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Understanding How Balance of Payments and Exchange Rates Work

Most economic commentators believe balance of trade is a key factor in a currency’s exchange rate. All other things being equal, an increase in imports, which leads to a trade deficit, gives rise to an increase in the demand for foreign currency.

To obtain foreign currency, importers sell their domestic currency for it. This strengthens the exchange rate of the foreign currency against the domestic currency—i.e., there is more domestic money per unit of a foreign money.

Conversely, all other things being equal, an increase in exports leads to a trade surplus. When exporters exchange their foreign currency earnings for their domestic money, this strengthens the domestic money’s exchange rate against the foreign money (there is less domestic money per unit of a foreign money).

Again, if a country exports more than it imports, there is a strengthening in the demand for the country’s goods, and thus for its currency. Consequently, the price of the domestic money in terms of foreign money is likely to increase.

Conversely, if a country imports more than it exports, the demand for the foreigners’ goods and for the foreign currency is strengthened. Consequently, the increase in the demand for the foreign money raises its price in terms of domestic money.

By the same logic, if foreigners’ demand for another country’s money suddenly increases, this is going to strengthen that currency’s exchange rate versus the foreign currency. If, however, the foreigners’ demand for the country’s money suddenly declines, this will weaken that currency’s exchange rate against other currencies.

Fundamental versus Nonfundamental Causes

Many factors determine a currency’s exchange rate. For example, an increase in the government foreign debt is a sign of a deterioration in economic fundamentals ahead, which provides a rationale to sell the currency.

Alternatively, consider what happens when the central bank tightens its interest rate stance. The increase in the domestic interest rate, all other things being equal, attracts foreign demand for the domestic money. This demand raises the price of the local currency in terms of foreign currency.

It would appear that government debt, the interest rate differential, the state of the economy, and the balance of trade are important determining factors for a currency’s exchange rate. Psychological factors also appear to be important: a change in individuals’ perceptions regarding the state of the economy is likely to influence the exchange rate.

But rather than focusing on numerous factors, it makes sense to identify the key factor that determines a currency’s exchange rate.

The Relative Purchasing Power of Money—the Essence of the Exchange Rate

Relative changes in the purchasing power of various monies, in our view, are the essence of exchange rates. The price of a basket of goods is the amount of money paid for this unit, and this means that the amount of money paid for a basket of goods is the purchasing power of money with respect to these goods. For example, if the price of a basket is one dollar in the US, while in the eurozone an identical basket of goods sells for two euros, then the exchange rate between the US dollar and the euro is two euros per dollar.

Another important factor in determining the purchasing power of money is the supply of money itself. If over time the US money supply’s growth rate exceeds that of the European money supply, all other things being equal, this will put downward pressure on the value of the US dollar.

Since the price of a good is the amount of money offered per good, this means that the prices of goods in dollar terms will increase faster than prices in euro terms, all other things being equal. Take an identical basket of goods that now is priced at two dollars against the previously price of one dollar. Its eurozone price is €2.5 against €2.0 previously. This implies that the exchange rate between the US dollar and the euro is now €1.25 per dollar.

Since changes in the domestic money supply affect its general purchasing power with a time lag, relative changes in money supply affect the currency exchange rate with a time lag as well. When new money enters a particular market, it pushes the price of goods in this particular market higher, as more money is spent on given number of goods than before. This means that past and present information about money supply can be employed in ascertaining the likely future shifts in the currency exchange rate.

Another important factor driving exchange rates and the purchasing power of money is the demand for money. For instance, if there is an increase in the production of goods, the demand for money in a given economy will likely follow suit. The demand for the services of the medium of exchange will likely increase, since more goods are now going to be exchanged. As a result, the purchasing power of a given supply money will strengthen, all other things being equal. Less money will now be chasing more goods.

Exchange Rate Deviation from Relative Purchasing Power Spurs Arbitrage

Any deviation of the exchange rate from the rate dictated by currencies’ relative purchasing power will likely create profit opportunities that will undo the deviation. For example, a deviation could emerge because of the market response to trade account data or because of a change in the interest rate differential in the domestic economy versus overseas economies. These deviations will likely create profit opportunities in arbitrage, which will undo those deviations.

Assume the Fed raises its policy interest rate while the European Central Bank’s policy rate remains unchanged. The price of a basket of goods was one dollar in the US and two euros in the eurozone, and the market exchange rate was one dollar for two euros. When the interest rate differential between the US and the eurozone widens, an increase in the demand for dollars pushes the exchange rate toward one dollar for three euros. (The holders of the euros are now exchanging more euros for dollars that will be placed in dollar deposits in order to earn higher interest rates.)

As a result, the dollar is now overvalued under the market exchange rate, as shown by the dollar’s changed relative purchasing power (which should be two euros to one dollar, not three euros to one dollar). In this scenario, a person should sell a basket of goods for dollars, exchange the dollars for euros, and then buy a basket of goods with euros, making a clear arbitrage gain.

For example, a person could sell a basket of goods for $1, exchange the dollar for €3, and then exchange the euros for 1.5 baskets, which would gain him an extra half basket of goods (since the basket’s price in the eurozone is €2). As dollar holders increase their demand for euros in order to profit from the arbitrage, euros will become more expensive in terms of dollars—i.e., there will be more dollars chasing each euro—pushing the exchange rate back in the direction of $1 for €2. Arbitrage is always set in motion when the exchange rate in terms of currencies’ relative purchasing power deviates from the market exchange rate.

Summary and Conclusion

Contrary to a popular view, the state of the balance of payments is not the determining factor in currencies’ exchange rates, nor are the interest rate differential or various psychological factors. The key factor is the relative purchasing power of various monies.

If the market exchange rate deviates from the exchange rate in terms of currencies’ relative purchasing power, this sets in motion arbitrage, which works toward realigning the market exchange rate with the currencies’ relative purchasing power. Furthermore, the relative purchasing power of money, all other things being equal, is determined by the relative supply of various monies, although changes to this are lagged. This, in turn, means that currency exchange rates are driven by the relative supply of various monies, taking the lag into account, all other things being equal.