ABSTRACT
This chapter examines the role of discrete changes in the exchange rate as the route to payments adjustment. In a most simple analogy, the exchange rate plays the same role in the foreign exchange market as the price of cars plays in the automobile market. If the demand for cars exceeds the supply, the price of automobiles rises. For example, if an excess supply for U.S. dollars exists in the exchange market because of a payments deficit, the price of dollars (the exchange rate) should decrease to eliminate the disequilibrium. A deficit in the United States’ balance of payments corresponds to an excess demand for foreign currency (and an excess supply of dollars), causing the price of foreign currency to increase (and the price of U.S. dollars to decrease). When exchange rates are fixed, this adjustment process is not automatic. Instead, a government facing a payments deficit must devalue its currency (revalue in the event of a surplus).
