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Exchange Rate and Net Exports

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Exchange Rate and Net Exports

If you're anything like me, you enjoy buying things online. It's so easy and convenient! You can compare different options, and with one click, presto! Your purchase will be at your doorstep in a matter of days.

Convenience is everything in the online world. And of course there are many moving parts in making that convenience possible. But have you ever noticed that sometimes the things you buy come from other countries? If you stop to think about it, people from all over the world purchase products online. As a result, if you're the manufacturer of a product that's being purchased by people in countries all around the world, it's not manageable to accept whatever currency happens to be associated with the country those are people are in.

So as a general rule, goods and services purchased from a given country need to be purchased in that country's currency.

So in a sense, you've been actively participating in the Foreign Exchange Market all this time. Let's dive into how changes in the foreign exchange market and net exports impact each other, and how your online purchases as well as other purchases from other countries, work together.

Exchange Rate and Net Exports Definition

Exchange rates and net exports are inextricably connected. In order to understand how, we must first understand how each measure is defined.

So what exactly is an exchange rate?

The simplest way to think of it is: it's the price of another country's money.

Let's use a chocolate bar as an example (albeit a weird one). Technically, there are two ways to think about the cost of that chocolate bar. The first is, how many dollars does it take to buy one chocolate bar? The second is, how much chocolate bar can I buy for one dollar?

For example, if a chocolate bar costs $1.50, the answer to the first question is $1.50. But looked at the other way, one dollar will buy you exactly 66.7% of one chocolate bar.

Think of exchange rates the same way.

For simplicity imagine there are only 2 countries in the world - Canada and the United States - and that you live in the United States. As of the writing of this explanation, 1 U.S. dollar (USD) can buy 1.30 Canadian dollars (CAD). So you can say that the USD:CAD exchange rate is 1.3. Alternatively, 1 CAD can buy 0.77 USD, so if you look at it this way, the CAD:USD exchange rate is 0.77.

Going forward, we will talk about the USD to CAD exchange rate in USD:CAD terms. In other words, how many CAD one USD can buy, or 1.3 for now.

Now that we've agreed on how we will talk about the USD to CAD exchange rate, let's talk about where the buying and selling of currencies happens.

As with any exchange, the buying and selling of currencies require a market. This market is called the Foreign Exchange Market. The Foreign Exchange Market is where currencies can be exchanged for each other. This market also determines the exchange rates, or the prices at which currencies are bought and sold.

The Foreign Exchange Market is the electronic market where currencies can be bought and sold in exchange for one another.

Don't think of the Foreign Exchange Market as a physical market located in a geographic spot but rather an electronic market that traders around the world use to buy and sell currencies.

Since the foreign exchange market is a market, after all, it's subject to the traditional economic rules of supply, demand, and equilibrium. So when we say the USD to CAD exchange rate is 1 to 1.3, we actually mean the equilibrium USD to CAD exchange rate.

Consider Figure 1 for a visual representation.

Exchange Rate and Net Exports Equilibrium Exchange Rate StudySmarter OriginalsFig 1. - Equilibrium Exchange Rate

As illustrated in Figure 1, the interaction of buyers and sellers exchanging currencies in the foreign exchange market determines the equilibrium exchange rate in a flexible exchange market, and also importantly influences the flow of goods, services, and financial capital between countries.

Imports, Exports, and Exchange Rates

Imports, exports, and exchange rates play a very real role in the daily lives of many consumers.

Consider online purchases. Since the products you buy online are purchased in your own currency, but the products may be manufactured in other countries, that means your currency has to be sold in the foreign exchange market to purchase that foreign currency so that the manufacturer can get paid in their currency.

This all occurs at the equilibrium exchange rate depicted in Figure 1.

It's also important to note that the interaction you just embarked on, buying a product from another country so you can use it in yours, is called an import.

An import is a product or service purchased in and brought to one country but is manufactured in another country.

Conversely, the very same interaction is considered an export from the point of view of the manufacturer - a sale of a product made in their country to be used in your country!

An export is a product or service manufactured in one country, but purchased in and sent to another country.

And so the Foreign Exchange Market and Net Export dance begins.

Net exports are the difference between a country’s exports and its imports. Net exports can be either positive (trade surplus) or negative (trade deficit).

Relationship Between Exchange Rate and Net Exports

The relationship between exchange rates and net exports probably seems fairly straightforward, but it's important to be able to explain how that relationship works. Let's start with the language used when discussing exchange rates.

