Explain the balance of trade and how exchange rate changes affect exports, imports and the trade balance

What this dot point is asking

The syllabus wants you to explain the balance of trade and how changes in the exchange rate affect a country's exports, imports and trade balance. The big idea is that the balance of trade records whether a country sells more abroad than it buys, and that the exchange rate, the price of its currency, is a powerful influence on that balance.

The answer

What the balance of trade is

There are two outcomes:

• A trade surplus is when exports are greater than imports: more money flows in from selling abroad than flows out to buy from abroad.
• A trade deficit is when imports are greater than exports: more money flows out to pay for imports than comes in from exports.

What an exchange rate is

The exchange rate can rise or fall:

• An appreciation is a rise in the value of the currency (it buys more foreign currency).
• A depreciation is a fall in the value of the currency (it buys less foreign currency).

How a depreciation affects trade

When a currency depreciates (becomes weaker):

• Exports become cheaper in foreign currency terms, so foreigners buy more of them. Exports rise.
• Imports become more expensive in domestic currency terms, so the country buys fewer of them. Imports fall.

With exports rising and imports falling, the balance of trade tends to improve (a deficit shrinks or a surplus grows). The catch is that dearer imports can raise the cost of living, causing imported inflation.

How an appreciation affects trade

When a currency appreciates (becomes stronger), the effects reverse:

• Exports become dearer abroad, so foreigners buy fewer of them. Exports fall.
• Imports become cheaper at home, so the country buys more of them. Imports rise.

With exports falling and imports rising, the balance of trade tends to worsen. But cheaper imports help to keep inflation low, which is exactly why a country worried about imported inflation, such as Singapore, may want a stronger currency.

Examples in context

Example 1. Singapore's strong-currency choice. Singapore generally favours a strong, stable Singapore dollar, because it imports most of its food, energy and inputs, so a stronger currency keeps imported inflation low. It accepts that this can make exports dearer, relying instead on high productivity and quality to stay competitive.

Example 2. A weaker currency boosting exports. A country whose currency falls sharply often sees its exports become more competitive abroad, helping its exporters and improving its trade balance. But its people pay more for imported goods such as fuel and food, showing the cost side of a weaker currency.

Try this

• Cue. Define the balance of trade. The difference between the value of a country's exports and the value of its imports of goods and services over a period of time.

• Cue. State the difference between an appreciation and a depreciation of a currency. An appreciation is a rise in the value of the currency (it buys more foreign currency); a depreciation is a fall in its value (it buys less).

• Cue. Explain how a depreciation improves a country's balance of trade. A weaker currency makes exports cheaper abroad (so exports rise) and imports dearer at home (so imports fall), so the balance of trade tends to improve.