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 when a fluctuation in relative currency strength can alter balance of payments.

Balance of Payments and Exchange Rates

A balance of payment is a statement of all transactions made between entities in one country and the rest of the world over a specific time frame, such as a quarter or a year. Two dynamics are in play which link a country's balance of payment and changes in the value of its currency: the market for all financial transactions on the international market (balance of payments) and the supply and demand for a specific currency (exchange rate).

Key Takeaways

  • Balance of payments is the statement of a country's trade with other nations.
  • 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.

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 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 do not want foreign currencies to finance their operations, thus their expectation for foreign investors to send them dollars. In this scenario, 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 needs of foreign investors or consumers, upward pressure is placed on the price of dollars. Put another way: it costs relatively more to exchange for dollars, in terms of foreign currencies.

Special Considerations

The exchange rate for dollars may not rise if other factors are concurrently pushing down the value of dollars. For example, expansionary monetary policy might increase the supply of dollars and decrease the currency's value relative to other currencies.

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