When the value of a currency relative to another currency increases, we say it has appreciated.

When the value of a currency relative to another currency decreases, we say it has depreciated.

But how do currencies appreciate and depreciate relative to one another?

Well, it all has to do with changes in the supply or demand for any given currency.

As a well-versed economist, you know that changes in supply or demand in any market eventually mean a change to its market equilibrium point. This is also true in the foreign exchange market. Changes in the supply or demand for a currency in the foreign exchange market establish a new equilibrium exchange rate.

Consider this visually in Figure 2 which illustrates a reduction in demand for USD, and a corresponding leftward shift of the USD demand curve.

Exchange Rate and Net Exports USD Depreciation Relative to CAD StudySmarter OriginalsFig 2. - USD Depreciation Relative to CAD

The initial equilibrium exchange rate was 1 USD to 1.3 CAD. However, a reduction in demand for USD causes a leftward shift in the USD demand curve.

At an exchange rate of 1 USD to 1.3 CAD, the demand for USD is now DdisE while the supply for USD is still at DE0. This disequilibrium results in an excess supply of USD, and in order to absorb that excess supply, the value of USD must be reduced relative to CAD, thereby establishing a new equilibrium exchange rate of 1 USD to 1.17 CAD.

Now that the equilibrium exchange rate for USD to CAD has changed, what do you suppose happens now? Well, as you know, changes in the equilibrium exchange rate will influence the flow of goods, services, and financial capital between countries.

But if you're wondering why a change in the equilibrium exchange rate influences the flow of goods, services, and capital, it's as simple as asking yourself "if the price of the product I bought online today increased by 10%, would I still buy it?" The answer might still be "yes", but there's a good chance it might change to a "no" or at the very least you might purchase less of that product.

When a currency appreciates relative to yours (or yours depreciates relative to it), all the goods and services from that country get more expensive.

Consider Figure 2 again. Since the equilibrium USD to CAD exchange rate changes from 1 to 1.3 to 1 to 1.17, that means all goods and services made in Canada just got 10% more expensive. (Since you now get 0.13 CAD less per USD, the purchasing power of the USD went down by 0.13 CAD, which is 10% of 1.3 CAD.)

Since these Canadian goods and services are imports into the United States, that also means that Canadian imports into the U.S. will decrease.

But here's the interesting thing. We know that when the CAD appreciates relative to the USD, that must also mean that the USD depreciates relative to the CAD. Therefore for people in Canada, all products and services made in the U.S. just got 10% cheaper, driving U.S. exports to Canada up!

A depreciation of a currency generally causes a decrease in imports into that country, and an increase in exports from that country, thereby increasing Net Exports.

An appreciation of a currency generally causes an increase in imports into that country, and a decrease in exports from that country, thereby decreasing Net Exports.

Impact of Exchange Rate on Exports

The impact of exchange rates on exports can't be understated. We know that when a currency's demand or supply shifts, it leads to changes in the equilibrium exchange rate. But what do you suppose would cause a currency's supply and demand curves to shift in the first place?

That's an interesting question, with an even more interesting answer.

For example, let's say the U.S. wanted to protect its forestry industry and imposed a quota on Canadian lumber. In this case, there would be a limit on how much Canadian lumber could be imported into the U.S. (presumably at a lower amount than would be demanded in an open market), thereby reducing the demand for CAD from U.S. citizens.

As we know, a reduction of demand for CAD has to be met with an equivalent reduction in USD supply (since fewer USD are being exchanged for CAD in order to buy Canadian lumber). When thought of this way, we can see that the ultimate effect would be an increase in the equilibrium exchange rate of USD to CAD, or an appreciation of the USD relative to the CAD as shown in Figure 3.

Exchange Rate and Net Exports Appreciation Relative to CAD due to US Tariff on Canadian Lumber StudySmarter Originals Fig 3. - Appreciation Relative to CAD due to U.S Tariff on Canadian Lumber

Since the USD just got 10% more expensive relative to the CAD, we know this means that U.S. products just became 9.1% more expensive to Canadians (see deep dive). Conversely, since the CAD equivalently got cheaper relative to the USD, Canadian goods and services just got cheaper for U.S. citizens. The net impact? U.S. exports to Canada decrease, while Canadian imports into the U.S. increase, reducing Net Exports.

Why does the USD appreciate by 10% but the CAD depreciates by 9.1%?

When considering an appreciation in the USD from the point of view of Canadian purchasing power, remember that you need to ask how many USD can 1 CAD purchase.

