How the Balance of Trade Affects Currency Exchange Rates
The balance of trade influences currency exchange rates through its effect on foreign exchange supply and demand. When a country's trade account does not net to zero—that is, when exports are not equal to imports—there is relatively more supply of or demand for a country's currency. This influences the price of that currency on the world market.
Currency exchange rates are quoted as relative values; the price of one currency is described in terms of another. For example, one U.S. dollar might be equal to 11 South African rand. In other words, an American business or person exchanging dollars for rand would buy 11 rand for every dollar sold, and a South African would buy $1 for every 11 rand sold.
Key Takeaways
- The balance of trade (which reflects higher or lower demand for a currency) can affect currency exchange rates.
- A country with a high demand for its goods tends to export more than it imports, increasing demand for its currency.
- A country that imports more than it exports will see less demand for its currency.
- Trade balances and, as a result, currencies can swing back and forth in value, assuming currencies are floating rather than fixed.
- Currencies that are fixed or pegged don’t move as easily as floating currencies in response to a trade imbalance.
How Trade Influences the Demand for Currency
The relative values of currencies are influenced by the demand for them, and that demand is influenced by trade. If a country exports more than it imports (known as a trade surplus), 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 (known as a trade deficit), 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. As a result, it needs to buy more dollars relative to rand sold. South Africa's demand for dollars outstrips America's demand for rand.
This means that the value of the rand falls. In this situation, we'll surmise 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.
Trade influences the demand for currency, which helps drive currency prices.
Trade Balance
The relative attractiveness of exports from a country also grows as a currency depreciates. For instance, assume an American candy bar costs $1. Before their currency depreciated, a South African could buy an American candy bar for 11 rand. Afterward, the same candy bar costs 15 rand, a huge price increase.
On the other hand, a South African candy bar costing 5 rand has become much cheaper by comparison: $1 now buys three South African candy bars instead of two.
South Africans might start buying fewer dollars because American candy bars have become quite expensive, and Americans might start buying more rand because South African candy bars are now cheaper. This, in turn, begins to affect the balance of trade. South Africa would start exporting more and importing less, reducing its trade deficit.
Traders, economists, and analysts await trade announcements because the balance of trade is seen as an indicator of GDP, a country's economic well-being, and its potential for growth. In addition, currencies and equities can fluctuate when trade figures are released, presenting trading opportunities.
How Does a Higher Exchange Rate Affect Trade?
When a country's exchange rate increases relative to another country's, the price of its goods and services increases. Imports become cheaper. Ultimately, this can decrease that country's exports and increase imports.
How Is the Value of Currency Affected by Demand?
Increasing demand for a country's goods and services increases demand for its currency. That, in turn, increases the currency's value.
What Factors Are Affected by Changes in Currency Exchange Rates?
Changes in currency exchange rates can affect the prices of goods and services, the value of currency, and the balance of trade.
The Bottom Line
The balance of trade can affect foreign exchange supply and demand. That can then affect currency exchange rates. Our example assumes that the currencies are on a floating regime, meaning that the market determines the value of a currency relative to others. In cases where one or both currencies are fixed or pegged to another currency, the exchange rate does not move as readily in response to a trade imbalance.
FAQs
If a country exports more than it imports (known as a trade surplus), 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.
What is the relationship between balance of payments and foreign exchange rates? ›
The market balance of payments refers to the balance of supply and demand for a country's currency in the foreign-exchange market at a given rate of exchange. If the exchange rate is fixed, the market balance of payments would be in balance only by chance.
What effect would currency appreciation have on balance of trade? ›
Effects of Currency Appreciation
Export costs rise: If the U.S. dollar appreciates, foreigners will find American goods more expensive because they have to spend more for those goods in USD. That means that with the higher price, the number of U.S. goods being exported will likely drop.
What happens to a country's balance of trade as the value of its currency falls? ›
A decrease in value of a country's currency relative to other currencies raises imports, reduces exports, and increases the balance of trade.
How does the value of a nation's currency affect the balance of trade? ›
A higher-valued currency makes a country's imports less expensive and its exports more expensive in foreign markets.1 A lower-valued currency makes a country's imports more expensive and its exports less expensive in foreign markets.
Why does a rise in foreign exchange rate cause a rise in its supply? ›
When price of a foreign currency rises domestic goods become relatively cheaper. It induces the foreign country to increase their imports from the domestic country. As a result supply of foreign currency rises.
Is balance of payments a method of keeping the foreign exchange market in equilibrium? ›
The balance of payments model postulates that a foreign exchange rate in equilibrium will remain in equilibrium, providing it maintains a stable account balance. The model is based on the expectation that foreign exchange rates are completely determined by the trade deficit (exports—imports).
What affects the exchange rate? ›
Currency fluctuations are a natural outcome of floating exchange rates, which is the norm for most major economies. Numerous factors influence exchange rates, including a country's economic performance, the outlook for inflation, interest rate differentials, capital flows and so on.
Why is balance of trade important? ›
Balanced trade helps prevent abrupt and disruptive changes in exchange rates and trade flows. For example, consider how volatile exchange rates and dependency on foreign countries for goods may cause undue strain on one's economy. Jobs and Domestic Industries: Balanced trade may benefit both jobs and domestic industry.
How does the current account deficit affect the exchange rate? ›
The huge import bill in the current account increases demand for foreign currency, while slowdown in exports of goods reduces the inflow of foreign currency. The combined effect exerts pressure on the exchange rate to depreciate (weaken).
A higher trade deficit leads to jobs being outsourced to foreign countries as more imports lead to fewer job opportunities. Demand for imported goods leads to a decline in demand for locally made goods, which leads to the closing of factories and the associated job losses.
What happens when a country has a negative trade balance? ›
A trade deficit creates downward pressure on a country's currency under a floating exchange rate regime. With a cheaper domestic currency, imports become more expensive in the country with the trade deficit. Consumers react by reducing their consumption of imports and shifting toward domestically produced alternatives.
What affects trade balance? ›
A country's balance of trade is defined by its net exports (exports minus imports) and is thus influenced by all the factors that affect international trade. These include factor endowments and productivity, trade policy, exchange rates, foreign currency reserves, inflation, and demand.
What is the strongest currency in the world? ›
The highest currency in the world is none other than Kuwaiti Dinar or KWD. Initially, one Kuwaiti dinar was worth one pound sterling when the Kuwaiti dinar was introduced in 1960. The currency code for Kuwaiti Dinar is KWD. The most popular Kuwait Dinar exchange rate is the INR to KWD rate.
When the dollar appreciates what happens to the trade deficit? ›
Thus, a stronger dollar tends to cause the trade deficit (exports less imports) to increase. Generally, the trade deficit has been increasing as a share of gross domestic product (GDP) since the beginning of 2020 and has continued rising since the dollar continued its upward trend in 2021 (see Figure 2).
Does currency appreciation cause current account deficit? ›
An overvalued currency makes imports cheaper and exports less competitive, thereby widening the current account deficit or narrowing the surplus. An undervalued currency, on the other hand, boosts exports and makes imports more expensive, thus increasing the current account surplus or narrowing the deficit.
How do appreciation and depreciation of a country's currency affect its balance of trade quizlet? ›
When a country's currency appreciates, the country's goods abroad become more expensive and foreign goods in that country become cheaper (holding prices constant). Conversely, when a country's currency depreciates, its goods abroad become cheaper and foreign goods in that country become more expensive.
How does currency appreciation affect investment? ›
Movements in currencies can have a substantial impact on the returns from foreign investments. Investing in securities that are denominated in an appreciating currency can boost total returns. However, investing in securities denominated in a depreciating currency can reduce profits.
