The Balance of Payments

Can highlight pressures for devaluation or revaluation, reflected in large and systematic trend of foreing currency reserves at the central bank. In particular, large inflows, due for instance to a rise in the world price of main exports tend to revaluate the exchange rate. Conversely, a collapse in the trust of government to manage the economic conditions might provoke a flight of capital, the exhaustion of foreign currency reserves and force a devaluation / depreciation.

Levels and Fluctuations

Impact on other variables

Levels and fluctuations in the exchange rate exert a powerful impact on exports, imports and the trade balance. A high and rising exchange rate tends to depress exports, to boost import and to deteriorate the trade balance, as far as these variables respond to price stimuli. Consumers find foreign goods cheaper so the consumption composition will change. Similarly, firms will reduce their costs by purchasing intermediate goods abroad.

In extreme cases, local firms producing for the domestic market might go bankrupt. If the reason of appreciation was a soaring world price of main exports (e.g. energy carriers, like oil for many oil producing countries), the composition of the industrial texture would be starkly simplified and concentrated to those exports, in the opposite direction of the diversification of the economy that is often the stated goal of public strategies in countries depending on too few productions (high export concentration).

Exchange Rates Behaviour

Business cycle behaviour

Too many elements are at work for the exchange rate possessing a clearly-defined business cycle behaviour. To the extent that the exchange rate is determined by the trade balance, the exchange rate is counter-cyclical as the latter. At peaks, the trade deficit would depress the exchange rate, forcing it to depreciate.

If it is rather the interest rate that turns out to the main driver of the exchange rate, a possible pro-cyclicity of the interest rate would imply a pro-cyclical exchange rate.

In this scenario, recovery and boom are accompanied by rising interest rates and exchange rates. At peaks, we would see very strong currency. Together with domestic demand pressures, this would be the source of a high trade deficit.

If autonomous dynamics in the forex market are the main determinants of the exchange rate, then intense micro-fluctuations and long term tides would ride the exchange rate, possibly with central bank significant interventions.