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Factors Influencing Foreign Exchange Market

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Factors Influencing Foreign Exchange Market

Shortly after the Fed announced an increase in interest rates, the value of the U.S. dollar against the Euro went up. What are the factors influencing foreign exchange market? Was it because of the rise in the interest rate? How can a change in policies affect the foreign exchange rate? Can the U.S. government cause the U.S. dollar to appreciate or depreciate? Do you want to learn about these and much more? Then read on!

Factors Influencing Foreign Exchange Market Explanation

Today, many of the goods we buy are imports from other countries. While we buy these goods in our currency, the U.S. dollar, the producer of the goods requires payment in their currency--the Euro, British pound, Mexican peso, or any of the many other currencies that exist worldwide. At some point, the U.S. dollars we pay at the store for an imported good must be exchanged for the currency used by the producer. This is the purpose of the foreign exchange market.

The foreign exchange market, often abbreviated as FOREX, is a market where the value of any currency is determined by supply and demand.

The value of all currencies rises or falls based on supply and demand in the FOREX market. Factors affecting supply and demand change the equilibrium exchange rate in the foreign exchange market.

Demand Factors

Demand for a currency is directly tied to demand for the imported products purchased with that currency. For example, demand for the Japanese yen is directly tied with demand for Toyota automobiles, Nintendo video game consoles, and Sony electronics.

When Japan exports more of these goods to other countries, importers in these other countries have an increased demand for the Japanese yen. More exports mean a nation's currency is gaining in value due to increased demand. This gain in value is called appreciation. Conversely, less demand for a country's exports will lead to reduced demand for that country's currency. The reduction in value is called depreciation.

Investors also demand currencies to invest in the nations using those currencies. When a nation has relatively low inflation, stable interest rates, and political stability, it is seen as favorable for investment, and the demand for its currency will rise. That's why the role of the government in building favorable conditions for the foreign exchange market is crucial for attracting new investors and raising the value of their domestic currency.

Supply Factors

There is a limited supply of all currencies on the FOREX market, and the supply of currencies on the FOREX market changes. When we import goods from a foreign country, we must sell our domestic currency and buy the goods using the foreign currency. As more imports occur, the domestic currency is sold in the FOREX market, raising the currency's supply. Effectively, this "replaces" the exporter's currency on the FOREX market with the importer's currency. This means that the exporter's currency is decreasing in supply (causing its value to rise) while the importer's currency is increasing in supply (causing its value to decrease).

Another supply factor is monetary policy which directly impacts the currency flow in the market. When the central bank decides to increase the money supply, more currencies are in circulation, which causes a depreciation of the currency.

Examples of Factors Influencing Foreign Exchange Market

Let's consider an imaginary where the U.S. government would allocate a huge part of its budget to fund research and development for cancer. Let's assume that the U.S. government-backed start-ups invent the cure for cancer. As a result, all the other countries will have to buy the medicine from the U.S. But to buy the medicine, they have to pay in U.S. dollars. Graphically, one can look at the change in currency values from exporting medicine from either the demand perspective. Foreigners have increased demand for the U.S. dollar to buy U.S. exports. This is how indirectly the government could affect the value of its currency.

factors influencing foreign exchange market shift in demand for usd studysmarterFigure 1. A shift in demand for USD, StudySmarter Originals

Figure 1 considers how an increase in demand for USD leads to an appreciation of USD. As demand for USD shifts from D1 to D2, the equilibrium in the foreign exchange market also changes from E1 to E2. That means that initially, one USD could get you 126 Japanese Yen, but now 1 USD can get you 128 Yen, two more Yen due to the increase in demand.

Aside from importing and exporting, currency value is affected by the demand for currency from investors. Let us assume that the Fed decides to increase the interest rate, which would result in the nation's banking system offering high-interest rates. In that case, foreigners will have increased demand for that currency to either deposit it in that nation's banks or purchase bonds because they will receive relatively higher interest payments than they could get with their domestic currency. Thus, demand for a currency rises when it has a relatively higher interest rate than other currencies, all else equal.

