Question

Can balance of payments dynamics explain exchange rate movements? Why or why not?

Answer 1

Explanation

Balance of payment can explain the movement in exchange rates.

Suppose increase in imports in any country will give rise the to increase in demand for foreign currency. Importera will send the domestic currency to purchase foreign currency. This will weaken the domestic currency. Opposite to imports, same thing applies to exports where increase in exports will strenghthen the domestic currency. Hence because of this supply and demand of currency, state of balance of payments (created by interplay between imports and exports) play a key role in determining the exchange rate movement.

The state of balance of payments does not impact the exchange rate in fixed rate system. Such system was prevalent till the year 1970.

Hence, by this explanation, we can say that state of balance of payments can explain the movement in exchange rate.