Use this review after the Unit 6 diagnostic. It links the six topics, then gives six questions that each combine two or more of them.
Big ideas of the unit
- One set of trades, recorded twice. Every international transaction appears in the balance of payments as a credit (money in) or a debit (money out), and CA + CFA = 0. See Topic 6.1.
- The same trades drive the currency market. People swap currencies to make exactly these CA and CFA transactions.
- An exchange rate is a price. Always say which currency is priced in which. If one currency appreciates, the other depreciates, by a different percentage. See Topic 6.2.
- Demand and supply set the rate. Foreigners buying a country’s goods, services and assets demand its currency; residents buying foreign ones supply it. Surpluses and shortages push the rate to equilibrium. See Topic 6.3.
- Ask “who is paying whom?” before you shift a curve. Foreign incomes, tastes, relative prices and interest rates, trade barriers and policy all shift demand or supply. See Topic 6.4.
- The exchange rate feeds back into the economy. Appreciation makes exports dearer and imports cheaper, so net exports fall and AD shifts left; depreciation does the reverse. See Topic 6.5.
- Real interest rates move money across borders. Funds flow to the higher real rate. That raises demand for the receiving country’s currency, adds to its supply of loanable funds and moves its CFA towards surplus. See Topic 6.6.
- Policy works through the open economy too. Tight money and borrowed fiscal stimulus both raise the real rate and the currency. Lower net exports then add to tight money’s effect on AD but offset part of the fiscal stimulus.
Key relationships and methods
| Idea | Relationship or method | Topic |
|---|---|---|
| Current account | CA = net exports + net income from abroad + net unilateral transfers | 6.1 |
| Capital and financial account | CFA = foreign purchases of domestic assets − domestic purchases of foreign assets | 6.1 |
| Balance of payments | CA + CFA = 0, so a CA deficit is matched by an equal CFA surplus | 6.1 |
| Reciprocal rates | VD per KS = 1 ÷ (KS per VD); work out each currency’s percentage change from its own price | 6.2 |
| Converting prices | VD × (KS per VD) = KS; KS ÷ (KS per VD) = VD | 6.2, 6.5 |
| Equilibrium exchange rate | Set Qd = Qs; a surplus means depreciation, a shortage means appreciation | 6.3 |
| Shifts | Demand up or supply down → appreciation; demand down or supply up → depreciation | 6.4 |
| Net exports and AD | Appreciation → X falls, M rises → NX falls → AD left (by the multiplier) | 6.5 |
| Real interest rate | Real rate = nominal rate − expected inflation; funds flow to the higher real rate | 6.6 |
The questions
These are original Marlbridge practice questions, not past exam questions. The rubrics are a suggested Marlbridge rubric, not official scoring. All questions use Valdoria (currency the valda, VD) and Kestria (currency the kesta, KS), two fictional countries; all data are fictional. Exchange rates are flexible and written as kestas per valda. Financial capital moves freely, and only the stated changes happen.
Question 1 (multiple choice · mixed)
Valdoria’s central bank uses expansionary monetary policy, and expected inflation does not change. Which row correctly describes the effects in Valdoria?
- (A) Real interest rate falls; net capital inflow falls; the current account moves towards deficit.
- (B) Real interest rate falls; net capital inflow falls; the current account moves towards surplus.
- (C) Real interest rate falls; net capital inflow rises; the current account moves towards deficit.
- (D) Real interest rate rises; net capital inflow rises; the current account moves towards deficit.
Answer and explanation
Answer: (B). With expected inflation unchanged, the real rate falls. Valdorian assets become less attractive, so net capital inflow falls and the CFA moves towards deficit. Because CA + CFA = 0, the CA moves towards surplus; on the trade side, the valda depreciates and net exports rise.
- (A) forgets that the two accounts must move in opposite directions.
- (C) sends funds towards the lower real rate.
- (D) describes contractionary policy.
Question 2 (multiple choice · mixed)
Valdoria places a tariff on goods imported from Kestria. Nothing else changes. Which statement must be true?