Therefore, while the USD appreciated from $1.30CAD to $1.43CAD (a 10% increase in American purchasing power of Canadian goods), Canadian purchasing power depreciated from $0.769USD to $0.699USD (1/$1.30 to 1/$1.43), which is a change of -9.1%.

As it turns out, the government also has another way of affecting the equilibrium exchange rate. That is, through fiscal policy.

Say, for example, the U.S. government wanted to positively stimulate the economy, and it decided to achieve that goal by reducing income tax rates.

As you can imagine, if income taxes are reduced, that means after-tax, or disposable income, increases.

Disposable income is the money that is left over from an individual’s salary after taxes are deducted.

Households and individuals are rational, so they'll save some of the new disposable income they now have, but they will also increase their consumption spending. It's not a stretch to imagine that some of this additional consumption spending will occur online, and therefore come in the form of purchases from other countries, or imports. If imports into the U.S. increase, that means that, all else being equal, the demand for international currencies will go up, which we know must mean a corresponding increase in the supply of USD.

Figure 4 illustrates what the impact of this type of fiscal policy will be on the UDS equilibrium exchange rate.

Exchange Rate and Net Exports USD Depreciation Relative to CAD due to US Fiscal Policy StudySmarter OriginalsFig 4. - USD Depreciation Relative to CAD due to U.S. Fiscal Policy

Since the USD just got 10% less expensive relative to the CAD, we know this means that U.S. goods and services just became 10% cheaper for Canadians. Conversely, since the CAD equivalently got more expensive relative to the USD, Canadian goods and services just got more expensive for U.S. citizens.

The net impact of this fiscal policy? U.S. exports to Canada increase, while Canadian imports into the U.S. decrease, increasing Net Exports.

Let's consider one last example of what can affect the supply and demand of a currency - Monetary Policy.

As you know, the interaction of buyers and sellers exchanging currencies in the foreign exchange market determines the equilibrium exchange rate, which also influences the flow of goods, services, and financial capital between countries.

We've discussed the flow of goods and services, but we haven't discussed the flows of financial capital.

Suppose that the Central Bank believes the economy is overheating, or performing above its full potential. It will use its monetary policy tools to reduce the money supply, which will result in a higher interest rate. As a good economics student, you already know that when interest rates rise, investment spending (I) decreases since loans for investment projects become more expensive, and consumption spending (C) also decreases since it becomes more profitable for a household to put more of its money into a savings account (in other words the opportunity cost of holding money increases). Thus the central bank has done its job.

But what impact do the Central Bank's actions have on the Foreign Exchange Market?

Well as we mentioned, when the U.S. interest rate rises, this makes the return associated with a loan in the U.S. more attractive to Canadian investors. However, in order to invest in the U.S., these Canadian investors need to convert their CAD into USD, thereby increasing demand for USD, and shifting the USD demand curve to the right as seen below in Figure 5.

Exchange Rate and Net Exports USD Appreciation Relative to CAD due to Monetary Policy StudySmarter OriginalsFigure 5. USD Appreciation Relative to CAD due to Monetary Policy, StudySmarter Originals

As you can see from Figure 5, and as you probably suspected, the impact of the Central Bank's contractionary policy is an appreciation in the USD.

Is there more to this story though? There sure is.

As we know, when the USD appreciates, it makes U.S. goods and services more expensive in foreign countries, while making foreign goods and services cheaper in the U.S. Alternately put, an appreciation in the USD reduces U.S. exports, and increases U.S. imports. In other words, Net Exports decrease, having a further contractionary impact on the U.S. economy.

Increase in Exports on Exchange Rate

Are you wondering if exports can impact exchange rates? If you are, that's good. In fact, an increase in exports will affect exchange rates in cases where a shift in demand for a currency is simply due to an increase in demand for one country's products or services.

For example, when a Japanese entertainment company releases a new video game console, there's usually a big rush of demand for these technological marvels, resulting in increased demand for the Japanese Yen.

However, for the purposes of this explanation let's stick to the U.S. and Canada. Let's say one morning all U.S. households wake up with an insatiable urge to have pancakes with maple syrup. It's possible.

As you might expect, U.S. demand for maple syrup goes through the roof, and so does demand for CAD since you can only buy maple syrup with CAD. Increased demand for CAD can only be satisfied by an increase in the supply of USD in exchange for those CAD, and Figure 6 below illustrates exactly what this looks like.

