannot continue selling foreign currency to defend the peg:

- The peg will fail; a sharp depreciation or devaluation is likely. - Reserves will be at critically low levels, limiting further intervention. - The policy authority may lose credibility, leading to higher risk premia and possibly further depreciation.
The country may shift to a more flexible regime and/or consider capital controls.

In practice, countries facing speculative attacks may adopt combinations of:

Interest rate hikes.
Temporary capital controls.
Exchange rate regime changes.
Fiscal adjustments.

The specific mix affects both short‑term currency stability and long‑term growth and investment conditions.

Capital controls and international policy

Capital controls are sometimes deployed to manage volatile inflows or outflows, especially in fixed or tightly managed exchange rate regimes. Tools include:

Transaction taxes on certain cross‑border flows.
Quantitative limits or quotas on foreign borrowing or lending.
Minimum holding periods or unremunerated reserve requirements on capital inflows.
Licensing or approval requirements for foreign investments by residents or non‑residents.

While controls can offer short‑term stability and policy space, they rarely solve fundamental macroeconomic imbalances such as unsustainable fiscal deficits or misaligned real exchange rates. Once relaxed, pent‑up pressures can re‑emerge.

Worked Example 1.8

A country restricts foreign purchases of domestic government bonds to support its currency. What is a likely long‑run result?

Answer:
Restrictions may slow capital outflows and reduce immediate depreciation pressures. However, over the long run:

- Foreign investors may view the country as less attractive due to reduced capital mobility. - Funding costs may rise (higher yields required by remaining investors). - Market liquidity and efficiency may decline.
Growth and investment may be adversely affected if such controls persist.

Exchange Rate Quotation and Calculation

Direct and indirect quotes

From the viewpoint of a country with domestic currency DC:

Direct quote: DC per unit of foreign currency (FC).
- Example for a US resident: USD/EUR = 1.10 (USD per 1 EUR).
Indirect quote: FC per unit of DC.
- Example for the US: EUR/USD = 0.91 (EUR per 1 USD).

Always determine:

Whose viewpoint the question uses.
Which is the base currency (first).
Which is the price currency (second).

Many exam errors come from inverting quotes incorrectly or mis‑identifying appreciation/depreciation.

A quick summary table (from the domestic standpoint):

Quote format	Example (US domestic)	Type	Interpretation
DC/FC	USD/EUR = 1.10	Direct quote	1 EUR costs 1.10 USD
FC/DC	EUR/USD = 0.91	Indirect quote	1 USD buys 0.91 EUR

Cross‑rates

Cross‑rates are exchange rates between two currencies that are both quoted against a third currency (often USD). You can compute them by multiplying or dividing the relevant quotes.

There are two safe approaches:

Unit‑canceling method (dimensional analysis): write the units (for example, USD/EUR, JPY/USD), multiply/divide so unwanted units cancel.
Algebraic method: express both desired and given rates consistently (for example, all as DC/FC) and solve.

Worked Example 1.9

If USD/JPY = 110.0 and USD/EUR = 1.25, what is the implied EUR/JPY?

Answer:
We want JPY per EUR.

- USD/JPY = 110.0 ⇒ 1 USD = 110 JPY. - USD/EUR = 1.25 ⇒ 1 EUR = 1.25 USD.
Therefore:
1 EUR = 1.25 USD × 110 JPY/USD = 137.5 JPY.
EUR/JPY = 137.5.

If you instead try to divide quotes without tracking units:
$\text{EUR/JPY} = \frac{\text{USD/JPY}}{\text{USD/EUR}} = \frac{110.0}{1.25} = 88.0$
This is wrong because in the second quote USD is the price currency, not the base. Always align units before manipulating the numbers.

To see the safe method explicitly:

- Start with EUR, multiply by USD/EUR to convert to USD, then by JPY/USD to convert to JPY:
$1\ \text{EUR} \times \frac{1.25\ \text{USD}}{1\ \text{EUR}} \times \frac{110\ \text{JPY}}{1\ \text{USD}} = 137.5\ \text{JPY}.$

Worked Example 1.10

The GBP/USD spot rate moves from 1.30 to 1.20 (USD per GBP). Calculate the percentage appreciation or depreciation of the GBP.

Answer:
Quote is USD per GBP, so GBP is the base currency.
Percentage change in GBP value:
$\frac{1.20 - 1.30}{1.30} = \frac{-0.10}{1.30} \approx -7.69\%.$
The GBP has depreciated by about 7.7% against the USD.

From the USD viewpoint, the quote is GBP/USD. The inverse (GBP/USD) moves from:

- 1 / 1.30 ≈ 0.7692 GBP per USD to - 1 / 1.20 ≈ 0.8333 GBP per USD.

