Modeling the Exchange Rate and Balance of Payments Essay

Modeling the Exchange Rate and Balance of Payments - Essay Example Many countries use financial institutions, central banks, to invest in several monetary and financial systems and other resources in their quest to predict exchange rate and determine international trade as well as a balance of payment. Several theories have been forwarded to determine the value of exchange rate and balance of payments, and in this summary, we will discuss the determinants of a balance of trade, the IS-LM-BP approach and the monetary approach in relation to the two (Melvin and Norrbin, 225). The elasticity approach to the balance of trade explains that the economic behavior involves satisfaction of the unlimited wants with limited resources. One effect of this is that consumers and business firms end up substituting the expensive good for the more affordable ones as prices change to stretch their budgets as far as they can. Relative prices normally change relative to demand and supply for individual goods. Such changes may be caused by an alteration in tastes, the method of production, government taxes, or subsidies amongst other possible causes. If the changes concern the prices of goods at home relative to the foreign goods, the international trade patterns may actually be altered. The elasticity approach to the balance of trade involves the way changing of relative prices of the domestic and foreign goods will affect and possibly change the balance of trade. Furthermore, it provides an analysis of how the issue of devaluation affects the balance of trade in relation t o the elasticity of supply and demand for foreign exchange and foreign goods in the concerned market (Melvin and Norrbin 226). The devaluation of a country’s currency domestically normally raises the price of foreign goods in relation to the domestic goods within that country.