1. Function of exchange rates is to balance the value of imports and exports (broad sense). With flexible exchange rates, countries use the market to adjust the various exchange rates so that the value of each countries imports and exports is balanced. With flexible exchange rates, speculators make money if they smooth out the fluctuations in exchange rates.



Fixed exchange rates: Central bank buys and sells currencies to maintain fixed rates. EU before the Euro was semi-fixed meaning a narrow trading range was allowed. Problem: Market is much bigger than central banks so if central bank tries to buck the market over any extended period of time the central bank will run out of reserves. Speculators function to destabilize the market by betting against the central bank in troubles times.

1. Goods and services

2. Capital flows (Our investments abroad and foreigners investments in the US)

3. Income from previous investments

4. Other minor items.

Note: 1 and 3 are called the current account and 2 is called the capital account.