Agents engage in a process of forecasting the exchange rate based on observations of macroeconomic fundamentals. Deviations in the realized exchange rate from agents' forecasts determine fluctuations in components of the current and financial accounts of the balance of payments in a sample of developing and industrial countries. Absent measures to stimulate export growth in developing countries and given their high dependency on imports, the current account balance deteriorates with respect to currency depreciation. Across industrial countries, the reduction in the value of exports with respect to currency depreciation correlates with a reduction in the value of imports. The combined effect cancel out on the trade and current account balances in industrial countries. Similarly, currency appreciation increases the nominal value of exports and imports without a significant effect on the current account balance in industrial countries. The combined evidence highlights the benefits of a flexible exchange rate system, prevailing in many industrial countries, to ensure that a depreciating rate curbs import growth and increases financial flows. In contrast, currency appreciation increases imports and deteriorates the current account balance across developing countries. Moreover, the evidence indicates the adverse effect of an overvalued exchange rate and the expected deterioration in the balance of payments should developing countries be forced to abandon a peg abruptly.
JEL Classification: E31, F41, F43