- (A) The valda depreciates, and Valdoria’s exports to Kestria rise.
- (B) The valda appreciates, so Valdoria’s imports from Kestria certainly rise.
- (C) Demand for valdas increases, so Valdoria’s net exports certainly rise.
- (D) The valda appreciates, and Valdoria’s exports to Kestria fall.
Answer and explanation
Answer: (D). Valdorians buy fewer Kestrian goods, so they need fewer kestas: the supply of valdas decreases and the valda appreciates. Valdorian goods now cost Kestrians more kestas, so Valdoria’s exports fall.
- (A) gets the direction of the currency wrong.
- (B) The appreciation only partly offsets the tariff, so imports do not rise.
- (C) The tariff shifts supply of valdas, not demand. Exports and imports both fall, so net exports need not rise.
Question 3 (constructed response · mixed)
The table shows Valdoria’s international transactions for one year (VD bn). One figure is missing.
| Transaction | VD bn |
|---|---|
| Exports of goods / of services | 210 / 55 |
| Imports of goods / of services | 190 / 70 |
| Income received from abroad / paid to foreigners | 14 / 31 |
| Transfers received from abroad / sent abroad | 9 / 3 |
| Foreign purchases of Valdorian assets | 48 |
| Valdorian purchases of foreign assets | ? |
(a) Calculate the balance of trade and the current account balance. (b) Calculate Valdorian purchases of foreign assets. (c) Valdorian bonds pay a nominal 5% with expected inflation of 2%; Kestrian bonds pay 6% with expected inflation of 4%. Show that these rates are consistent with the sign of Valdoria’s CFA. (d) Valdoria’s central bank cuts the nominal rate to 3%, and expected inflation does not change. Explain the effect on capital flows and on the value of the valda. (e) The next year Valdoria’s CFA is −VD 4 bn. Calculate the current account balance, and explain how the change in (d) helps cause it.
Worked solution and suggested Marlbridge rubric
(a) Exports = 265; imports = 260. Balance of trade = +5 (a surplus). Net income = 14 − 31 = −17; net transfers = 9 − 3 = +6. CA = 5 − 17 + 6 = −6: a deficit, despite the trade surplus.
(b) CFA = −CA = +6, so 48 − purchases = 6, giving VD 42 bn. (Check: credits and debits both total 336.)
(c) Real rates: Valdoria 5 − 2 = 3%; Kestria 6 − 4 = 2%. Funds flow to the higher real rate, Valdoria’s, so a CFA surplus (net inflow) is consistent.
(d) Valdoria’s real rate falls to 3 − 2 = 1%, below Kestria’s 2%. Kestrians buy fewer Valdorian assets and Valdorians buy more Kestrian ones, so the net inflow falls (the flow reverses). Demand for valdas falls and supply rises: the valda depreciates.
(e) CA = −CFA = +VD 4 bn, a rise of VD 10 bn. The weaker valda makes Valdorian goods cheaper in Kestria (exports rise) and Kestrian goods dearer in Valdoria (imports fall), so net exports and the CA rise.
| Point | What earns it |
|---|---|
| 1 | Balance of trade +5 and CA −6 |
| 1 | Valdorian purchases of foreign assets = 42, using CFA = +6 |
| 1 | Real rates 3% and 2%, linked to the net inflow |
| 1 | New real rate 1%, so net capital inflow falls or reverses |
| 1 | Valda depreciates, because demand for valdas falls (or supply rises) |
| 1 | CA = +4 from CA + CFA = 0 |
| 1 | Depreciation raises exports and lowers imports, so NX and the CA rise |
Total: 7 points. Accept values carried forward. In (c), comparing nominal rates earns no point.
Question 4 (constructed response · mixed)
In the market for valdas, Qd = 260 − 40e and Qs = −20 + 30e, where e is in KS per valda and quantities are millions of valdas a month.
