The theory of elasticities holds that the exchange rate is simply the price of foreign exchange that maintains the balance of payments in equilibrium. For instance, if the imports of country A are strong, then the trade balance is weak.
Consequently, the exchange rate rises, leading to the growth of country A's exports, and triggers in turn a rise in its domestic income, along with a decrease in its foreign income. Whereas a rise in the domestic income (in country A) will trigger an increase in the domestic consumption of both domestic and foreign goods and, therefore, more demand for foreign currencies, a decrease in the foreign income (in country B) will trigger a decrease in the domestic consumption of both country B's domestic and foreign goods, and therefore less demand for its own currency.
The elasticities approach is not problem-free because in the short term the exchange rate is more inelastic than it is in the long term and the additional exchange rate variables arise continuously, changing the rules of the game.
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