Every cross-border transaction lands in one of two accounts:
The accounting identity is CA + financial account = 0 (ignoring the small statistical discrepancy). A country running a current account deficit (importing more than it exports) must run a financial account surplus (selling assets to, or borrowing from, foreigners) of equal size. The dollars foreigners earn selling goods to us return as purchases of our assets.
Sorting drill: a resident buys an imported car → current account (import). A foreign pension fund buys U.S. Treasury bonds → financial account (inflow). A firm earns dividends from its foreign subsidiary → current account (income). A bond purchase is not "trade."
The exchange rate is the price of one currency in terms of another. Appreciation means a currency strengthens (it buys more foreign currency); depreciation means it weakens. Rates are set in the foreign exchange market. For the market for the U.S. dollar:
Shifters — each has a mirror on the other curve:
| Event | Effect on the dollar |
|---|---|
| U.S. real interest rates rise relative to abroad | Foreigners buy U.S. assets → demand for dollars rises → appreciation |
| Foreign incomes rise | More U.S. exports bought → demand for dollars rises → appreciation |
| U.S. incomes rise | Americans buy more imports → supply of dollars rises → depreciation |
| U.S. inflation higher than abroad | U.S. goods pricier → export demand falls, imports rise → depreciation |
| Expected appreciation of the dollar | Speculative demand rises → appreciation |
The interest-rate channel is the exam's favorite: policy moves relative rates → capital chases the higher return → the currency moves → net exports respond.
Now chain a full policy story. Tighter monetary policy raises U.S. rates → capital inflows → the dollar appreciates → net exports fall → aggregate demand shifts further left, reinforcing the contraction. Fiscal deficits do a parallel dance: deficits raise real rates → capital inflows → appreciation → net exports fall — an international crowding out layered on the domestic kind.
Tariffs (taxes on imports) and quotas (quantity limits) raise the domestic price of protected goods, help protected producers, hurt consumers and downstream industries, invite retaliation, and shrink the gains from trade. They may narrow a trade deficit, but at an efficiency cost.
[GRAPH: Foreign exchange — the market for the U.S. dollar
X-axis: Quantity of dollars
Y-axis: Exchange rate (foreign currency per dollar — the price of $1)
Curve 1: Demand for dollars, downward-sloping (foreigners buying U.S. exports and assets)
Curve 2: Supply of dollars, upward-sloping (Americans buying imports and foreign assets)
Initial equilibrium at (Q1, e1)
Shift: U.S. interest rates rise relative to abroad → foreigners buy U.S. bonds
→ demand for dollars shifts right → new equilibrium (Q2, e2 > e1)
→ the dollar appreciates → U.S. net exports fall]
1. C. Buying a foreign good is an import, recorded in the current account. A and E: no asset changed hands, so nothing hits the financial account. B: an export flows the other way. D: transfers are gifts or remittances, not purchases.
Fix: Goods and services go in the current account; imports are the debit side.
2. B. A foreign purchase of U.S. assets is a financial account inflow. A: bonds are not goods or services. C: nothing was imported. D: not a gift. E: every cross-border transaction is recorded somewhere.
Fix: Asset purchases — stocks, bonds, property — live in the financial account.
3. E. By the identity CA + financial account = 0, a \$150 billion current account deficit is financed by a \$150 billion net capital inflow (financial account surplus). A, B, C: these violate the identity. D: the identity holds under any exchange-rate regime.
Fix: The two accounts are mirror images; a trade deficit means borrowing from or selling assets to foreigners, dollar for dollar.
4. B. Appreciation means the currency buys more foreign currency — it strengthens. A: that describes depreciation. C and E: higher inflation or more currency tends to weaken the dollar. D: a wider deficit does not define appreciation.
Fix: Appreciate = strengthen = more foreign currency per unit; depreciate is the reverse.
5. B. Foreigners need dollars to buy U.S. exports and assets — that is the demand side. A and C: Americans supply dollars when buying foreign goods or assets. D and E: the central bank and Treasury are not the model's foreign-exchange participants.
Fix: Demand for a currency comes from outsiders wanting that country's exports and assets.
6. A. Higher relative U.S. returns pull in foreign capital, raising demand for dollars and appreciating the currency. B and C: wrong curve or direction for a capital inflow. D: only demand shifts, not both. E: interest rates reach the exchange rate through asset demand.
Fix: Relatively higher real rates → capital inflow → the currency appreciates.
7. A. A stronger dollar prices U.S. goods out abroad and makes imports cheaper, so net exports fall. B: a stronger dollar hurts exporters. C: net exports are not fixed. D: imports become cheaper, not more expensive. E: tariffs are a separate instrument.
Fix: Appreciation lowers net exports; depreciation raises them — finish every foreign-exchange chain with this line.
8. D. Higher U.S. incomes raise import demand, so Americans supply more dollars, depreciating the currency. A and E: that is what foreign income growth does. B: private trade does not wait for the central bank. C: only supply shifts.
Fix: Whose income rose? Ours → supply of our currency rises; theirs → demand for our currency rises.
