24. Freely fluctuating exchange rates perform which of the following functions? a. They automatically correct a lack of equilibrium in the balance of payments. b. They make imports cheaper and exports more expensive. c. They impose constraints on the domestic economy. d. They eliminate the need for foreign currency hedging. Solution: Choice "a" is correct. As we have mentioned in our explanations of other questions, sometimes questions that are released by the AICPA are released because they will never be used again or because they were test questions that didn't "make" it to be used as part of the recurring database. This may be the case with this question, but it is a good learning experience for candidates, as questions like this may appear on any exam. According to the examiners, it appears that "freely fluctuating (currency) exchange rates" correct a lack of equilibrium in the balance of payments. It is clear that none of the other choices is correct (see explanations below). It is unclear what the statement in "a" even means, but it is the correct answer, and we know that none of the others are correct. Our best explanation of the answer option follows. The balance of payments has two major components: the current account (which is basically imports and exports) and the capital account (which is basically investments in this country and foreign countries). The two components generally offset each other (for the most part). Freely fluctuating exchange rates will impact both of these components because the price of the currencies will fluctuate. What the examiners appear to be saying is that freely fluctuating exchange rates will affect the two components in opposite directions. Assume dollars and euros. If dollars are or become cheaper, imports will be more expensive and exports will be less expense. This condition will reduce imports and increase exports, thereby worsening the current component of the balance of payments. However, if dollars are cheaper, investments in the US will be less expensive. Thus, those in the euro zone will be able to come into the US and buy investments at a good price for them. When they do that, the capital account balance will move in the opposite direction from the current account balance. Choice "b" is incorrect. Freely fluctuating (currency) exchange rates do not necessarily make imports cheaper and exports more expensive. It depends on the direction of the exchange rate movements. Choice "c" is incorrect. Freely fluctuating exchange rates do not impose constraints on the domestic economy. Exchange rates will have an effect on the domestic economy, but the effect will be indirect over a period of time. Choice "d" is incorrect. Freely fluctuating (currency) exchange rates may actually increase (not eliminate) the need for foreign currency hedging because the exchange rates will change on a continuous basis and may change in either direction.