(a) Calculate the equilibrium exchange rate and quantity. (b) A boom in Valdorian technology firms leads Kestrian investors to want 21 million more valdas a month at every rate. Find the shortage at the old rate, and the new equilibrium. (c) Draw a correctly labelled graph of the market for valdas showing the change in (b). (d) Calculate the percentage change in the value of each currency. (e) A Valdorian sofa costs VD 900 and a Kestrian e-reader costs KS 430. Calculate each price in the buyer’s currency before and after, and explain the effect on Valdoria’s net exports and AD.
Worked solution and suggested Marlbridge rubric
(a) 260 − 40e = −20 + 30e, so 280 = 70e and e = KS 4.0. Q = 260 − 160 = 100 million valdas.
(b) New demand: Qd = 281 − 40e. At KS 4.0, Qd = 121 and Qs = 100: a shortage of 21 million valdas, so buyers bid the valda up. New equilibrium: 301 = 70e, so e = KS 4.3 and Q = 281 − 172 = 109 million valdas.
(c) Axes “Exchange rate (KS per VD)” and “Quantity of valdas”. D₂ lies right of D₁; S is unchanged. e rises from 4.0 to 4.3, Q from 100 to 109.
(d) Valda: (4.3 − 4.0) ÷ 4.0 × 100 = +7.5%. Kesta: from 1 ÷ 4.0 = VD 0.2500 to 1 ÷ 4.3 = VD 0.2326, a 6.98% depreciation.
(e) Sofa in Kestria: 900 × 4.0 = KS 3,600 before; 900 × 4.3 = KS 3,870 after. E-reader in Valdoria: 430 ÷ 4.0 = VD 107.50 before; 430 ÷ 4.3 = VD 100 after. Valdorian goods are dearer abroad (exports fall) and Kestrian goods cheaper in Valdoria (imports rise). Net exports fall, so AD shifts left.
| Point | What earns it |
|---|---|
| 1 | e = KS 4.0 and Q = 100 million |
| 1 | Shortage of 21 million at KS 4.0, so the valda appreciates |
| 1 | New equilibrium KS 4.3 and 109 million |
| 1 | Graph: labelled axes with currencies, demand shifts right, higher e |
| 1 | Both percentage changes, each from its own base |
| 1 | All four prices correct |
| 1 | Exports fall and imports rise, so NX fall and AD shifts left |
Total: 7 points. In (d), “7.5% both ways” earns no point. In (e), “NX fall” with no reason earns no point.
Question 5 (constructed response · mixed)
Valdoria is in a recession. Its central bank buys government bonds on the open market.
(a) State the effect on Valdoria’s interest rate, and explain the effect on the value of the valda. (b) Draw a correctly labelled graph of the market for valdas showing your answer to (a). (c) Explain the effect on Valdoria’s net exports. (d) Net exports rise by VD 4 bn and the MPC is 0.6. Calculate the shift in AD from this change in net exports, and state the short-run effects on real GDP, the price level and unemployment. (e) Suppose instead the government had raised spending, financed by borrowing. Explain why the exchange-rate effect would weaken that policy but strengthen the policy in (a)–(d).
Worked solution and suggested Marlbridge rubric
(a) Buying bonds is expansionary, so the interest rate falls. Valdorian assets become less attractive: foreigners want fewer valdas and Valdorians buy more foreign assets, so the valda depreciates.
(b) Axes “Exchange rate (KS per VD)” and “Quantity of valdas”. Demand shifts left (or supply shifts right, or both), and e falls.
(c) Valdorian goods cost Kestrians fewer kestas (exports rise); Kestrian goods cost Valdorians more valdas (imports fall). Net exports rise.
(d) Multiplier = 1 ÷ (1 − 0.6) = 2.5. AD shifts right by 4 × 2.5 = VD 10 bn. In the short run real GDP rises, the price level rises and unemployment falls.
