Exactly what are the forces for change that an imbalance in the balance of payments engenders? This is a crucial question, the answer to which depends on whether the economy is operating on a flexible or a fixed exchange rate system. Let us first examine a flexible exchange rate system.

Under a flexible exchange rate system, the government allows the forces of supply and demand to determine the exchange rate. If there is a balance of payments surplus, demand for our dollar on the foreign exchange market exceeds its supply, so market forces cause a rise in the value of our dollar. Those who want the extra, unavailable dollars try to obtain them by offering extra foreign currency for them, so our dollar becomes more valuable in terms of foreign currency. This appreciation of our dollar is often described by the statement “The exchange rate has risen.”

This process operates in reverse if there is a balance of payments deficit. In this case, the demand for our dollar on the foreign exchange market is less than its supply, so market forces cause a fall in its value. This depreciation of our dollar is often described by the statement “The exchange rate has fallen.”

Note that under a flexible exchange rate system, any tendency toward a balance of payments surplus or deficit is automatically and instantaneously eliminated by a flexing of the exchange rate, so that our measure of the imbalance (the balance of payments) is always zero. The balance of payments measure is nonzero only if the government engages in some net buying or selling of foreign currency. In the context of a flexible exchange rate, the terminology “balance of payments surplus or deficit” must be interpreted as reflecting a surplus or deficit that would appear if the exchange rate were not permitted to adjust instantaneously.

Under a flexible exchange rate, therefore, the initial reaction of the economy to an imbalance in the balance of payments is a change in the exchange rate, which in turn creates additional forces for change in the economy. If, with other variables constant, the exchange rate rises, demand for our exports falls because foreigners find our exports more expensive in terms of their currency. Furthermore, imports become cheaper to us (because our dollar now buys more foreign exchange), so there is a fall in demand for domestically produced goods and services that compete with imports. Both phenomena imply that aggregate demand for domestically produced goods and services falls.

Similarly, if the exchange rate falls, demand for exports and import-competing goods and services should be stimulated, implying a rise in demand for domestically produced goods and services.

To summarize, if the economy has a flexible exchange rate, an imbalance in the international sector of the economy, measured by the balance of payments, automatically causes the exchange rate to change; this change in turn causes the import-competing and export sectors of the economy to adjust, thus affecting aggregate demand for goods and services.