Exchange Rates and the Balance of Payments

What is the connection between exchange rates and adjustments in the balance of payments? In the simplest case, assume that exchange rates are determined by private supply and demand with no government intervention. Consider what happened in 1990 after German unification when the German central bank decided to raise interest rates to curb’ inflation. After the monetary tightening, foreigners moved some of their assets into German.

Here is where the exchange rate plays its role as equilibrium. Ar. the demand for German marks increased, it led to an appreciation of the German mark and a depredation of other- currencies, such as the U.s. dollar. The movement in the exchange rate contain until the financial and current accounts back in balance. The equilibration for irreverent ~ is easiest to understand. Here, . the appreciation of the mark. made German goods add led to a decline in German exports and an increase in German imports. Both of these factors tended to reduce the German current account surplus. Damaged-rate movement as a Balanchine to balance of payments.

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