What Is The Connection Between Exchange Rates And The Balance Of Payments?

We can now see the connection between exchange rates and adjustments in the balance payments. In the simplest case, assume that exchange rates are determined by supply and demand. Consider what happened after German unification when the German central bank decided to raise interest rates to curb inflation. After the monetary tightening, foreigners moved some of their assets into German marks to benefit from High German interest rates. This produced an excess demand for the German mark at the old exchange rate. In other words, at the old foreign exchange rate, people were on balance buying German marks and selling other currencies.

Here is where the exchange rate plays its role as equilibrator. As the demand or German marks increased, it led to an appreciation of the German mark and a depreciation of other currencies, like the U.S dollar. The movement in the exchange rate continued until the capital and current accounts were back in balance. The equilibration for the current account is easiest to understand. Here, the appreciation of the mark made German goods more expensive and led to a decline in German exports and an increase in German imports. Both of these factors tended to reduce the German current account surplus.