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Study notes

Foreign Currency Gaps

  • Levels: A Level, IB
  • Exam boards: AQA, Edexcel, OCR, IB, Eduqas, WJEC

Many developing countries face a big imbalance between inflows and outflows of foreign currencies. A foreign exchange gap happens when currency outflows persistently exceed currency inflows

This can occur when:

  • A country is running a persistent current account deficit on their balance of payments
  • There is an outflow of capital from investors in money and capital markets (this is known as capital flight)
  • There is a fall in the value of inflows of remittances from nationals living and working overseas

One measure of the extent of foreign-exchange cover for a country is the value of a nation’s foreign currency reserves measured in terms of the number of months of imports that this currency could finance (this is known as import cover).

A key consequence of a foreign currency gap can be that a nation does not have enough foreign currency to pay for essential imports such as medicines, foodstuffs and critical raw materials and replacement component parts for machinery. In this way, a foreign currency shortage can severely hamper short run economic growth.

Some countries resort to devaluing their exchange rates in a bid to improve the competitiveness of export industries but there is no guarantee that a weaker currency will help to resolve a foreign currency gap. Indeed, the threat of a currency devaluation might prompt a further outflow of currency from a country as investors get nervous.

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