Learning Outcomes
After this article, you will be able to distinguish nominal and real exchange rates, calculate cross-rates, and interpret the balance of payments for CFA Level 1. You will recognize how different FX regimes, fiscal and monetary policy, and capital controls influence exchange rates and cross-border capital flows, and analyze how these factors affect a country's international accounts and currency stability.
CFA Level 1 Syllabus
For CFA Level 1, you are required to understand exchange rates and the balance of payments, focusing on their interplay with fiscal and monetary policy. For effective revision, ensure you can:
- Identify and describe different exchange rate regimes and evaluate their impacts on policy autonomy and external stability.
- Calculate and interpret nominal and real 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).
- Analyze the relationship between current account and capital/financial account flows.
- Assess the effects of capital controls, FX interventions, and international capital flows.
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.
- What are the practical differences between fixed and flexible exchange rate regimes for monetary policy?
- If Country X experiences a persistent current account deficit, what must be true of its other balance of payments components?
- How does an increase in domestic interest rates affect a floating exchange rate, all else equal?
- What is one risk associated with a country adopting a currency board?
Introduction
Understanding exchange rates and the balance of payments is essential for CFA Level 1. These topics connect monetary/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, 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.
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.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, and current transfers.Key Term: Capital account
Section of the balance of payments that tracks cross-border capital transfers and investment flows, including direct and portfolio investment.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).
Exchange Rate Concepts
Foreign exchange (FX) markets quote exchange rates directly (domestic currency per unit of foreign currency) or indirectly (foreign currency per unit of domestic currency), depending on convention. Direct quote and indirect quote conventions are common on the exam—always identify which currency is the "base" and which is the "price" currency.
Nominal and Real Exchange Rates
Most exchange rates are nominal. However, for international comparisons, CFA candidates must understand real exchange rates—these remove the impact of inflation differences between countries, allowing evaluation of true changes in competitiveness.
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.
A country with a rising nominal exchange rate (domestic currency depreciating) may see its competitive position worsen, especially if accompanied by higher domestic inflation.
Worked Example 1.1
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?
Answer:
The real exchange rate appreciates about 5% (= 20% nominal depreciation minus 15% inflation differential), so domestic goods are relatively less competitive.
Exchange Rate Regimes
Countries choose among various FX regimes:
- Freely floating: Market forces set the rate; policy is independent but currency volatility can be high.
- Managed float: Central bank intervenes as desired without a precise target.
- Fixed/Pegged: Central bank targets a specific parity; maintains it by buying/selling reserves or adjusting policy.
- Currency board/dollarization/monetary union: Extreme fixity or adoption of a foreign/common currency; monetary policy autonomy is lost.
Key Term: Currency board
An FX regime where the domestic currency is fully backed by foreign reserves at a fixed rate, limiting policy discretion.Key Term: Dollarization
Use of another country’s currency (often USD) as legal tender, replacing the domestic currency.Key Term: Monetary union
Adoption of a common currency by two or more countries (e.g., eurozone).
Balance of Payments (BOP)
The balance of payments is divided into major accounts:
- Current account: Net trade in goods/services, net income (investment earnings, worker remittances), and current transfers.
- Capital account: Capital transfers and acquisition/disposal of non-produced assets.
- Financial account: Net FDI, net portfolio flows, other investments, reserve assets.
BOP identity: The sum of the current account, capital account, and financial account equals zero (with statistical discrepancy). A current account deficit must be offset by capital/financial inflows or reserve drawdown.
Worked Example 1.2
If a country’s current account balance is –$50 billion and the capital and financial account is +$43 billion, what must be true of the balance of payments?
Answer:
Official reserves decrease or "errors and omissions" account for the $7 billion difference, so the BOP sums to zero.
Policy, Capital Flows, and the Impossible Trinity
Trade-offs between FX regime, capital mobility, and policy independence are central for CFA candidates.
Key Term: Impossible trinity (trilemma)
The concept that a country cannot simultaneously have a fixed exchange rate, independent monetary policy, and perfect capital mobility.
For example, under a fixed rate with high capital mobility, domestic interest rates must match foreign rates, or arbitrage will force capital flows that threaten the peg.
Worked Example 1.3
Country A pegs its currency to the USD but wants to lower domestic interest rates to stimulate growth. What happens?
Answer:
Lower rates will prompt outflows as investors seek higher USD returns; the central bank must intervene (selling reserves) to defend the peg, possibly leading to reserve depletion.
FX Interventions and Capital Controls
Countries may intervene in FX markets to smooth volatility or maintain a peg. If sustained, interventions affect the central bank's reserves—prolonged outflows often prompt a move to floating or currency devaluation.
Key Term: Capital controls
Legal restrictions on the movement of capital across borders, such as limits on foreign investment or repatriation.
Controls can insulate an economy during crises but may reduce long-term investment and market discipline.
Worked Example 1.4
If Country X experiences rapid capital outflows and tries to maintain its fixed FX rate but reserves run out, what are likely implications?
Answer:
The peg will fail. The currency will depreciate, reserves will be at low levels, and the policy authority may lose credibility.
Exchange Rate Quotation and Calculation
Direct and Indirect Quotes
- Direct quote: Units of domestic currency per one unit of foreign currency.
- Indirect quote: Units of foreign currency per one unit of domestic currency.
Identify the currencies from the viewpoint in the question—errors here are common on the exam.
Cross-Rates
Calculate the exchange rate between two currencies using their rates against a third currency.
Worked Example 1.5
If USD/JPY = 110.0 and USD/EUR = 1.25, what is the implied EUR/JPY?
Answer:
EUR/JPY = (USD/JPY) / (USD/EUR) = 110.0 / 1.25 = 88.0
Exam Warning
A frequent exam mistake is to invert the quote or to calculate appreciation/depreciation in the wrong direction. Check which currency is the "base" and which is the "price" in every calculation and when determining if a currency is appreciating or depreciating.
Capital Controls and International Policy
Capital controls are sometimes deployed to manage volatile inflows or outflows, especially in fixed exchange rate regimes. Tools include transaction taxes, approval requirements, and quantitative limits. While controls offer temporary policy autonomy, they often reduce foreign investment and market depth.
Worked Example 1.6
A country restricts foreign purchases of debt securities to support its currency. What is a likely long-run result?
Answer:
Lower foreign investment, possibly higher funding costs, and eventually a reduction in economic growth and market efficiency.
Summary
Exchange rates and the balance of payments are at the core of a country’s international market position. Currency regime choices dictate the scope for fiscal and monetary policy. Persistent current account deficits are financed by capital inflows or reserve sales, and capital controls/interventions carry trade-offs. For CFA Level 1, accurate calculation of exchange rates, understanding FX regimes and BOP identities, and their policy consequences is essential.
Key Point Checklist
This article has covered the following key knowledge points:
- Classification and implications of exchange rate regimes (fixed, floating, currency board, etc.)
- Calculation and interpretation of nominal and real exchange rates
- Structure and accounting identity of the balance of payments
- Relationship between current account deficits and capital inflows
- The impossible trinity and its policy implications
- Direct, indirect and cross-rate computation for exchange rates
- Impact and limitations of capital controls and FX intervention for policy autonomy
Key Terms and Concepts
- Exchange rate
- Nominal exchange rate
- Real exchange rate
- Balance of payments
- Current account
- Capital account
- FX regime
- Capital controls
- Purchasing power parity (PPP)
- Currency board
- Dollarization
- Monetary union
- Impossible trinity (trilemma)