The exchange rate ensures that the balance of payments really does balance.

Question

Quizplus · Accepted Answer

The exchange rate plays a critical role in ensuring that a country's balance of payments is in equilibrium. The balance of payments consists of current account balance (exports minus imports), capital account balance (inflow of foreign investment minus outflow of domestic investment), and financial account balance (changes in foreign ownership of domestic assets). When a country's balance of payments is in deficit, the exchange rate will adjust to make exports more competitive and imports more expensive, which will shift the balance towards surplus. Conversely, when the balance of payments is in surplus, the exchange rate will appreciate, making exports more expensive and imports cheaper, which will shift the balance towards equilibrium. Therefore, the exchange rate is a critical anchor for ensuring that the balance of payments really does balance.

The Exchange Rate Ensures That the Balance of Payments Really