USD has appreciated by approximately:
$\frac{0.8333 - 0.7692}{0.7692} \approx 8.3\%.$

Spot versus forward and basic hedging logic

Although the emphasis in this reading is on spot exchange rates and the balance of payments, you should also be aware of the basic role of forward exchange contracts:

A domestic investor holding a foreign‑currency asset is exposed to FX risk.
Entering into a forward contract to sell the foreign currency at a fixed rate in the future can hedge this risk, locking in a known domestic‑currency value.

Forward rates are linked to spot rates and interest rate differentials by a no‑arbitrage condition (covered interest parity). The details are covered in the currency exchange rates reading, but the intuition is:

If foreign interest rates are higher than domestic rates, the foreign currency tends to trade at a forward discount (one unit of foreign currency buys fewer units of domestic currency in the forward than in the spot).
If foreign interest rates are lower, the foreign currency tends to trade at a forward premium.

For Level 1, recognize that forwards can be used to hedge exchange rate risk arising from cross‑border investments or trade receivables/payables, and that hedging with forwards can make the domestic‑currency return on a foreign investment essentially risk free if the instrument itself is risk free.

Exam warning

A frequent exam mistake is to invert the quote or to calculate appreciation/depreciation in the wrong direction. To avoid this:

Check which currency is the base and which is the price.
Confirm whose viewpoint is “domestic.”
Write units explicitly when computing cross‑rates.
When in doubt, convert step‑by‑step using dimensional analysis rather than manipulating bare numbers.

Summary

Exchange rates and the balance of payments are at the core of a country’s international economic position. Key points for CFA Level 1 include:

How to interpret and calculate nominal, real, and cross‑exchange rates, including simple real exchange rate adjustments using inflation differentials.
How different FX regimes constrain monetary policy and interact with capital mobility (the impossible trinity).
How the balance of payments is structured and why every current account deficit must be financed by capital/financial inflows, reserve changes, or statistical discrepancies.
How depreciation affects the trade balance via the Marshall–Lerner condition and the J‑curve, and why elasticities matter.
How FX interventions (sterilized and unsterilized) and capital controls operate, along with their typical benefits and costs.
How current account balances relate to national saving and investment and to changes in a country’s net foreign asset position (net international investment position).
How different combinations of exchange rate regimes, monetary policies, and capital mobility shape a country’s vulnerability to currency crises and its ability to stabilize output and inflation.

For the exam, you must be comfortable with basic calculations (percentage changes, cross‑rates, simple real exchange rate adjustments) and with qualitative reasoning about regime choices, BOP identities, the impossible trinity, and the trade effects of exchange rate movements.

Key Point Checklist

This article has covered the following key knowledge points:

Classification and implications of exchange rate regimes (freely floating, managed float, fixed/pegged, currency board, dollarization, monetary union, crawling pegs, and bands).
Calculation and interpretation of nominal exchange rates, real exchange rates, nominal and real effective exchange rates, and basic percentage appreciations/depreciations.
Structure, components, and double‑entry logic of the balance of payments, including current, capital, financial, official reserve accounts, and statistical discrepancies.
Relationship between current account deficits/surpluses, capital/financial account flows, and how external imbalances must be financed.
Link between the current account and national saving–investment balances and implications for a country’s net foreign asset position.
The impossible trinity (trilemma) and its implications for combining exchange rate policy, monetary policy, and capital mobility.
Direct versus indirect exchange rate quotations and computation of cross‑rates, with careful attention to base and price currencies and unit consistency.
The elasticities (Marshall–Lerner) approach to the trade balance and the J‑curve effect following exchange rate changes.
Impact and limitations of FX intervention (sterilized and unsterilized) and capital controls for currency stability, crisis management, and longer‑term investment conditions.
The basic role of forward exchange contracts in hedging currency risk associated with foreign‑currency investments and trade flows.

Key Terms and Concepts

Exchange rate
Nominal exchange rate
Real exchange rate
Direct quote
Indirect quote
Base currency
Price currency
Appreciation
Depreciation
Spot exchange rate
Forward exchange rate
Balance of payments
Current account
Capital account
Financial account
Statistical discrepancy (errors and omissions)
FX regime
Capital controls
Nominal effective exchange rate (NEER)
Real effective exchange rate (REER)
Purchasing power parity (PPP)
Freely floating exchange rate
Managed float
Fixed/pegged exchange rate
Currency board
Dollarization
Monetary union
Devaluation
Revaluation
Official reserve assets
Trade balance
Net foreign asset position (net international investment position)
Marshall–Lerner condition
J‑curve effect
Impossible trinity (trilemma)
Unsterilized intervention
Sterilized intervention

Monetary fiscal and FX - Exchange rates and balance of payme...