9. C. Relatively expensive U.S. goods mean foreigners buy fewer (demand for dollars falls) and Americans import more (supply of dollars rises), so the dollar depreciates. A and D: high inflation does not strengthen a currency here. B: relative prices are exactly what foreign exchange trades on. E: nothing fixes the rate.
Fix: Relatively high inflation depreciates a currency as trade shifts toward cheaper foreign goods.
10. E. Lower relative U.S. rates push capital abroad — less demand for dollars and more supply — depreciating the currency. A, B, C, D: each strengthens the dollar (inflows, export demand, asset purchases, and self-fulfilling expectations).
Fix: Rate cuts weaken a currency; rate hikes strengthen it — always relative to the rest of the world.
11. D. Deficits raise real rates, drawing foreign capital that appreciates the dollar and cuts net exports — international crowding out stacked on the domestic kind. A, B, C: these describe the opposite capital flow. E: the financial account moves toward surplus while the current account weakens.
Fix: Fiscal deficits hit net exports at one remove: higher rates → appreciation → lower net exports.
12. A. A tariff raises the import's domestic price: protected producers gain, while consumers and downstream steel-using industries pay more, and trade gains shrink. B and E: a tax on imports raises prices. C: barriers reduce the gains from trade. D: foreign producers lose sales.
Fix: Tariffs redistribute from consumers and users to protected producers, with an efficiency loss on top.
1. C. Buying a foreign good is an import, recorded in the current account. A and E: no asset changed hands, so nothing hits the financial account. B: an export flows the other way. D: transfers are gifts or remittances, not purchases. Fix: Goods and services go in the current account; imports are the debit side.
2. B. A foreign purchase of U.S. assets is a financial account inflow. A: bonds are not goods or services. C: nothing was imported. D: not a gift. E: every cross-border transaction is recorded somewhere. Fix: Asset purchases — stocks, bonds, property — live in the financial account.
3. E. By the identity CA + financial account = 0, a \$150 billion current account deficit is financed by a \$150 billion net capital inflow (financial account surplus). A, B, C: these violate the identity. D: the identity holds under any exchange-rate regime. Fix: The two accounts are mirror images; a trade deficit means borrowing from or selling assets to foreigners, dollar for dollar.
4. B. Appreciation means the currency buys more foreign currency — it strengthens. A: that describes depreciation. C and E: higher inflation or more currency tends to weaken the dollar. D: a wider deficit does not define appreciation. Fix: Appreciate = strengthen = more foreign currency per unit; depreciate is the reverse.
5. B. Foreigners need dollars to buy U.S. exports and assets — that is the demand side. A and C: Americans supply dollars when buying foreign goods or assets. D and E: the central bank and Treasury are not the model's foreign-exchange participants. Fix: Demand for a currency comes from outsiders wanting that country's exports and assets.
6. A. Higher relative U.S. returns pull in foreign capital, raising demand for dollars and appreciating the currency. B and C: wrong curve or direction for a capital inflow. D: only demand shifts, not both. E: interest rates reach the exchange rate through asset demand. Fix: Relatively higher real rates → capital inflow → the currency appreciates.
7. A. A stronger dollar prices U.S. goods out abroad and makes imports cheaper, so net exports fall. B: a stronger dollar hurts exporters. C: net exports are not fixed. D: imports become cheaper, not more expensive. E: tariffs are a separate instrument. Fix: Appreciation lowers net exports; depreciation raises them — finish every foreign-exchange chain with this line.
8. D. Higher U.S. incomes raise import demand, so Americans supply more dollars, depreciating the currency. A and E: that is what foreign income growth does. B: private trade does not wait for the central bank. C: only supply shifts. Fix: Whose income rose? Ours → supply of our currency rises; theirs → demand for our currency rises.
9. C. Relatively expensive U.S. goods mean foreigners buy fewer (demand for dollars falls) and Americans import more (supply of dollars rises), so the dollar depreciates. A and D: high inflation does not strengthen a currency here. B: relative prices are exactly what foreign exchange trades on. E: nothing fixes the rate. Fix: Relatively high inflation depreciates a currency as trade shifts toward cheaper foreign goods.
10. E. Lower relative U.S. rates push capital abroad — less demand for dollars and more supply — depreciating the currency. A, B, C, D: each strengthens the dollar (inflows, export demand, asset purchases, and self-fulfilling expectations). Fix: Rate cuts weaken a currency; rate hikes strengthen it — always relative to the rest of the world.
11. D. Deficits raise real rates, drawing foreign capital that appreciates the dollar and cuts net exports — international crowding out stacked on the domestic kind. A, B, C: these describe the opposite capital flow. E: the financial account moves toward surplus while the current account weakens. Fix: Fiscal deficits hit net exports at one remove: higher rates → appreciation → lower net exports.
12. A. A tariff raises the import's domestic price: protected producers gain, while consumers and downstream steel-using industries pay more, and trade gains shrink. B and E: a tax on imports raises prices. C: barriers reduce the gains from trade. D: foreign producers lose sales. Fix: Tariffs redistribute from consumers and users to protected producers, with an efficiency loss on top.