Understanding How Balance of Payments and Exchange Rates Work

 NOTE:
The following article was a snoozer, so I made it better by moving the SUMMARY from the end to the beginning (with no edits), but presented a shorter, edited version of the DETAILS.

There is really no such thing as a balance of payments problem. We voluntarily buy products and services we want from other nations. We may get a good price (for goods manufactured in China) or a commodity we don't have at home (cobalt from The Congo). They buy American products and services. If they extra dollars, they can buy US assets, put them in a bank, which will buy US assets, or put the spare dollars under their mattresses. Why should we care? We get products and services we voluntarily paid for. And they get pieces of paper -- IOU's actually -- that lose purchasing power every month.  They can use those dollars for spending now, or later, or investing now, or later.

When you add up net purchases of goods and services and investment flows among nations, there should be a balance of payments (BOP). According to economic theory, it's impossible to sustain a deficit in the balance of payments. In practice, temporary imbalances do occur because of accounting difficulties. In double-entry accounting, payments and receipts are necessarily equal. Thus, the balance of payments must theoretically always be equal as well.

There are three main categories of the BOP: The current account, the capital account, and the financial account. The current account is used to mark the inflow and outflow of goods and services into a country. The capital account is where all international capital transfers are recorded. In the financial account, international monetary flows related to investment in business, real estate, bonds, and stocks are documented. Also included are government-owned assets, such as foreign reserves, gold, special drawing rights (SDRs) held with the International Monetary Fund (IMF), private assets held abroad, and direct foreign investment. Assets owned by foreigners, private and official, are also recorded in the financial account.

That's probably all you need to know.
Ye Editor

Source:
https://mises.org/wire/understanding-how-balance-payments-and-exchange-rates-work

"SUMMARY:
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.

DETAILS:
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.

... 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."