The Impact of Currency Appreciation & Depreciation on Trade Deficits

Instructor: Laurie Smith
In this lesson, we'll examine how currency appreciation or depreciation affects a country's trade deficit. You'll learn about the impact on the domestic economy and explore measures that governments might take to counteract negative effects.

Trade Deficit

Ideally, a country would produce everything it needs locally and would be able to export without needing to import any raw material, good, or service. That country wouldn't have a trade deficit. However, that's not realistic.

Most countries lack the resources to produce everything on their own, so they rely on foreign trade to buy what they lack and sell what they produce. Many economies import more goods and services than what they export, causing a trade deficit. If the exports are bigger, the country has a trade surplus.

Sometimes, trade deficits can be big. In 2017, the United States had a deficit of about 450 billion dollars, the United Kingdom of some 100 billion, and Canada's deficit was around 50 billion. Other countries export much more than they import. China is a huge manufacturer and had a trade surplus of over 160 billion. Japan, South Korea, and Germany also have trade surpluses.

Currency Fluctuations

Most countries have their own currency, and they exchange it for foreign currency in order to buy foreign products. When they sell exports, they also exchange payments made in foreign currency back into the domestic money.

The exchange rate compares the value of one currency to another, usually the US dollar. For example, One US dollar buys about 6 Chinese yuan or over 60 Indian rupees, but it only buys around 0.74 British pounds.

The continuous international transactions cause the exchange rate to rise or fall, depending on supply, demand, and geopolitical events. Appreciation is the increase in the value of a currency compared to others, and that currency can now buy more foreign money. Depreciation, or devaluation, is the decrease in value of that currency, so it can buy less.

Small daily variations usually have no effect on trade deficit. They might upset a business or two that will make less profit that day, but there are no major consequences. However, bigger long-term variations can have an impact on trade deficit because they affect the costs of imports, the relative price of exports, and the demand for domestic products.

Effects of Currency Appreciation

Let's assume one US dollar equals 600 Chilean pesos, and a pound of local apples costs 1 dollar. Chilean apples cost 600 Chilean pesos (also one dollar). If the dollar appreciates and buys 700 pesos, imported apples will now cost 0.85 dollars (the same 600 pesos). In Chile, American apples will cost 700 pesos instead of 600.

Currency appreciation tends to make imports cheaper because the same amount of local currency can buy more foreign products. Local consumers might find better prices on imported goods, so imports tend to increase. Appreciation might also cause domestic production to lose competitiveness in the international market because local products are now worth more in foreign currency. Therefore, exports tend to decrease. More imports and fewer exports expand the trade deficit.

Measures to Counteract the Effects

The actions to counteract the effects of currency appreciation usually focus on stabilizing the exchange rate and protecting local producers. To prevent further appreciation, governments might increase national reserves in foreign currency. By buying foreign currency, they increase its demand and prevent further appreciation. To prevent imports from replacing local production, governments sometimes increase taxes on certain imported goods, so local consumers remain likely to buy local products. Some countries also offer subsidies to local producers, helping them to remain competitive and cope with lower local prices and less profitable exports.

Effects of Currency Depreciation

When the local currency depreciates, imports become more expensive, so locals often buy fewer imported goods. On the other hand, exported goods cost less to international buyers, so their demand tends to grow. Fewer imports and more exports will reduce the trade deficit and could lead to a surplus.

If we look at the apple example again, this will be Chile's perspective. More Americans are demanding the now-cheaper Chilean apples, and local Chilean consumers find the domestic product more attractive in terms of price. Therefore, more apples will be exported and fewer apples will be imported.

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