The flip side of interest rates is inflation. Investors seek higher relative interest rates but dislike inflation, defined as the rise in the general level of prices. Inflation reduces the purchasing power of money. When one currency has a higher relative inflation rate, it experiences reduced demand on the FOREX market. There is a direct relationship between interest rates and demand for currency, but an inverse relationship between inflation rates and demand for currency.

Inflation rates reduce interest rates. The interest rate adjusted for inflation is called the real interest rate, r. It is simply found by subtracting the inflation rate, , from the nominal (current) interest rate, i.

Investors demand currencies with higher relative real interest rates. The real interest rate within a country can be affected by both monetary policy and fiscal policy.

Effects of Changes in Policies on the Foreign Exchange Market

Economic policies tremendously impact the foreign exchange market in any country. Monetary policy refers to the central bank's control of the money supply to affect interest rates. The central bank uses monetary policy to cause the interest rate in a country to rise or fall to either discourage or encourage borrowing and spending.

The Fed pursues an expansionary monetary policy during a recession to expand the money supply and lower interest rates. This increases borrowing and spending within the country, boosting aggregate demand, and reducing demand for the currency from foreign investors. The currency's value will fall on the FOREX market due to reduced demand.

Conversely, when excessive inflation is in an economy, the government uses contractionary monetary policy to restrict the money supply and raise interest rates. This causes foreign investors to demand the currency more, which increases its value on the FOREX market.

Fiscal policy is the adjustment of government spending and taxation to affect aggregate demand. When the federal government increases its spending, that in turn causes an increase in aggregate demand - there will be more consumption of goods and services. This pushes up the rate of inflation. Higher inflation means a lower real interest rate, all else equal, which reduces foreign investors' demand for the U.S. dollar. The increase in aggregate demand also leads to an increase in imports. As imports increase, U.S. importers need to sell their dollars to buy foreign currencies to buy foreign goods. This leads to a drop in the relative demand for the U.S. dollar, decreasing the value of the U.S. dollar.

Effect of Changes in Economic Conditions on the Foreign Exchange Market

When a nation is experiencing increased aggregate demand, it tends to import more goods from other countries. This importing causes its currency value to depreciate. This helps achieve a natural balance in international trade: when a nation imports heavily, its currency value decreases, making it more attractive for other nations to buy its exports. A relative balance of trade should occur in the long run. As a nation imports more goods, its currency value decreases, making it more expensive to continue purchasing imports. To domestic consumers, it appears that the price of imports is rising. This is because it takes increasing units of that nation's depreciated currency to purchase one unit of the exporter's currency.

Conversely, when a nation is experiencing a recession, it imports fewer goods from other countries. This causes its currency to appreciate, as it puts less supply on the FOREX market to buy foreign currencies. As the currency appreciates, it can now buy more units of foreign currency, making it appear to domestic consumers that the prices of imported goods are decreasing.

Effects of Inflation on the Foreign Exchange Market

Investors dislike inflation. When a country is experiencing lower inflation, the country's currency will appreciate due to higher demand. Investors want to place their wealth in currencies of countries with low inflation. This can sometimes lead to the harmful phenomenon of capital flight, where wealth made in developing nations is quickly converted into well-established currencies like the U.S. dollar or Euro. This results in developing nations struggling to develop, as those who do become financially successful invest their money in wealthy nations.

Factors Influencing Foreign Exchange Market - Key takeaways

  • Factors that shift the demand or supply for a currency affect the equilibrium exchange rate in the foreign exchange market.
  • Fiscal policy impacts aggregate demand, real output, price level, and the exchange rate.
  • Monetary policy impacts aggregate demand, real output, price level, interest rate, and the exchange rate.

Frequently Asked Questions about Factors Influencing Foreign Exchange Market

Some of the factors influencing the foreign exchange market include economic conditions, inflation, interest rate, political stability, monetary policy, and fiscal policy.

The Fed pursues an expansionary monetary policy during a recession to expand the money supply and lower interest rates. This increases borrowing and spending within the country, boosting aggregate demand, and also reduces demand for the currency from foreign investors. On the FOREX market, the currency's value will fall due to reduced demand.

