A:

A change in a country's balance of payments can cause fluctuations in the exchange rate between its currency and foreign currencies. The reverse is also true where a fluctuation in relative currency strength can alter the balance of payments. There are two different and interrelated markets at work: the market for all financial transactions on the international market (balance of payments) and the supply and demand for a specific currency (exchange rate).

These conditions only exist 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.

The world has not operated under any single rules-based or fixed exchange-rate system since the end of Bretton Woods in the 1970s.

Suppose a consumer in France wants to purchase goods from an American company. The American company is not likely to accept euros as payment; it wants U.S. dollars. Somehow the French consumer needs to purchase dollars (ostensibly by selling euros in the forex market) and exchange them for the American product. Today, most of these exchanges are automated through an intermediary so that the individual consumer doesn't have to enter the forex market to make an online purchase. After the trade is finally made, it is recorded in the current account portion of the balance of payments.

The same holds true for investments, loans or other capital flows. American companies normally don't want to receive foreign currencies to finance their operations; foreign investors need to send them dollars. Capital flows between countries show up in the capital account portion of the balance of payments.

As more U.S. dollars are demanded to satisfy the wants of foreign investors or consumers, upward pressure is placed on the price of dollars. In other words, it costs relatively more to exchange for dollars, in terms of foreign currencies.

The exchange rate for dollars may not actually rise if other factors are concurrently pushing down the value of dollars. For example, expansionary monetary policy might increase the supply of dollars.

RELATED FAQS
  1. How are international exchange rates set?

    International currency exchange rates display how much one unit of a currency can be exchanged for another currency. Currency ... Read Answer >>
  2. What is foreign exchange?

    Foreign exchange, or Forex, is the conversion of one country's currency into that of another. In a free economy, a country's ... Read Answer >>
  3. Which is more important to a nation's economy, the balance of trade or the balance ...

    Learn how to differentiate between the balance of trade and balance of payments for international trade and why the balance ... Read Answer >>
  4. Is a deficit in the balance of payments a bad thing?

    Discover how it might be possible to run a balance of payments deficit, what that means in terms of international trade and ... Read Answer >>
  5. What types of companies benefit from reporting results utilizing constant currencies ...

    Understand constant currency figures, and explore some of the reasons why a company is likely to benefit from reporting using ... Read Answer >>
Related Articles
  1. Investing

    Explaining Foreign Exchange Risk

    Foreign exchange risk is the chance that an investment’s value will decrease due to changes in currency exchange rates.
  2. Trading

    The Forex Market: Who Trades Currency And Why

    The forex market has a lot of unique attributes that may come as a surprise for new traders.
  3. Trading

    6 Factors That Influence Exchange Rates

    An in depth look at out how a currency's relative value reflects a country's economic health and impacts your investment returns.
  4. Investing

    Protect Your Foreign Investments From Currency Risk

    Hedging against currency risk can add a level of safety to your offshore investments.
  5. Trading

    How to Calculate an Exchange Rate

    Struggling to get a grasp on exchange rates? Here's what you need to know.
  6. Trading

    How Are International Exchange Rates Set?

    International exchange rates show how much one unit of a currency can be exchanged for another currency.
  7. Trading

    Dual And Multiple Exchange Rates 101

    Why would a country choose to implement dual or multiple exchange rates? It's risky, but it can work.
  8. Insights

    The Balance Of Payments

    The "Balance of Payments" is a record of all payments or monetary transactions between a particular country and other nations during a specific time period. It provides a useful glimpse into ...
RELATED TERMS
  1. International Currency Exchange Rate

    The rate at which two currencies in the market can be exchanged. ...
  2. Balance Of Payments (BOP)

    A record of all transactions made between one particular country ...
  3. Basic Balance

    An economic measure for the balance of payments that combines ...
  4. Currency Exchange

    A business that allows customers to exchange one currency for ...
  5. Foreign Exchange Reserves

    Foreign exchange reserves are reserve assets held by a central ...
  6. Currency Pairs

    Two currencies with exchange rates that are traded in the retail ...
Hot Definitions
  1. Market Capitalization

    The total dollar market value of all of a company's outstanding shares. Market capitalization is calculated by multiplying ...
  2. Expense Ratio

    A measure of what it costs an investment company to operate a mutual fund. An expense ratio is determined through an annual ...
  3. Mezzanine Financing

    A hybrid of debt and equity financing that is typically used to finance the expansion of existing companies. Mezzanine financing ...
  4. Long Run

    A period of time in which all factors of production and costs are variable. In the long run, firms are able to adjust all ...
  5. Quasi Contract

    A legal agreement created by the courts between two parties who did not have a previous obligation to each other. A normal ...
  6. Wage-Price Spiral

    A macroeconomic theory to explain the cause-and-effect relationship between rising wages and rising prices, or inflation. ...
Trading Center