Business Economics · Globalisation and multinational business

Exchange Rates, Balance of Payments and Global Finance Explained

Updated 11 October 2026 · Fact-checked

An exchange rate is the price of one currency in terms of another. In a floating system it is set by demand and supply for the currency. The balance of payments records all transactions between a country and the rest of the world. Currency moves change export prices, import costs and multinational profits.

Understand Exchange Rates, Balance of Payments and Global Finance

An exchange rate is the price of one currency in terms of another. For example, ₹85 per US dollar means one dollar costs ₹85. When the number of rupees per dollar rises, the rupee has depreciated. When it falls, the rupee has appreciated. Be careful about which currency is the base in the quote.

In a floating exchange rate system, the rate is set by the demand for and supply of the currency in the foreign exchange market. Demand for rupees comes from foreigners buying Indian exports, investing in India or speculating on the rupee. Supply of rupees comes from Indians buying imports, investing abroad or selling rupees. Anything that shifts these curves shifts the rate. Key drivers are relative interest rates, relative inflation, growth, investor confidence and speculation. In a fixed system, the central bank sets the rate and must buy or sell currency from its reserves to hold it.

The balance of payments (BoP) is a record of all transactions between residents of a country and the rest of the world over a period. It has two main parts. The current account records trade in goods, trade in services, primary income (such as profits, interest and wages earned abroad) and secondary income (such as remittances and gifts). The capital and financial account records flows of investment: foreign direct investment, portfolio investment, loans and changes in reserves. Because every transaction has two sides, the BoP as a whole always balances. A deficit on one account is matched by a surplus on another.

The link between the two is important. A country with a current account deficit must finance it by net inflows on the financial account, such as borrowing or foreign investment, or by drawing down reserves. If investors stop financing the deficit, the currency is under pressure to fall. In a floating system, depreciation can then make exports cheaper and imports dearer, which tends to narrow the deficit over time.

For multinational firms, exchange rates matter in three ways. Transaction risk is the risk that a rate moves between agreeing a price and receiving or paying cash. Translation risk arises when foreign subsidiary accounts are converted into the parent's currency. Economic risk is the long-term effect of rate changes on competitiveness and future cash flows. Firms can reduce these risks by hedging with forwards, options or swaps, by matching revenues and costs in the same currency, or by invoicing in their home currency.

Key rules to remember

Percentage change in value of home currency: With the rate in ₹ per $: change in the rupee's value (%) = (old rate ÷ new rate − 1) × 100; A negative result means the home currency has depreciated. For ₹80 to ₹84 per dollar: (80 ÷ 84 − 1) × 100 = −4.76%. If the rate is quoted as foreign currency per unit of home currency, use (new rate ÷ old rate − 1) × 100 instead.
Balance of payments identity: Current account + Capital account + Financial account (including reserve assets) + Net errors and omissions = 0; In principle the total balances. Some presentations show changes in reserves as a separate balancing line instead of inside the financial account, so state your convention.
Trade balance: Trade balance = Exports of goods − Imports of goods; This is only one part of the current account. Add services, primary income and secondary income for the full current account.
Current account: Current account = Trade in goods + Trade in services + Primary income + Secondary income; A negative total is a current account deficit.
Marshall-Lerner condition: Depreciation improves the trade balance if |PEDx| + |PEDm| > 1; PEDx is the price elasticity of demand for exports. PEDm is that for imports. It assumes the trade balance starts at zero.
Relative purchasing power parity (approximate): For a rate quoted as home currency per unit of foreign currency (such as ₹ per $): % rise in the rate (home currency depreciation) ≈ domestic inflation − foreign inflation; This is a long-run tendency, not an exact rule. A positive value means the home currency depreciates. If the quote is the other way round, the sign flips.

How to solve Exchange Rates, Balance of Payments and Global Finance questions

Use this method for any question on exchange rates, the BoP or currency effects on firms.

1Identify what is asked: a rate movement, a BoP item, a policy effect or a firm's exposure.
2Fix the quote direction. Write the rate as 'currency X per unit of currency Y' and note what a rise means.
3For rate determination, draw or describe the demand and supply for the currency. Name the shift and its cause.
4For BoP questions, place each item in the correct account: current (goods, services, income, transfers) or capital and financial (investment, loans, reserves).
5Apply the double-entry idea: a deficit on one account must be matched by a net surplus elsewhere.
6Trace the effect: rate change, then export and import prices, then volumes (using elasticity), then profits or the trade balance.
7For firms, classify the risk as transaction, translation or economic, and suggest a suitable response.
8Show any calculation clearly with units and state your assumptions.

Quickest way: Direction-first shortcut

When to use it: Use this for multiple-choice questions and for short written parts under time pressure.

Ask: more demand for the currency or more supply of it? More demand means appreciation. More supply means depreciation.
Higher domestic interest rates relative to abroad usually attract capital and raise demand for the currency, other things equal.
Higher domestic inflation relative to abroad tends to weaken the currency over time.
For BoP items, ask: is it a payment for goods, services, income or a gift (current), or a purchase of an asset or a loan (capital and financial)?
Depreciation helps exporters and hurts importers, but the trade balance only improves if elasticities are high enough.

