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According to conventional analysis, a key factor in exchange rate determination is the state of the balance of payments.

An increase in imports gives rise to an increase in a demand for foreign currency. To obtain the foreign currency importers will sell the domestic currency for it. Obviously, this will lead to the strengthening in the exchange rate of the foreign currency against the domestic currency.

Conversely, if there is an increase in exports, all other things being equal, then once the exporters exchange their foreign currency earnings for domestic currency this sets in motion a strengthening in the domestic currency exchange rate against the foreign currency.

Is there any model which relates the changes in exchange rate with balance of payment quantitatively?

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  • $\begingroup$ If a good quantitative model for an exchange rate exists, it would likely imply that making money trading the currency would be easy. Of course, everyone would try to use the model, breaking it. We do not see such events in the real world. By implication, we are left with poor economic models, with weak forecasting abilities. Therefore, even if some studies find a relationship, their practical implications are weak. $\endgroup$ Mar 10 '18 at 13:48

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