The balance of payments, the foreign exchange market and the exchange rate

The balance of payments and the exchange rate

For simplicity we will initially refer to a world with only two countries, the home country and the ‘Rest of the World’.

The balance of payments was introduced in section 3.7: all economic transactions that normally give rise to payments and receipts in foreign currency are usually recorded. The residents of the home country that need to make payments to non-residents will demand foreign currency; conversely, residents that receive payments in foreign currency will supply it. This is the foreign exchange market where, like all other markets, a price, called the exchange rate or, more precisely, the nominal bilateral exchange rate, is determined.

The nominal bilateral exchange rate is the price of a currency in terms of another currency. There are two ways to express this price. With the first, the reference unit is the foreign currency and its price is expressed in terms of the domestic currency: this is the price-quotation system, which indicates the variable price in terms of the domestic currency for one unit of foreign currency. The second method, known as the volume-quotation system, expresses the variable quantity of foreign currency that can be purchased with a unit of domestic currency. Unless otherwise indicated, we will adopt the price-quotation system, which is used by most countries (the United Kingdom and the euro area being the major exceptions).