Currency Changes on Trade

Introduction

Key Concepts

Exchange Rates and Their Determination

Exchange rates represent the value of one country's currency in terms of another's. They are determined by various factors, including interest rates, inflation, political stability, and overall economic performance. Exchange rates can be classified into two main types:

• Floating Exchange Rates: These rates are determined by the free market forces of supply and demand without direct government or central bank intervention.
• Fixed Exchange Rates: These are pegged to another major currency or a basket of currencies, with the government or central bank actively maintaining the rate.

Impact of Currency Appreciation

When a country's currency appreciates, it gains value relative to other currencies. This appreciation can have several effects on trade:

• Exports Become More Expensive: Higher currency value makes a country's goods and services more costly for foreign buyers, potentially reducing export volumes.
• Imports Become Cheaper: Foreign goods and services become less expensive for domestic consumers, likely increasing import volumes.
• Trade Balance Impact: An appreciated currency can lead to a decrease in net exports ($NX = X - M$), where $X$ represents exports and $M$ represents imports.

Impact of Currency Depreciation

Conversely, when a country's currency depreciates, it loses value relative to other currencies, affecting trade as follows:

• Exports Become Cheaper: Lower currency value makes a country's goods and services more affordable for foreign buyers, potentially increasing export volumes.
• Imports Become More Expensive: Foreign goods and services become costlier for domestic consumers, likely reducing import volumes.
• Trade Balance Impact: A depreciated currency can lead to an increase in net exports, enhancing aggregate demand.

Pass-Through Effect

The pass-through effect refers to the extent to which changes in exchange rates influence domestic prices of imported and exported goods. Factors influencing the pass-through rate include:

• Market Structure: Competitive markets may exhibit higher pass-through rates as firms adjust prices swiftly in response to currency changes.
• Time Lags: Delays in price adjustments can reduce the immediate impact of exchange rate fluctuations on trade.
• Pricing Strategies: Firms employing long-term contracts or localized pricing may experience lower pass-through rates.

J-Curve Effect

The J-curve effect illustrates the short-term and long-term impacts of currency depreciation on a country's trade balance:

• Short-Term: Immediately after a depreciation, the trade balance may worsen due to higher import prices and contracted demand for exports.
• Long-Term: Over time, as export volumes increase and import volumes decrease, the trade balance improves, creating a "J" shaped curve when graphed.

Aggregate Demand and Net Exports

Net exports ($NX$) are a component of aggregate demand ($AD$) and are influenced by currency fluctuations:

Changes in $NX$ due to currency appreciation or depreciation directly affect the overall aggregate demand within an economy. An increase in $NX$ stimulates aggregate demand, potentially boosting economic growth, while a decrease in $NX$ can have a contractionary effect.

Examples of Currency Impact on Trade

Consider the following scenarios illustrating currency changes affecting trade:

• Appreciation Example: If the US dollar appreciates against the euro, American cars become more expensive for European consumers, potentially reducing US exports to Europe.
• Depreciation Example: If the Japanese yen depreciates relative to the US dollar, Japanese electronics become cheaper for American consumers, potentially increasing US imports from Japan.

Government and Central Bank Interventions

Governments and central banks may intervene in foreign exchange markets to stabilize or influence their currency's value:

• Monetary Policy Adjustments: Altering interest rates can attract or repel foreign investment, impacting currency value.
• Foreign Exchange Reserves: Buying or selling foreign currencies can directly affect the supply and demand dynamics of the domestic currency.
• Capital Controls: Implementing measures to restrict or encourage capital flows can influence currency stability.

Elasticity of Demand for Exports and Imports

The responsiveness of export and import demand to changes in exchange rates is determined by their price elasticity:

• Elastic Demand: If demand is elastic, small changes in exchange rates result in significant changes in quantities demanded.
• Inelastic Demand: If demand is inelastic, changes in exchange rates have a muted effect on trade volumes.

Understanding the elasticity of goods and services is crucial for predicting the impact of currency changes on trade balance.

Real vs. Nominal Exchange Rates

While nominal exchange rates reflect the current price of one currency in terms of another, real exchange rates adjust for price level differences between countries:

Real exchange rates provide a more accurate measure of a country's competitiveness, as they account for inflation and purchasing power parity.

Trade Policies and Currency Value

Trade policies, such as tariffs and import quotas, can interact with currency values to influence trade outcomes:

• Tariffs: Imposing tariffs on imports can make foreign goods more expensive, potentially offsetting the effects of currency appreciation.
• Subsidies: Providing subsidies to exporters can enhance the competitiveness of domestic products, influencing net exports.

Balance of Payments and Currency Stability

A country's balance of payments, comprising the current account and capital account, reflects its economic transactions with the rest of the world:

• Current Account Surplus: Indicates higher exports than imports, potentially strengthening the domestic currency.
• Current Account Deficit: Indicates higher imports than exports, potentially weakening the domestic currency.

Maintaining a balanced balance of payments is essential for currency stability and sustainable economic growth.

Comparison Table

Summary and Key Takeaways