Why trade balance is not the essence of currency exchange rate determination

 

In July this year the US trade balance stood at a deficit of $63.6 billion against a deficit of $51 billion in July last year (see chart). Some commentators regard a widening in the trade deficit as an ominous sign for the exchange rate of the US$ against major currencies in the times ahead.

 

For most economic commentators a key factor in determining the currency rate of exchange is the trade account balance. On this way of thinking, a trade deficit weakens the price of the domestic money in terms of foreign money whilst the trade surplus works towards the strengthening of the price.

 

On this logic if a country exports more than it imports, there is a high relative demand for its goods, and thus, for its currency so the price of the local money in terms of foreign money is likely to increase. Conversely, when there is more imports than exports there is relatively less demand for its currency so the price of domestic money in terms of foreign money should decline.

 

Similarly following this way of thinking, if for some reason there is a sudden increase in the foreigners demand for a country’s currency this will strengthen the currency rate of exchange versus other currencies. If, however there is a sudden decline in the foreigner’s demand for a country’s currency, this will weaken the currency rate of exchange against other currencies. Notwithstanding we suggest that this way of thinking is questionable. Here is why.

 

The purchasing power of money and the supply and demand for money

The subject matter of the currency rate of exchange is the price of one money in terms of other money. The rate of exchange of a given money with respect to something is the amount of money paid per unit of something. Alternatively, we can say that the price of something is the amount of money paid for something.

 

The amount of money paid for something is the money’s purchasing power with respect to something. Note that something could be a particular good. As with the prices of goods, the supply and the demand for money determines the amount of money paid for goods.

 

If the supply of money increases for a given stock of goods, the purchasing power of money with respect to the given stock of goods is going to weaken since now there are more money per goods.

 

Conversely, for a given supply of money, an increase in the production of goods implies that producers would demand more money since more goods must now be exchanged for money. As a result, the exchange value or the purchasing power of money will increase. Every dollar will now command more goods.

Now, if a given basket of goods is exchanged in the U.S. for one dollar and the same basket of goods is exchanged for two euros in Europe, the rate of exchange between the U.S. dollar and the Euro will be set as one dollar for two Euros. Any deviation of the exchange rate from the level dictated by the purchasing power of currencies will set corrective forces in motion.

 

Suppose that because of a trade surplus and the consequent relative increase in the demand for US dollars the rate of exchange was set in the market at one dollar for three euros. In this case, the dollar is now overvalued in relation to its purchasing power versus the purchasing power of the euro. Because of the strengthening of the dollar due to the trade balance surplus it will pay to sell the basket of goods for dollars then exchange dollars for euros and then buy the basket of goods with euros—thus making a clear arbitrage gain.

 

For example, individuals will sell the basket of goods for one dollar, exchange the one dollar for three euros, and then exchange three euros for 1.5 basket, gaining 0.5 of a basket. The fact that holders of dollars will increase their demand for euros in order to profit from the arbitrage will make euros more expensive in terms of dollars and this in turn will push the exchange rate in the direction of one dollar to two euros.

 

It follows then that the essence of the currency exchange rate determination is the relative purchasing power of money in respective countries.

 

Why trade balance does not determine the currency rate of exchange

In order to establish that the trade balance is a determinant of the currency rate of exchange, we need to be able to show that the purchasing power of money is determined by the trade balance.

 

The question is whether the trade balance – that is the difference between the monetary values of what was sold versus the monetary value of what was bought – can determine the supply and the demand for money?

 

Now, with respect to the supply of money, only central bank monetary policies and fractional reserve banking can determine it.

 

Similarly, the balance of trade does not determine the amount of goods produced, which determines the demand for money. The balance of trade only records the value of given goods bought and sold by an individual or a group of individuals.

 

Since the trade balance has nothing to do as such with either the supply of money or the demand for money, we can conclude that trade balances do not determine the purchasing power of money of respective countries.

 

We do not say that a relative changes in exports or imports as mirrored by the trade balance will not influence the currency rate of exchange. We are suggesting that these changes are not the fundamental causes of the exchange rate determination. Consequently, the influences of these changes are likely to vanish over time as the currency rate of exchange converges towards its fundamental value as dictated by the relative purchasing power of money.

 

Fundamental versus non-fundamental causes

Often various non-fundamental factors are perceived to be important in determining a currency rate of exchange because “it feels ok”. A sharp widening in the trade deficit is regarded as a sign of a likely deterioration in economic fundamentals ahead. This provides the rationale for the selling of the currency of concern.

 

Alternatively, let us say that an analyst determines that a growing US government debt will at some stage likely cause foreigners to stop buying US Treasuries. Consequently, this will lower the demand for dollars and result in the dollar’s collapse.

 

It would appear that various factors such as the government debt, the interest rate differential, the state of the economy and the balance of trade could be employed to illustrate a scenario of a collapsing dollar. All this amounts to a curve fitting.

 

Irrespective of the popularity of the view that the trade balance determines the currency rate of exchange, this view contradicts the relative purchasing power of money framework – the essence of the currency rate of exchange determination. Hence, we suggest that an analysis that ignores the essence of the subject of investigation is highly questionable.

 

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