Balance of Payments Approach
Changes in national income affect both current and capital account, thus causing predictable reactions in the exchange rate in order to restore balance of payments equilibrium. Here’s a simple equation to show what I’m trying to explain here and is used in economics to show how economies adjust to changes in economic dynamics:
We also know that countries all around the world have different strategies in governing their economies, especially their exchange rates, but in general they can be split into 2 forms:
1. Fixed/Pegged Exchange Rate Regime
As capital mobility is limited, we have to focus on the current account rather than the capital account. To simplify the whole process, here’s a flowchart:
Change in national income (increase causes imports to increase, and vice versa) -> Change in current account balance -> Monetary reaction (by authorities, where they have the choice of buying/selling forex reserves or tightening/loosening policies) -> Reversal of current account balance change -> Balance of payments equilibrium restored.
2. Floating Exchange Rate Regime
In this case, we have to consider both capital and current accounts.
Change in national income (as it rises, import demand rises, current balance decreases) -> Change in current account balance -> Change in real interest rates (if current balance decreases, interest rates rises) -> Change in capital flows -> National income change reversed -> Current account reversed -> Capital flows reversed -> Real interest rates reversed -> Balance of payments equilibrium restored.
These are all theoretical predictions and in real life, there are often lags in their movements and many other factors that has to be taken into account.