How the balance of payments exchange rate affects the currency?


The change in the balance of payments can lead to fluctuations in the exchange rate of its currency and foreign currencies. The reverse is also true, when the fluctuation of relative currency strength can change the balance of payments. There are two different and interconnected markets at work: the market of all financial transactions in the international currency market (balance of payments) and the supply and demand of a particular currency (exchange rate).

These conditions exist only under free or floating exchange rate regime. The balance of payments does not affect the exchange rate in the system with a fixed exchange rate because Central banks regulate currency flows to compensate for the international monetary funds.

The world is not managed in any uniform rules or a fixed exchange rate system since the end of the Bretton woods system in the 1970s.

To further explain, assume that consumers in France want to buy products from American companies. The American company can not accept euros as payment; it wants American dollars. Once the needs of the French consumers to purchase dollars (supposedly selling the Euro on the Forex market) and to exchange them for American products. Today, the majority of these exchanges are automated through an intermediary, so that the individual consumer should not enter the Forex market to make a purchase online. After the closing of the transaction recorded in the current portion of the account balance.

The same is true for investments, loans or other capital flows. American companies Typically don’t want foreign currency to Finance their operations, thus, their expectations for foreign investors to send their dollars. In this case, capital flows between countries appear to be part of the account of capital transactions of the balance of payments.

And dollars were no longer required to meet the needs of foreign investors or consumers, the upward pressure on the prices of dollars. In other words, it costs relatively more in exchange for dollars, from the point of view of foreign currencies.

The dollar may actually be higher if other factors are simultaneously reducing the value of dollars. For example, expansionary monetary policy can increase the supply of dollars.

For further reading, see understanding the capital and financial account balance of payments.

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