Exchange Rate and Net Exports USD Depreciation due to Increased Demand for Maple Syrup StudySmarter OriginalsFigure 6. USD Depreciation due to Increased Demand for Maple Syrup, StudySmarter Originals

If Figure 6 looks familiar, it's because it's the same visual as Figure 4 albeit for very different reasons.

Changes in the Foreign Exchange Market and Net Exports - Key Takeaways

  • The demand for a currency in a foreign exchange market arises from the demand for the country’s goods, services, and financial assets and shows the inverse relationship between the exchange rate and the quantity demanded of a currency.
  • The supply of a currency in a foreign exchange market arises from making payments in other currencies and shows the positive relationship between the exchange rate and the quantity supplied of a currency.
  • Both Fiscal and Monetary policy can impact exchange rates.
  • Factors that cause a currency to depreciate cause that country’s exports to increase and its imports to decrease. As a result, net exports will increase.
  • Factors that cause a currency to appreciate cause that country’s exports to decrease and its imports to increase. As a result, net exports will decrease.

Frequently Asked Questions about Exchange Rate and Net Exports

A depreciation of a currency generally causes a decrease in imports into that country, and an increase in exports from that country, thereby increasing Net Exports. 


An appreciation of a currency generally causes an increase in imports into that country, and a decrease in exports from that country, thereby decreasing Net Exports. 

When a country's exports increase, its exchange rate also increases due to an increase in demand for that currency.

When a country's interest rates rise, its currency appreciates causing a decrease in net exports.

A depreciation of a currency generally causes a decrease in imports into that country, and an increase in exports from that country, thereby increasing Net Exports. 

An appreciation of a currency generally causes an increase in imports into that country, and a decrease in exports from that country, thereby decreasing Net Exports. 

The real exchange rate is a measure of the exchange rate between two currencies after adjusting for the difference in those countries' price levels and is calculated as follows:

Real exchange rateAB = Nominal exchange rateAB x (Prices country A / Prices country B)

Final Exchange Rate and Net Exports Quiz

Question

What is a devaluation of a currency?

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Answer

A devaluation is when the value of a currency, that has been pegged to a foreign currency under a fixed exchange rate, is reduced.

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What is a revaluation of a currency?

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Answer

A revaluation is when the value of a currency, that has been pegged to a foreign currency under a fixed exchange rate, is increased.

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What are 3 benefits of devaluating a currency?

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Answer

It increases domestic exports. It decreases foreign imports. It helps increase aggregate demand, which helps prevent recession.

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What is a con of devaluating currency?

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Answer

It can cause inflation.

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What are the benefits of revaluation?

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It makes foreign goods appear cheaper and allows domestic consumers to purchase off the foreign market, diversify their consumption and hold more foreign assets.

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What is a con of revaluation?

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It can hurt a nation's export market because domestic goods appear less competitive. 

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Why might a devaluation in currency cause a decrease in production efficiency?

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Answer

It might demotivate domestic producers to improve efficiency if they know they can rely on devaluation to keep them competitive in the market.

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What is the exchange rate?

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Answer

The value of one currency compared to another.

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What is the difference between a floating and a fixed exchange rate?

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Answer

A floating exchange rate adjusts with the demand and supply in the foreign exchange market, whereas a fixed exchange rate bases its value off of the target value in terms of another currency. 

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What happens to demand for domestic goods when the currency is devalued?

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Answer

Aggregate demand for domestically produced goods increases.

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What will happen to aggregate demand when the currency experiences revaluation?

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Answer

Aggregate demand will fall due to the increase in imports and the fall in exports.

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Question

What was the effect of China's fixed exchange rate on its economic growth?

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Answer

China saw a huge benefit from having its exchange rate fixed because it allowed its prices to remain competitive with the foreign market.

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Did China fix Yuan below or above the US dollar? Why?

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Below, because China always wanted its prices lower than the competitor's prices.

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Did the Swiss franc see a depreciation or an appreciation after it was no longer pegged to the euro?

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It saw an appreciation because the value of the Swiss franc increased by about 30%

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What benefit did Swiss exporters gain when the franc was pegged to the euro?

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Swiss exporters were able to be more competitive in the European market because their goods seemed relatively less expensive when the fixed exchange rate limited how valuable the Swiss franc could be.

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What is appreciation of currency?

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Appreciation is when a currency experiences an increase in value when it is compared to other currencies.

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What is depreciation of currency?

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Depreciation is when a currency experiences a decrease in value when it is compared to other currencies. 

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How does the interest rate affect appreciation?

