Relationship of balance payment and exchange rate

relationship of balance payment and exchange rate

Balance of payments and the exchange rate: is there a connection? . What is clear that there is no observable clear relationship, which. Abstract: Relationships between the nominal exchange rate, the current account and the financial account of the balance of payments in the Czech. Republic are . Usually it is assumed, that weaker local currency makes the local products more attractive for foreigners and thus the trade balance turns more.

Obviously, this will lead to the strengthening in the exchange rate of the foreign currency against the domestic currency, so it is held. Conversely, if there is an increase in exports, all other things being equal, then once the exporters exchange their foreign currency earnings for domestic currency this sets in motion a strengthening in the domestic currency exchange rate against the foreign currency.

In this way of thinking, exporters determine the supply of foreign currency whilst importers determine the demand for foreign currency.

relationship of balance payment and exchange rate

Hence, the interaction between the supply and demand establishes a foreign exchange rate. Following this logic, it makes sense to conclude that the state of the balance of payments, which is the result of the interplay between exports and imports, is a key in determining the foreign exchange rate.

Balance of payments and the exchange rate: is there a connection? | The Cobden Centre

Importers and exporters and the demand and supply of foreign currency Is it correct to say that the supply of foreign currency is determined by exporters whilst the demand for foreign currency is set by importers? For instance, the demand for the Yen emanates not only from American importers of Japanese goods and services but also from the Japanese themselves. Every bit of economic activity that takes place in Japan gives rise to demand for Japanese money — the Yen.

  • Explain the relationship between the balance of payment and exchange rates of a country.
  • Exchange Rate and Current Account

For instance, a Japanese producer of shoes exercises his demand for money by selling his product shoes for Yen, which in turn he could employ some time in the future, in order to be able to buy other goods and services.

Likewise, the producers of other goods and services exercising their demand for money by exchanging their produced goods and services for money, which in due course is going to be exchanged for other goods and services.

relationship of balance payment and exchange rate

What is the source of the supply of foreign currency such as Yen and the Euro? In the modern monetary system, the source is central bank monetary policy and fractional reserve banking. The quantity of Yen and Euros is set by the relevant central banks and fractional reserve banking and has nothing to do with the activity of exporters.

Moreover, we suggest that, with all other things being equal, the respective monetary policies of central banks determine the respective purchasing power of money.

Balance of payments and the exchange rate: is there a connection?

This in turn determines the exchange rates. The relative purchasing power of money and the exchange rate A price of a basket of goods is the amount of money paid for the basket. We can also say that the amount of money paid for the basket of goods is the purchasing power of money with respect to the basket of goods. An important factor in setting the purchasing power of money is the supply of money. Since a price of a good is the amount of money per good, this now means that the prices of goods in dollar terms will increase faster than prices in Euro terms, all other things being equal.

Another important factor in driving the purchasing power of money and the exchange rate is the demand for money. For instance, with an increase in the production of goods the demand for money will follow suit. The exporters will be motivated to export more from 4, million dollars to 4, million dollars.

relationship of balance payment and exchange rate

If the exchange rates are freely flexible, there will not be a deficit or surplus in the balance of payment because such imbalances are automatically adjusted in the foreign exchange markets. When the exchange rates change i. Depreciation makes the imports more expensive. The prices of exportable are expressed in the currency of home country where the prices of importable are measured in the currencies of the exporting countries.

Thus, after rupee depreciates the rupee prices of importable rise relative to the rupee prices of exportable causing a deterioration in the commodity terms of trade. Under the fixed exchange rate system a government is committed to maintain the stated or official par value of its currency, allowing the deviation of currency value from the par value only within a fixed or an agreed upon percentage, say one per cent on either side of the par value.

The central bank intervenes in the foreign exchange market to maintain the par value and if it could not be maintained the exchange rate is officially devalued or revalued. Thus, under the fixed exchange rate system a deficit in the balance of payment is adjusted by money supply changes and the consequent changes in the price level.

The exchange rate is not used as a tool for correcting the imbalance in the balance of payments. Time period The J Curve effect states how a depreciation can worsen current account in the short term because demand is inelastic, but, over time, demand becomes more elastic and therefore the current account improves following a devaluation.

Balance of Payments Unit: Relationship Between the Current Account and Exchange Rate

One reason was the sluggish global growth. There was little foreign demand for UK exports despite the fall in price.

relationship of balance payment and exchange rate

A key determinant of the current account is domestic spending. When consumer spending is growing, countries will be buying more imports.

relationship of balance payment and exchange rate

In a recession, with falling consumer spending, the current account tends to improve lower deficit. For example, in the examples below fromthe current account improved — despite the Sterling index remaining constant. The reason for this improvement was the recession of and slowdown in consumer spending. Afterthe current account improved — leading to a small surplus in