Conversely, when excessive inflation is in an economy, the government uses contractionary monetary policy to restrict the money supply and raise interest rates. This causes foreign investors to demand the currency, which increases its value on the FOREX market.

When a nation is experiencing increased aggregate demand, it tends to import more goods from other countries. This importing causes its currency value to depreciate. 

Conversely, when a nation is experiencing a recession, it imports fewer goods from other countries. This causes its currency to appreciate, as it puts less supply on the FOREX market to buy foreign currencies. 

Investors dislike inflation. When a currency is experiencing higher relative inflation than another currency, its value will depreciate due to lower demand. Conversely, when a currency is experiencing lower relative inflation than another currency, its value will appreciate due to higher demand.

Demand for the country's exports, the country's demand for foreign imports, and the real interest rate.

Final Factors Influencing Foreign Exchange Market Quiz

Question

The equilibrium exchange rate is the exchange rate at which the quantity of a ________ demanded is equal to the quantity supplied.

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currency

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The place where people buy and sell currencies is called the _______ ________ ______.

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foreign exchange market

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If 10 US Dollars can be exchanged for 8.5 Euros, what is the USD to EUR exchange rate?

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1 USD to 0.85 EUR, 1 to 0.85

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When the value of a currency relative to another currency increases, we say it has ___________.


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appreciated

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When the value of a currency relative to another currency decreases, we say it has ___________.


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depreciated

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The summary of one country's transactions with another country is called the _______ of ________. 


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balance payments

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The Balance of Payments consists of the _______ Account and the ________ Account.


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Current, Capital and Financial

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Which of the following is NOT included in the Current Account

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Asset sales and purchases

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The Financial Account includes the purchases and sales of assets by the private sector and ___________.


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governments

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Demand for currency slopes ________ because when one currency becomes cheaper relative to another that means that Country's goods, services, and financial assets become cheaper for the other country.


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downward

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Supply for currency slopes ______ because when one currency becomes more expensive relative to another that means that country's goods, services, and financial assets become cheaper for the other country.


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upward

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At the equilibrium exchange rate, the sum of the balance of payments on the current account plus the balance of payments on the financial account is ____.


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zero

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Question

The __________ _____ ______  between two countries’ currencies is the exchange rate at which a given basket of goods and services would cost the same amount in each country. 


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purchasing power parity

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A quota imposed on Japanese goods by the U.S Government would:

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Shift the supply of USD to the left

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Question

An increase in a country's interest rate will also result in an ________ in its equilibrium exchange rate, all else being equal.


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increase

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What is the foreign exchange market?

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The foreign exchange market, often abbreviated as FOREX, is a market where the value of any currency is determined by supply and demand. 

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How is the value of currencies determined in the foreign exchange market?

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The value of all currencies rises or falls based on supply and demand in the FOREX market.

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What happens when there is a change in demand or supply for USD?

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The equilibrium exchange rate also changes.

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What do more exports mean for a country's currency?

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More exports mean a nation's currency is gaining in value due to increased demand.

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What is the appreciation of a currency?

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When a currency gains value.

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What are the factors influencing the foreign exchange market?


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Some of the factors influencing the foreign exchange market include: economic conditions, low inflation, interest political stability, monetary policy, fiscal policy.

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What happens to the value of the currency if the interest rate increases?

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Answer

The value of the currency will increase as investors will look for higher returns.

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What are the effects of changes in policies on the foreign exchange market?


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Answer

The Fed pursues an expansionary monetary policy during a recession to expand the money supply and lower interest rates. This increases borrowing and spending within the country, boosting aggregate demand, and also reduces demand for the currency from foreign investors. On the FOREX market, the currency's value will fall due to reduced demand.

Conversely, when excessive inflation is in an economy, the government uses contractionary monetary policy to restrict the money supply and raise interest rates. This causes foreign investors to demand the currency, which increases its value on the FOREX market.

Show question

Question

What are the effects of changes in economic condition on the foreign exchange market?


Show answer

Answer

When a nation is experiencing increased aggregate demand, it tends to import more goods from other countries. This importing causes its currency value to depreciate. 

