Understanding How Balance of Payments and Exchange Rates Work
Most economic commentators believe balance of trade is a key factor in a currency’s exchange rate. All other things being equal, an increase in imports, which leads to a trade deficit, gives rise to an increase in the demand for foreign currency.
To obtain foreign currency, importers sell their domestic currency for it. This strengthens the exchange rate of the foreign currency against the domestic currency—i.e., there is more domestic money per unit of a foreign money.
Conversely, all other things being equal, an increase in exports leads to a trade surplus. When exporters exchange their foreign currency earnings for their domestic money, this strengthens the domestic money’s exchange rate against the foreign money (there is less domestic money per unit of a foreign money).
Again, if a country exports more than it imports, there is a strengthening in the demand for the country’s goods, and thus for its currency. Consequently, the price of the domestic money in terms of foreign money is likely to increase.
Conversely, if a country imports more than it exports, the demand for the foreigners’ goods and for the foreign currency is strengthened. Consequently, the increase in the demand for the foreign money raises its price in terms of domestic money.
By the same logic, if foreigners’ demand for another country’s money suddenly increases, this is going to strengthen that currency’s exchange rate versus the foreign currency. If, however, the foreigners’ demand for the country’s money suddenly declines, this will weaken that currency’s exchange rate against other currencies.
Fundamental versus Nonfundamental Causes
Many factors determine a currency’s exchange rate. For example, an increase in the government foreign debt is a sign of a deterioration in economic fundamentals ahead, which provides a rationale to sell the currency.
Alternatively, consider what happens when the central bank tightens its interest rate stance. The increase in the domestic interest rate, all other things being equal, attracts foreign demand for the domestic m
Article from Mises Wire