The Balance of Payments — Exchange Rates | IGCSE Economics

Exam Frequency Analysis

Past paper frequency (2018 to 2024)

This topic accounts for approximately 11% of your exam marks.

increasing

Medium

Increasing11%

Exchange rate definitions, depreciation/appreciation effects on exports, imports, and inflation are increasingly examined since 2021.

Exchange-rate questions are often paired with questions about the balance of payments.

The balance of payments (BoP) keeps track of every financial flow into and out of a country over a given period, covering all dealings with other economies. Its biggest component for IGCSE purposes is the current account.

The current account

The current account is split into four parts:

Trade in goods: exports and imports of physical goods (cars, oil, electronics).
Trade in services: exports and imports of services (tourism, banking, insurance, education).
Primary income: income earned abroad (dividends, interest, wages received from abroad) minus income paid abroad.
Secondary income: transfers like foreign aid and remittances from migrant workers.

The trade balance = exports − imports (for goods, services, or both combined). If exports > imports, the country has a trade surplus; if imports > exports, it has a trade deficit.

Why the current account matters

A persistent current-account deficit means the country is consuming more than it produces and must finance the gap by borrowing from abroad or selling assets. Eventually:

Foreign currency reserves run down.
The currency may depreciate sharply.
Foreign borrowing becomes harder and more expensive.
The country may face a balance-of-payments crisis.

A persistent current-account surplus is usually less worrying. It means the country exports more than it imports and accumulates foreign assets. It may face complaints from trading partners or face exchange-rate appreciation pressure.

Current-account deficits and exchange rates

Under floating rates, a current-account deficit tends to depreciate the currency, which then makes exports cheaper and imports dearer, partially correcting the deficit (the Marshall-Lerner condition again).

Under fixed rates, the central bank has to spend foreign reserves to defend the peg. If reserves run out, the peg breaks and the currency devalues sharply.

This is why exchange rates and the balance of payments are linked: each affects the other.