Explain the balance of payments and the two underlying accounts within it. How does balance of payments affect exchange rates? Provide one example. 

Balance of payments is a systematic record of all the economic transactions which take place between the individuals of a country and the rest of the world.

The two underlying accounts within the balance of payments are current account and capital account.

A change in a country's balance of payments can cause fluctuations in the exchange rate between its currency and foreign currencies. Surplus balance of payment will exert upward pressure on a country's currency hence making it stronger while deficit balance of payment will exert down ward pressure on a country's currency hence making it weaker.

Step-by-step explanation

Basically, when countries trade they need to drive value from each other. This value should be documented. The official document denoting the financial position of a country as a result of trading with others is called balance of payment. Notably, balance of payments BOP is a systematic record of all the economic transactions which take place between the individuals of a country and the rest of the world.

Essentially, balance of payment can also be defined as a summary of statements of all the transactions between the residents of one country and the rest of the world. There are three possible positions of balance of payments namely; surplus balance of payment (favorable), deficit BOP ( unfavorable) and balanced BOP.

There are two major balance of payment accounts namely; current account and capital account. Current account shows the balance between the export and imports of visible and invisible items during a particular year. It is that part of BOP account that lists all short term transactions. Capital account shows the balance between the receipts and payments regarding foreign loans and aids. It is that part of BOP account that lists all the long term loans.

The sum of all transactions recorded in the balance of payments must be zero, as long as the capital account is defined broadly. The reason is that every credit appearing in the current account has a corresponding debit in the capital account, and vice-versa. If a country exports an item (a current account transaction), it effectively imports foreign capital when that item is paid for (a capital account transaction).

A change in a country's balance of payments can cause fluctuations in the exchange rate between its currency and foreign currencies. Surplus balance of payment will exert upward pressure on a country's currency hence making it stronger while deficit balance of payment will exert down ward pressure on a country's currency hence making it weaker.

Importantly, the balance of payments impacts currency exchange rates as supply and demand can leads to an appreciation or depreciation of currencies. A country with a high demand for its goods tends to export more than it imports, increasing demand for its currency.

The balance of payment influences currency exchange rates through its effect on the supply and demand for foreign exchange. When a country's payment account does not net to zero that is, when exports are not equal to imports. Therefore, there is relatively more supply or demand for a country's currency, which influences the price of that currency on the world market.

If a country exports more than it imports, there is a high demand for its goods and thus for its currency. The economics of supply and demand dictate that when demand is high, prices rise and the currency appreciates in value. In contrast, if a country imports more than it exports, there is relatively less demand for its currency, so prices should decline. In the case of currency, it depreciates or loses value.

For example, let's say that candy bars are the only product on the market and South Africa imports more candy bars from the U.S. than it exports, so it needs to buy more dollars relative to rand sold. South Africa's demand for dollars outstrips America's demand for rand, meaning that the value of the rand falls. In this situation, we will summarize that the rand might fall to 15 relative to the dollar. Now, for every $1 sold, an American gets 15 rand. To buy $1, a South African has to sell 15 rand.

It is important to note that the relationship between balance of payments and exchange rates exists only under a free or floating exchange rate regime. The balance of payments does not impact the exchange rate in a fixed-rate system because central banks adjust currency flows to offset the international exchange of funds.