Common mistakes in Exchange Rates, Balance of Payments and Global Finance

Reading the quoted rate backwards, saying the rupee strengthened when ₹ per $ rose.
Students focus on the number going up and assume the currency is stronger.
Fix: Always ask what one unit of which currency costs. If more rupees buy one dollar, the rupee is weaker.
Saying the balance of payments can be in deficit overall.
Students mix up the BoP with the current account or trade balance.
Fix: State that the full BoP balances by construction. Say which account or sub-balance is in deficit, and how it is financed.
Putting FDI or loans in the current account.
Students link any money flow with trade.
Fix: Current account covers goods, services, income and transfers. Investment and borrowing flows belong to the capital and financial account.
Claiming depreciation always improves the trade balance.
Students memorise that exports get cheaper and stop there.
Fix: Mention elasticity and the Marshall-Lerner condition. In the short run demand is often inelastic, so the balance can worsen first.
Treating hedging as removing all exchange rate risk.
Students think a forward contract has no downside.
Fix: Say that hedging fixes the rate, so the firm loses any favourable move and may bear costs. Economic risk is hard to hedge.
Treating purchasing power parity as an exact short-run rule.
The formula looks precise.
Fix: Describe it as a long-run tendency. Trade costs, capital flows and speculation cause large short-run gaps.

Worked examples

Example 1

The rupee moves from ₹80 per US dollar to ₹84 per US dollar. (a) Has the rupee appreciated or depreciated? (b) An Indian firm imports goods priced at $50,000. By how much does the rupee cost of the import change?

Show the solution

The rupee price of a dollar has risen, so each dollar costs more rupees. The rupee has depreciated.
Cost at ₹80: 50,000 × 80 = ₹40,00,000.
Cost at ₹84: 50,000 × 84 = ₹42,00,000.
Change: ₹42,00,000 − ₹40,00,000 = ₹2,00,000 increase.

Answer: The rupee has depreciated. The import now costs ₹2,00,000 more, rising from ₹40,00,000 to ₹42,00,000.

Example 2

A country's transactions for a year (in billions) are: exports of goods 120, imports of goods 150, net services income +20, net primary income −15, net secondary income (remittances) +25, net FDI inflow 18, net portfolio inflow 12. Find the current account balance and the amount the country must finance from other sources, treating errors and the capital account as zero. Explain.

Show the solution

Trade balance in goods: 120 − 150 = −30.
Current account = −30 + 20 − 15 + 25 = 0.
A current account of 0 means there is no deficit to finance. The amount to finance from other sources is 0.
State the convention first. Here the financial account is shown as net capital inflow: a net inflow of funds from abroad is positive. An increase in reserve assets is recorded as a negative balancing entry. (Under the BPM6 presentation, FDI inflows are recorded as a net incurrence of liabilities and the signs are set out differently. The totals below are the same.)
Net capital inflow excluding reserves = 18 + 12 = +30.
Overall balance before reserves = current account + capital account + net capital inflow + errors = 0 + 0 + 30 + 0 = +30. This is an overall surplus of 30.
This surplus of 30 is added to reserves. Under our convention the increase in reserve assets is recorded as −30.
Check: 0 + 0 + 30 + (−30) + 0 = 0. The BoP balances.
Interpretation: the goods trade deficit is offset by services and remittances. The net capital inflows are not needed to fund a deficit, so they add to reserves.

Answer: The current account balance is 0 (balanced), so the financing requirement is 0. The net capital inflow of 30 gives an overall surplus of 30. This is added to reserves, recorded as −30 in the balancing entry under the stated convention, so the BoP total is 0.

Exam tips

Draw a small demand and supply diagram for the currency when asked how a rate is determined. Label axes with the quote direction.
In written answers, name the account for each BoP item and mention that the total balances.
Always link a currency move to a firm's cash flows with numbers if data are given.
When discussing depreciation, bring in elasticity and time lags to show depth and earn evaluation marks.
For multinational risk questions, separate transaction, translation and economic risk and match a response to each.

Practice questions from Globalisation and multinational business

Exchange Rates, Balance of Payments and Global Finance in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Exchange Rates, Balance of Payments and Global Finance: frequently asked questions

How are exchange rates determined?

In a floating system, by demand and supply for the currency in the foreign exchange market. Interest rate differences, inflation, growth, confidence and speculation shift demand and supply. In a fixed system the central bank sets the rate and defends it using reserves.

What is the difference between the current account and the capital account?

The current account records trade in goods and services, income and transfers. The capital and financial account records investment and loan flows, such as FDI and portfolio investment. Together with reserve changes they balance.

Does a current account deficit mean a country is in trouble?

Not necessarily. A deficit can reflect strong investment funded by foreign capital. It becomes a concern if it is large, persistent and relies on flows that may stop suddenly, which can put pressure on the currency.

What is exchange rate risk for multinational companies?

It is the risk that currency moves reduce profits or the value of assets. It appears as transaction, translation and economic risk. Firms manage it through hedging, matching currencies and diversifying operations.