JC Economics Balance of Payments & Currency Depreciation Essay Model Answers
As one of the main macroeconomic objectives of an economy is the balance of payments, this macro aim is more important for countries that trade a lot more, such as Singapore, who is being small and open. As BOP summarises the transactions between Singapore and the rest of the world, many changes in the global economy may affect a country’s Current Account (CAcc) and Capital & Financial Account (KFA).
In your H2 Econs Syllabus (Code: 9757), the BOP and exchange rates are considered the external macro econs objectives.
(Note that in some countries, exchange rate is not considered an macro goal. Why so?)
(For H1 Econs students. you merely need to learn exchange rates as a monetary policy instrument.)
The following question (with full length outline answers) demonstrates how Current Account and KFA are affected, and its consequences on an depreciation of an economy’s exchange rate.
(a) Explain how how might a increase in the level of interest rates affect both the current account and capital & financial account in the balance of payments of the Singapore economy. 
(b) Discuss the possible effects of an appreciation of economy’s exchange rate. 
Current Account and Capital & Financial Account of BOP
Suggested Answer Part (a)
Define BOP: Records transactions between the residents of the country with the rest of the world in a year. It consists of current account (CAcc), capital and financial account (KFA), as well as foreign reserves account (FRA).
Current account comprises the Goods balance, Services balance, Primary income and Secondary income sub-accounts.
(i) Explain how a rise in interest rates affect the current account (CAcc) of Singapore’s balance of payments
Rise in interest rates -> increase in the price of money, so raises cost of borrowing. Singaporean households maybe enticed to borrow less to consume goods, not just from the local SG economy, but also from overseas. Hence demand for imports falls, and CAcc improves.
(i) Explain how a rise in interest rates affect the capital and financial account (KFA ) of Singapore’s balance of payments
Rise in interest rates -> SG destination more attractive to overseas consumers, in particular the portfolio investment or hot money (aka short term capital flows). Net capital inflows, so KFA improves.
Thus, overall BOP improves.
H2 Economics Tutor Remarks:
1. Is there a diagram that we can use to illustrate the impacts in this question?
2. What possible stronger analysis is possible for the above? For example, Singapore in a price taker in the global economy. If we factor this in, how will the NOP impact change?
(Link to many more BOP essays)
Currency Depreciation & Macroeconomic Consequences
Intro: define exchange rates and depreciation.
Depreciating the currency: an undervalued currency will have Impact on all the macroeconomic objectives of a country with the extent of the impact dependent on the degree of under-valuation of the currency ve impacts.
Thesis: Positive Impacts
Encourage exports and discourage imports. BOP disequilibrium (surplus) likely to occur X>M now. The undervalued currency will make exports appear more attractive to foreigners, who then increase their purchase of the country’s exports. With this in demand, the dd for labour (FOP) also rise. Increasing employment. [UnN falls]I At the same time, it raises the prices of imports to domestic residents and causes expenditure switching effects as domestic residents opt for domestic goods instead.
➜ However, no country would like to incur a balance of payments deficit. It is highly possible that other countries may adopt retaliatory actions like depreciating their own currency as well to prevent their own BOP deficit from deteriorating.
(Note: currency depreciation / devaluation is also known as a type of Unfair Trading Practices. learn more with us at our Econs intensive revision lessons.)
However, an undervalued currency will make the foreign price of investment in the country cheaper for foreign companies, encouraging foreign domestic investments. This will likely boost inward investments by foreign firms boosting the capital account and both actual and potential growth.
(Sketch the AD-AS diagram to show expansion of both types of economic growth.)
Anti-Thesis: Negative Impacts
When currency is undervalued, cost of foreign imports being expensive will discourage the import of capital goods, hindering technological transfers and potential economic growth.
Though a burgeoning BOP is a welcomed sign, as it allows the country to accumulate foreign reserves while maintaining an undervalued currency (sell domestic currency in exchange for foreign reserves), a persistently enlarged BOP runs the risk of triggering an overheated economy and hence dd-pull inflation. (eg is China) [dd-pull inflation or inflationary pressures).
The release of domestic currency into the markets also meant that inflationary pressures were increased due to excess liquidity, hindering the goal of price stability. [price instability]. In having an under-valued currency, the imports now cost more. This leads to cost-push inflation in the form of an import-price-push inflation. This is especially damaging in a country like Singapore, which is heavily dependent on its imports. Singapore has to maintain a relatively strong currency, in order to import cheap and maintain competitiveness of its goods in the global market.
An undervalued currency will increase speculative inflows as Investors expect an upward movement of the currency so that the currency par value can be adjusted to the market value. Speculative inflows are destabilising as these will revert out quickly once capital gain has been made, causing a rapid increase in the supply of currency as speculative flows flock out. This will cause the currency value to drop and such volatility in the XA rate value distorts trade and cost of Imports.
(Question: Is this a strong point to apply in this question? If yes / no, why?)
- overall good or bad, depends on type of economy. For eg, you can compare a small and open economy (SOE) like S’pore, vs a large and less open (LLO) one like USA.
- overall good or bad, also depends on the exchange rate system adopted. If fixed, requires a large amount of foreign reserves. This becomes an opportunity cost for the economy. (See Singapore’s foreign reserves data here.)
- etc. (More evaluation techniques in our H2 Economics intensive revision lessons.)
In summary, an under-valued currency is able to promote economic growth in the sense that it can boost exports due to relatively lower prices. However, the danger remains in terms of generating excessive growth and hence Inflation as well as increased speculative flows.
Comment by JC Econs Tuition Teacher:
1. This is a relatively tough question, for tough topic. Most likely coming out this year for your eventual GCE A-Level examinations!
2. Essay on currency appreciation here.
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More full length essays examples: JC Econs Essay #35