(e) Borrowing raises the demand for loanable funds, so the real interest rate rises. Funds flow in, the valda appreciates and net exports fall, offsetting part of the rise in AD. In (a)–(d), the lower rate raises investment and net exports: both push AD right.
| Point | What earns it |
|---|---|
| 1 | Interest rate falls; valda depreciates, linked to less attractive Valdorian assets |
| 1 | Graph with currencies on the axis and a shift that lowers e |
| 1 | Exports rise and imports fall, with price reasons |
| 1 | AD shift of VD 10 bn |
| 1 | Real GDP and price level rise, unemployment falls |
| 1 | Fiscal case: higher real rate, inflow, appreciation |
| 1 | NX fall offsets fiscal policy; under monetary policy both channels raise AD |
Total: 7 points. In (e), “crowding out” with no exchange-rate chain earns no point.
Question 6 (constructed response · mixed)
Valdoria and Kestria both start with a real interest rate of 3%. Kestria’s government then runs a much larger budget deficit, financed by borrowing, and Kestria’s real rate rises to 5%. Valdoria’s policies do not change.
(a) Draw a correctly labelled graph of Kestria’s loanable funds market showing the cause of the rise in its real interest rate. (b) Explain the direction of financial capital flows between the two countries. (c) Explain the effect on Valdoria’s real interest rate, using Valdoria’s loanable funds market. (d) Explain the effect on the value of the valda. (e) Explain the effect on Valdoria’s net exports and on Valdoria’s current account. (f) Explain how the flows in (b) then affect Kestria’s real interest rate.
Worked solution and suggested Marlbridge rubric
(a) Axes “Real interest rate” and “Quantity of loanable funds”. Government borrowing shifts demand for loanable funds right, raising the real rate from 3% to 5%.
(b) Kestria’s real rate (5%) is now above Valdoria’s (3%), so funds flow from Valdoria to Kestria.
(c) Funds leaving Valdoria reduce its supply of loanable funds (shift left), so Valdoria’s real rate rises.
(d) Valdorians sell valdas to buy kestas for Kestrian assets, so the supply of valdas increases and the valda depreciates (the kesta appreciates).
(e) Valdorian goods become cheaper in Kestria and Kestrian goods dearer in Valdoria, so Valdoria’s net exports rise. The outflow moves Valdoria’s CFA towards deficit, so its CA moves towards surplus, matching the higher net exports.
(f) The inflow raises Kestria’s supply of loanable funds, pulling its real rate back down from 5%. With Valdoria’s rate rising, the two rates move closer together.
| Point | What earns it |
|---|---|
| 1 | Kestria’s graph: labelled axes, demand shifts right, higher real rate |
| 1 | Funds flow from Valdoria to Kestria, because Kestria’s real rate is higher |
| 1 | Valdoria’s supply of loanable funds falls, so its real rate rises |
| 1 | Supply of valdas rises (or demand falls), so the valda depreciates |
| 1 | Valdoria’s NX rise, with price reasons |
| 1 | Valdoria’s CFA towards deficit and CA towards surplus |
| 1 | Inflow raises Kestria’s supply of loanable funds, so its rate falls back from 5% |
Total: 7 points. In (c), shifting Valdoria’s demand for loanable funds earns no point.
How did you do?
Find the parts where you lost marks:
- Q1 or Q3(a)–(b), (e): the accounts and CA + CFA = 0. Use the Topic 6.1 checklist.
- Q4(d)–(e): currency values and price conversions. Use the Topic 6.2 checklist.
- Q4(a)–(c): equilibrium, shortages and graph labels. Use the Topic 6.3 checklist.
- Q2, Q5(a)–(b) or Q6(d): which curve shifts and why. Use the Topic 6.4 checklist.
- Q4(e), Q5(c)–(d) or Q6(e): net exports and AD. Use the Topic 6.5 checklist.
- Q3(c)–(d), Q5(e) or Q6(a)–(c), (f): real rates, capital flows and loanable funds. Use the Topic 6.6 checklist.
If several topics feel shaky, return to the Unit 6 diagnostic.