Exchange Rate and Net Exports

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.

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.

Fig 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.

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!

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

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.

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.

Fig 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 D_disE while the supply for USD is still at D_E0. 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!

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.

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.

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.

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.

Fig 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.

Figure 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.

Figure 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.