Balance of Payments Problems and The Invisible Balance
Problems with a country's balance of trade (or balance of payments) are often associated with an inappropriate valuation of its currency – that is, its country's foreign exchange rate.
If a country's exchange rate is too high, its exports will become uncompetitive as buyers in foreign countries require more of their own currency to pay for them. In the meantime, it also becomes cheaper for the citizens of the country to buy goods from overseas (as opposed to buying locally produced goods) – because an over-valued currency makes foreign products less expensive.
The simultaneous decline in currency inflows (due to decreased exports) and the rise in outflows (due to increased imports) sends the Balance of Trade into deficit which then needs to be paid for by a transfer of funds in some form – either invisible transfers (aid, etc.) or capital flows (loans, etc.). However, relying on funds like this, to support a trade deficit, is unsustainable, and the country may eventually be placed in a position where its currency needs to be devalued.
If, on the other hand, a currency is under-valued, its exports will become cheaper and therefore more competitive internationally. At the same time, imports will also become more costly – stimulating the production of domestic substitutes to replace them. This will result in a growth of currency flowing into the country and a decline in currency flowing out of it – resulting in an improvement in the country's balance of trade.
Because a nation's exchange rate has a big impact on its 'balance of trade' and its 'balance of payments' many economists favour freely floating exchange rates over the older, fixed (or pegged) rates of foreign currency exchange. Floating exchange rates allow more regular adjustments in exchange rates to occur, allowing the greater opportunity for international payments to maintain equilibrium.
Read more about this topic: Invisible Balance
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