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.
How does bop affect exchange rates? ›
Balance of payments is the statement of a country's trade with other nations. The relationship between balance of payments and exchange rates under a floating-rate exchange system will be driven by the supply and demand for the country's currency and all transactions taking place with other countries.
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? ›
Economic effects
Thus, depreciation of a currency tends to increase a country's balance of trade (exports minus imports) by improving the competitiveness of domestic goods in foreign markets while making foreign goods less competitive in the domestic market by becoming more expensive.
What is balance of trade How does it affect the economy? ›
Balance of trade is defined as the difference between the value of a country's exports and its imports over a certain period. A positive balance of trade, also known as a trade surplus, signifies that the value of exports exceeds that of imports.
What is BOP approach to exchange rate? ›
According to the BOP theory of exchange rates, the supply and demand for a currency arise from the flows related to the BOP, that is, trade in goods and services, portfolio investment, and direct investment. Equilibrium exchange rates are determined when the BOP is in equilibrium.
What is the monetary approach to BOP and exchange rate? ›
The monetary approach postulates that changes in a nation's balance of payments or exchange rate are a monetary phenomenon. The small country illustrates the impact of changes in domestic credit, foreign price shocks, and changes in domestic real income.
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.
What happens to the exchange rate when a currency appreciates and depreciates? ›
If a currency appreciates it is more valuable; if a currency depreciates it is less valuable. When an exchange rate changes, the value of one currency will go up while the value of the other currency will go down. When the value of a currency increases, it is said to have appreciated.
What causes the dollar to weaken? ›
Easy monetary policy by the Fed can weaken the dollar when investment capital flees the U.S. as investors search elsewhere for higher yield. Declining economic growth and corporate profits can cause investors to take their money elsewhere.
When the value of a currency changes, prices for goods traded using that currency can be affected. A currency appreciation (when the value increases over time) results in a lower effective price for imported goods; currency depreciation (when the value decreases over time) translates to higher import prices.
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.
How does a trade deficit affect the value of the U.S. dollar? ›
During a trade deficit, the U.S. dollar should typically depreciate, but in many instances, the dollar has strengthened. A trade deficit means that the United States is buying more goods and services from abroad (importing) than it is selling abroad (exporting).
What factors affect the value of a country's currency? ›
The value of a currency, like any other asset, is determined by supply and demand. An increase in demand for a particular currency will increase the value of the currency, while an increase in supply will decrease the currency's value. The exchange rate is the value of one country's currency in relation to another.
How does balance of trade affect inflation? ›
The more important trade is and the more responsive demand and supply are to price changes, the more readily inflation will surge from one country to another. Completely fixed exchange rates are one polar extreme.
What is an example of balance of trade? ›
The balance of trade formula subtracts the value of a country's imports from the value of its exports. For example, imagine a country's exports in the past month were $200 million while its imports were $240 million. The difference between the country's exports and imports is -$40 million (a negative integer).
How does floating exchange rate affect BOP? ›
Benefits of a Floating Exchange Rate
The country's exports would become cheaper, resulting in an increase in demand and eventually attaining equilibrium in the BOP.
Is the BOP an important indicator of pressure on a country's foreign exchange rate? ›
The BOP is an important indicator of pressure on a country's foreign exchange rate and thus on the potential for a firm trading with or investing in that country to experience foreign exchange gains or losses. Changes in the BOP may predict the imposition or removal of foreign exchange controls.
What are the factors that affect the exchange rate? ›
In this article, we highlight Factors that affects currency exchange rates, starting with the most significant factor – inflation.
- Inflation. ...
- Interest Rates. ...
- Public Debt. ...
- Political Stability. ...
- Economic Health. ...
- Balance of Trade. ...
- Current Account Deficit. ...
- Confidence/ Speculation.
The value of a currency, like any other asset, is determined by supply and demand. An increase in demand for a particular currency will increase the value of the currency, while an increase in supply will decrease the currency's value. The exchange rate is the value of one country's currency in relation to another.
