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 trade balance affect exchange rates? ›
Overview of Exchange Rates
A higher exchange rate can be expected to damage a country's balance of trade. That is, the country is making less on its exports and spending more on its imports. A lower exchange rate can be expected to improve the balance of trade.
How does bop affect exchange rates? ›
A change in a country's balance of payments can cause fluctuations in the exchange rate between its currency and foreign currencies. The reverse is also true when a fluctuation in relative currency strength can alter balance of payments.
What is the relationship between currency strength and the balance of trade? ›
Exchange rates affect trade balance by changing the relative prices of goods and services across countries. A depreciation of a country's currency makes its exports cheaper and its imports more expensive, which can increase its trade surplus or reduce its trade deficit.
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 reduces imports, raises exports, and increases the balance of trade.
Is a higher balance of trade good? ›
In general, a trade surplus is seen as a positive sign for a country's economy, while a trade deficit is often seen as a negative sign. However, this is not always the case. A trade surplus or trade deficit is not inherently good nor bad. The balance of trade alone is not an indicator of economic health.
Why is balance of trade important? ›
Currency value: The trade balance can influence the value of a nation's currency. A surplus typically strengthens a currency, while a deficit can weaken it. Government policies: Trade policies, tariffs, and political relations can significantly impact the trade balance.
What is the relationship between trade and foreign exchange? ›
International trade itself also affects exchange rates. When the demand for domestic goods is high, exports exceed imports, resulting in a trade surplus. This increases the demand for the the country's currency and currency exchange rates rise. Inflation is directly related to exchange rates.
What is the BOP theory of exchange rates determination? ›
Balance of Payments Model
The model is based on the expectation that foreign exchange rates are completely determined by the trade deficit (exports—imports). A country with a trade deficit (e.g., the country is importing more goods than it is exporting) will experience a devaluation of its foreign exchange rate.
What happens to the exchange rate when the current account balance falls? ›
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).
Iranian Rial (IRR)
Currently, the Iranian Rial is considered the world's least valuable currency. This is the result of factors like political unrest in the country.
What is the strongest currency in the world? ›
The Kuwaiti Dinar is renowned as the strongest currency in the world. Introduced in 1961, it has maintained a commanding presence due to Kuwait's substantial oil reserves, which account for a significant portion of its economic output.
What influences the exchange rate? ›
Below are some of the key influences on exchange rate movements.
- Interest rates and inflation. Inflation and interest rates are closely related, and both affect exchange rates. ...
- Trade. A country's trading relationship with the rest of the world can also affect its currency. ...
- Market expectations.
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.
Does balance of trade affect exchange rate? ›
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.
What is a negative impact of balance of trade? ›
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 are the factors influencing exchange rates? ›
There are several factors that influence exchange rates, such as inflation, interest rates, deficits, debt, and import-export balances. A strong understanding of these factors is important for traders, businesses, and governments.
What does balance of trade involves the exchange of? ›
The balance of trade involves the exchange of goods and services between countries. Goods are physical products that can be traded, such as cars, clothes, and food. Services, on the other hand, are intangible products that cannot be touched, such as transportation, banking, and tourism.
What increases trade balance? ›
The balance of trade is the difference between a country's exports and imports of goods and services. Some factors influencing the balance of trade include export competitiveness, exchange rates, consumer demand, trade policies, economic growth, technological advancements, natural resources, and individual demoraphics.
