Effect of exchange rates on balance of trade and capital account
In the post on balance of payments we had learned how payments from international trade transactions are segregated into current and capital accounts.
You can read the posts on international trade here below;
Today we will learn about the effect of changes in currency exchange rates on the current and capital accounts.
(Catch up the previous two installments on currency exchange rates below)
We will look at two approaches to examine the effect of changes in currency exchange rates on balance of payments. The first approach is the elasticities approach which is a microeconomic approach and focuses on the effect of exchange rates on balance of trade. The second approach is the absorption approach which is a macroeconomic approach and looks at the effect of exchange rates on capital flows.
We know that if the exports of a country exceed its imports we have a trade surplus and if the imports exceed exports we have a trade deficit. (Read up on balance of payments here.) Now consider a country that has a trade deficit. If the currency exchange rate of the country depreciates, its imports will become expensive and its exports will become cheaper for the importing countries. So the imports of the country will decrease and the exports will increase thus leading to a trade surplus situation. However trade surplus is not achieved by changes in the quantity of exports and imports but by the changes in the expenditure on imports and earnings from exports. Therefore an important concept to consider here is the elasticity of demand of the goods exported and imported.
In case of goods that have less elastic demand relative to price (read up on price elasticity of demand), like goods that do not have close substitutes and necessity goods, depreciation of the currency will not change the demand much thus not adding much to or reducing much from the export earnings or import expenditure respectively . However in case of goods that have more elastic demand, like goods with close substitutes and luxury goods, depreciation in the currency will greatly improve the trade deficit situation.
Absorption approach is a macroeconomic approach that focuses on the capital account. The balance of trade under this approach is given as;
Balance of trade = Y – E
Y = domestic production of goods and services and national income
E = domestic absorption of goods and services
Domestic production here includes goods produced domestically for domestic consumption and for exports. Domestic absorption includes all goods consumed domestically which includes goods produced domestically and imported goods.
When the currency exchange rate depreciates, the demand for imported goods falls and the domestically produced goods become more attractive. So the overall expenditure on consumption reduces even though there is an increase in consumption of domestically produced goods. On the other hand the income increases as the exports increase and demand for domestically produced goods increases. This leads to an increase in national savings which adds to the national income. So the trade balance position improves towards a surplus.
However this is possible only when the economy is not operating at full capacity. When the economy is operating at full capacity an increase in spending on domestic goods leads to an increase in domestic prices. This makes imported goods more attractive thus reversing the effect of depreciation in currency exchange rate on the trade balance and moving back to a trade deficit situation.
That’s all in this post of effect of exchange rates on balance of trade…..Thanks for reading….hope you liked what you read…..in the next post we will move on to Financial reporting and analysis……stay with me for interesting posts on the subject….you can also SUBSCRIBE to the blog to get the posts in your inbox…..bye
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For solved examples please refer to the CFA Institute books or CFA study notes. The problems can be easily solved using the CFA institute approved financial calculators. Please refer to the CFA exam policy and CFA calculator guide.
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