Real exchange rates, current accounts and the net foreign asset position *

What is the relationship between a country's current account and its real exchange rate? Is an exchange rate appreciation positively correlated with a current account deficit? Much discussion of exchange rate movements in recent years, especially among policy makers and market commentators, has linked exchange rate appreciations with capital inflows or current account deficits. ¹ The implication is that capital inflows used to finance a country's current account deficit raise the demand for assets denominated in that country's currency, causing the domestic currency to appreciate. An example of this kind of reasoning among policy makers is given by the following quote:

The bilateral [exchange] rates that are frequently quoted in fact tell us very little about sterling: they are essentially a reflection of the persistent general strength of the dollar on the one hand and the persistent general weakness of the euro on the other, resulting from [emphasis added] sustained capital inflows to the United States in large part from the Eurozone. ²