Question

3. Explicate how the exchange rates, in a flexible exchange rate regime, and the balance of payments, in a fixed exchange rate world, are affected by deficits and surpluses.

Answer 1

The relationship between balance of payments and exchange rates under a floating-rate exchange system will be driven by the supply and demand for the country's currency and all transactions taking place with other countries.

Currency exchange rates are influenced by the demand for currency, which is in turn influenced by trade. If a country exports more than it imports (i.e surplus), there is a high demand for its goods, and thus, for its currency. The economics of supply and demand dictate that when demand is high, prices rise and the currency appreciates in value. In contrast, if a country imports more than it exports(i.e deficit) there is relatively less demand for its currency, so prices should decline. In the case of currency, it depreciates or loses value.

The relationship between balance of payments and exchange rates described here only exists under a free or floating exchange rate regime. The balance of payments does not impact the exchange rate in a fixed-rate system because central banks adjust currency flows to offset the international exchange of funds.