Balance of payments surpluses and deficits arise from changes in the supply of and demand for our dollar on the foreign exchange market. Several variables affect supply and demand activity in this market:

1. Exchange rate. The price or value of our dollar in terms of foreign exchange, called the exchange rate, is determined in the foreign exchange market. If, for example, a dollar can buy five French francs, the exchange rate is five francs per dollar. A balance of payments surplus means that demand for our dollar on the foreign exchange market exceeds its supply, so the price of the dollar (the exchange rate) will be bid up, say to six francs per dollar. The dollar is now more valuable; it buys six instead of five francs. This stronger dollar makes imports cheaper for U.S. citizens, so imports increase—thus increasing the supply of dollars on the foreign exchange market. Similarly, our exports are more expensive to foreigners so exports fall, decreasing the demand for dollars on the foreign exchange market. In this way, the rise in the exchange rate eliminates the balance of payments surplus. The opposite occurs when we have a balance of payments deficit: the exchange rate falls to eliminate the deficit.

2. Income. At a higher level of income, we import more. As a result, our supply of dollars on the foreign exchange market increases, creating a balance of payments deficit and downward pressure on the exchange rate. Note that this result assumes that our rise in income is unique to us; it is not part of a worldwide boom. If other countries’ incomes are increasing at the same time, then our exports should also increase, making uncertain the net effect on our balance of payments and exchange rate.

3. Interest rate. When our interest rate is higher, foreigners are more interested in buying our financial assets, so they demand more of our dollars on the foreign exchange market. This demand creates capital inflows, a balance of payments surplus, and upward pressure on the exchange rate. Two caveats concerning capital inflows are important. First, the result depends on the interest rate increase not being part of a worldwide pattern. If interest rates throughout the world rise, the fact that our interest rate is higher should not entice foreigr ers to switch to our bonds. Second, the relevant difference in interest rates is the difference in real interest rates, not nominal interest rates; investors are concerned with real returns. For more on this topic, see chapter 18.

4. Price level. A rise in our price level increases the price of our exports and the price of import-competing goods and services, so our exports fall and our imports rise. As a result, the demand for our dollars decreases, and the supply of our dollars increases, creating a balance of payments deficit and downward pressure on the exchange rate. Again, such effects occur only if there is no equivalent price increase in the rest of the world.

5. Expectations. If foreigners expect the value of the dollar to rise, they can reap a capital gain by buying our bonds and then selling them again after the exchange rate has risen. This speculation creates an inflow of capital, a balance of payments surplus, and upward pressure on the exchange rate. Such speculative funds are available in large amounts and can be moved very quickly from one currency to another. Indeed, speculative activity is the primary determinant of exchange rates in the short run. Daily volume on the foreign exchange market is about $1 trillion, the bulk of which is speculative.

To summarize, several factors influence activity in the foreign exchange market. The balance of payments summarizes this activity, telling us whether the market is in disequilibrium, in what direction, and by how much, allowing us to predict economic forces for change.