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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