Conversely, when a nation is experiencing a recession, it imports fewer goods from other countries. This causes its currency to appreciate, as it puts less supply on the FOREX market to buy foreign currencies. 

Show question

Question

What are the effects of inflation on the foreign exchange market? 

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Answer

Investors dislike inflation. When a currency is experiencing higher relative inflation than another currency, its value will depreciate due to lower demand. Conversely, when a currency is experiencing lower relative inflation than another currency, its value will appreciate due to higher demand.

Show question

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Assume a country has a relatively low inflation rate, what would it mean for the value of its currency?

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The value of the currency would appreciate as investors look to invest their money in countries that are less risky.

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Explain how monetary policy affects the foreign exchange market.

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Monetary policy, which involves the Fed's control of the money supply to affect interest rates, causes interest rates in a country to rise or fall to either encourage borrowing and spending (low interest) or discourage borrowing and spending (high interest). 

The Fed pursues an expansionary monetary policy during a recession to expand the money supply and lower interest rates. This increases borrowing and spending within the country, boosting aggregate demand, and also reduces demand for the currency from foreign investors. On the FOREX market, the currency's value will fall due to reduced demand.

Show question

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Explain how fiscal policy influences the foreign exchange market.

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Fiscal policy is the adjustment of government spending and taxation to affect aggregate demand. During a recession, the government uses expansionary fiscal policy to expand aggregate demand by increasing government spending and/or reducing taxation. This causes interest rates to rise, as the government must engage in deficit spending and borrow money, reducing the supply of loanable funds.

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How would a recession affect the value of the US dollar?

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When a nation is experiencing a recession, it imports fewer goods from other countries. This causes its currency to appreciate, as it puts less supply on the FOREX market to buy foreign currencies. As the currency appreciates, it can now buy more units of foreign currency, making it appear to domestic consumers that the prices of imported goods are decreasing.

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What happens to a currency that has higher inflation rate relative to others?

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When one currency has a higher relative inflation rate, it experiences reduced demand on the FOREX market.

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Which conditions make a nation appear favorable for investment?

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Low inflation, stable interest rates, and political stability.

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Who is responsible for adjusting the interest rate?

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The Federal Reserve.

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When a currency has a ________ relative inflation rate, it experiences __________ demand on the FOREX market


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higher, reduced

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Suppose the inflation rate is 3.76% and the interest rate is 5%. What is the real interest rate?

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1.24%

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What is the rate of inflation when the real interest rate is 3.43% and the nominal interest rate is 7%?

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3.57%

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Interest rates can be adjusted using which type of policy?

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Both 

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What is an effective method to reduce or slow excessive inflation?

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Contractionary monetary policy.

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What effect does importing lots of goods have on the value of a currency?

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It causes the value to depreciate?

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What is capital flight?

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Where wealth made in developing nations is quickly converted into well-established currencies, to protect it from any instability.

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Why are higher interest rates good for investors?

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They are good for investors because it means they will get higher returns from their investments.

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If you strike it big in your home country of Zimbabwe, and you want to protect your wealth, should you choose to invest in your home country or in an already developed nation?

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If you want stability for your money you would choose to invest in a developed nation whose currency has proven itself stable.

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What is the adjustment of government spending and taxation to affect aggregate demand?


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Fiscal policy.

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As the US increases imports, they need more foreign currency, What does this mean for the value of the USD and the foreign currency?

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The USD will depreciate and the foreign currency will appreciate.

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How might a currency's purchasing power be reduced?

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By an increase in inflation.

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What is purchasing power?

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It is the value of a currency thought of in terms of what you can buy with it.

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How does expansionary monetary policy increase spending?

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It increases spending by lowering interest rates which encourages people to borrow and decreases demand for the currency by foreign investors.

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When a nation is experiencing increased aggregate demand, it tends to import ______ goods from other countries. This importing causes its currency value to ________.

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More, depreciate.

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What effect will decreasing the interest rate have on the demand and supply of USD?

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It will cause the demand to decrease, and the supply to increase.

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How might a decrease in US income taxes affect the exchange rate with the JPY?

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It would lower the USD equilibrium exchange rate.

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Question

What accounts does the balance of payments consist of?

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The current account.

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