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Answer

A higher domestic interest rate can encourage foreign investors to invest in a currency if they think they will be able to earn a higher yield. This will lead to currency appreciation.

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How do the interest rate and appreciation affect trade?

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An increase in the value of the currency increases the number of imports and decreases the number of exports a nation has.

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How can the value of a currency affect aggregate demand?

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The value of a currency has an impact on a county's net exports (exports minus imports), which makes up a portion of aggregate demand. If net exports increase due to a depreciation in the currency, then the country sees an increase in aggregate demand because they have more expendable income.

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How does depreciation impact trade?

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Depreciation increases exports and decreases imports.

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Why does depreciation increase exports?

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Depreciation increases exports because it makes domestic goods appear cheaper to foreign markets.

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Why does appreciation decrease exports? 

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Appreciation decreases exports because domestic goods appear more expensive in foreign markets.

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What is the formula for calculating appreciation and depreciation?

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Answer

(New value of currency - Old value of currency) / Old value of currency

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Question

Consider the following exchange rate: £0.78/1€. 

Then, imagine the pound appreciates to £1.02/1€. 

Has the euro appreciated or depreciated against the pound? 

By how much?

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Answer

Appreciated by 31%

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Consider the following scenario: 

The exchange rate from dollars to euros went from €0.82/$1 to €0.73/$1. 

Did the dollar appreciate or depreciate against the euro? 

By how much?

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Answer

Depreciated, by 11%

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What determines a currency's value?

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Answer

A currency’s value is determined by the market's demand and supply for the currency just like any other good or service.

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Question

What is the exchange rate?

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Answer

The exchange rate is the price or value of one currency in relation to another. 

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How does speculation impact the value of a currency?

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Speculation can influence the value of a currency because as traders invest where they think they will make a profit, others will follow. This means that as more and more traders invest in a currency, the more it appreciates. 

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What is speculation?

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Speculation is when traders in the foreign exchange market buy and sell currencies based on if they think a currency will appreciate or depreciate.

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If the exchange rate between the US and Canada was 1USD:2CAD, and the Canadian currency appreciated by 15%, what is the new exchange rate?

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Answer

1USD:2.30CAD

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Households and individuals are ________, so they would save _____ of any new _________ income they have.


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Answer

rational, some, disposable

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The interaction of buyers and sellers exchanging currencies in the foreign exchange market determines what?

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Answer

The equilibrium exchange rate.

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Question

Why would the central bank want to slow the economy down?

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Answer

To prevent it from overheating. 

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What happens to domestic goods when the domestic currency appreciates?

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Answer

They become more expensive to foreign markets.

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As interest rates rise, what happens to investment spending and consumer spending?

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Answer

They both decrease.

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Can exports impact exchange rates?

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Yes, an increase in exports will affect exchange rates when a shift in demand for a currency is due to an increase in demand for one country's products.

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What is disposable income?

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Answer

Disposable income is the money that is left over from an individual’s salary after taxes are deducted.

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If imports increase, what happens to the demand for foreign currency?

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Answer

Demand for foreign currency increases.

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If taxes are increased, what happens to disposable income?

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Disposable income decreases.

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The equilibrium exchange rate can be affected through fiscal policy.

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Answer

True.

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Question

If Canada decided that only 20% of its fish could be imported from Russia, how might this affect its exchange rate with the Ruble?

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Answer

There would be less demand for the Ruble and less supply of the CAD. The CAD would appreciate.

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How are net exports affected by depreciation?

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Answer

Net exports increase.

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How are net exports affected by appreciation?

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Net exports decrease.

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What is the price of another country's money?

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Answer

The exchange rate.

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What is the Foreign Exchange Market?

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Answer

The Foreign Exchange Market is the electronic market where currencies can be bought and sold in exchange for one another.

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Question

If a video game is heavily featured in the hottest new movie in the cinema. Everyone rushes to buy the video game, so the price rises. What is this an example of?

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Answer

Demand-pull inflation.

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Due to climate change, the purest freshwater spring is drying up. Because of the reduced supply, the price of each bottle has doubled. What is this an example of?

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Cost-push inflation.

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If there is a surplus in a currency and the government wants to prevent it from falling, what can it do?

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Answer

It can buy its own currency.

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Say India's Rupee is pegged to the GBP. India wants its goods to appear cheaper in the UK market. What measures should the Indian government take to make this happen?

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Answer

They should lower their currency peg to make the Rupee devaluate.

Show question

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