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 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.
- 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 have less demand for its currency.
- Trade balances and, as a result, currencies can swing back and forth, 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
These relative values are influenced by the demand for currency, which is in turn influenced by trade. 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. 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.
The relative attractiveness of exports from that 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 then start exporting more and importing less, reducing the trade deficit.
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.