Balance of Payments and Exchange Rates

Abstract

The balance of payments between the monies that we have spent abroad on imports and the monies that we have received from the sale of exports is important to the economy for a number of reasons. To purchase imports it is usually necessary to exchange our currency for the exporter’s currency. This is done because pounds sterling are not of much use to the exporter who must pay his workforce and buy more goods for export in his own country’s currency. Pounds are not legal tender in, say, France. To buy French goods we must first buy francs (or the exporter may accept pounds and then buy francs himself). This is done in the main through the banking system, but the banks only have a limited reserve of foreign currency. Once that is used up the banks will have to exchange pounds for francs in the foreign exchange markets. Like any other demand the demand for another currency puts pressure on its price level. Balance of payments will therefore affect exchange rates.