BALANCE OF PAYMENTS AND EXCHANGE RATES

Balance of Payments and Exchange Rates

Balance of Payments and Exchange Rates

Exchange Rates and the Balance of Payments

Just as the basic determinants behind the supply of and demand for wheat are critical in fully understanding the behavior of wheat prices, so it is important to understand the factors behind the supply of and demand for foreign exchange to determine the price of a foreign currency. Again, it should be stressed that the factors determining the demand for Euros are also the factors determining the supply of dollars, and the factors determining the supply of Euros also determine the demand for dollars.  The balance of payments is a systematic array of all the factors that determine the foreign exchange rate.  That array follows long established conventions and is all-inclusive and mutually exclusive among the individual factors.

 

 

Assuming the supply of Euros constant (demand for $$ is constant) the effect of an increase in any of the factors determining the demand for Euros (supply of $$) would cause the $ price of the Euro to rise (the Euro price of the dollar to fall). Hence, if there is an increase in UK imports of goods from Germany, imports of services from Germany, more UK gifts to Germany, more UK longterm investment in Germany, or more UK shortterm investment in Germany, the demand for Euros increases (the supply of $$ increases) and causes the $ price of the Euro to rise (the Euro price of the $ to fall). This would be termed a depreciation of the dollar in respect to the Euro (appreciation of the Euro in respect to the UK Dollar).

UK balance of payments and its effects

During the last five years the US balance of payment deficit is expanding reaching total of $4.3 trillion in 2004. The US balance of payments deficit expanded to $144.9 billion in the first quarter of this year—a record in dollar terms—and a big jump from the deficit of $127 billion in the last quarter of 2003 (The Wall Street Journal 2004, 5). As a percentage of gross domestic product, the deficit rose sharply from 4.6 percent to 5.1 percent. At this level, the US needs to attract more than $1.5 billion per day in foreign investment to cover the payments shortfall (Boshara 2004, NY Times).

More than half of the increase, which was well above market forecasts of around $140 billion, came from the increase in the deficit on goods and services. That rose to $136.9 billion for the quarter compared to a deficit of $125.5 billion in the last quarter of 2003. With energy prices still at high levels, there seems little prospect of the trade gap narrowing in the immediate future, with the deficit for April coming in at a record $48.3 billion (The Economist 2004, 90).

The release of the balance of payments data saw the dollar take a sharp fall on international currency markets when, as the Financial Times put it, the “spectre of the long-run structural US current ...