Exchange Rates and Net Exports: Study with Video Lessons, Practice Problems & Examples

The nominal exchange rate reflects how much one currency can be exchanged for another, impacting net exports. When a currency appreciates, imports increase as foreign goods become cheaper, while exports decrease due to higher costs for foreign buyers, leading to a potential trade deficit. Conversely, currency depreciation makes imports more expensive and boosts exports, resulting in increased net exports and possibly a trade surplus. This relationship highlights the inverse correlation between currency strength and trade balance, emphasizing the dynamics of appreciation and depreciation in international trade.

Exchange Rates and Net Exports

All right. Now, let's see the relationship that exchange rates have with net exports. So when we talk about the nominal exchange rate, well, that's just the exchange rate we can get on the market. What one currency trades for another currency, just the current exchange rate. For example, you go to the bank and the bank trades 108 yen for $1. So if you go to the bank with $1, they'll hand you 108 yen. If you go to the bank with 108 yen, they'll give you $1, right? Excuse me. Of course, sometimes they offer different exchange rates because they're trying to make a little profit but to keep things simple we'll say there's just this one exchange rate, right? 108 yen for $1 Now the exchange rate changes all the time. Right? So, on a daily basis, there are markets for the exchange rate where they're going up and down. So if the currency appreciates, this means that your currency can buy more of the foreign currency. Your currency got stronger. It appreciated. The bank now offers more yen for 1 US dollar. So before they were offering 108, this would be a situation where they offer say 112 yen for 1 US dollar, you're getting more yen per dollar, the dollar has appreciated. So let's see what happens with appreciation. What happens to net exports in this case? So in the US dollar appreciates relative to a foreign currency like we saw here with the yen, then what happens? Each dollar, the US dollar can afford more or less. Can we afford more Japanese goods or less Japanese goods? We can afford more, right? If the prices are held constant and our dollar can go further, our dollar buys more yen, We can buy more stuff in Japan, right? So, a US dollar can afford more Japanese goods when the dollar gets stronger. So our imports go up, imports increase. Because the US dollar got stronger, we're going to buy more foreign goods. But the opposite happens with Japan because Japanese yen depreciated. There's always going to be this inverse effect. If the dollar got stronger, well the yen got weaker in relative terms. Because now, the Japanese yen can afford less US goods, right? Because it cost them more yen. Before, they could trade 108 yen for a dollar, now it costs them 112 yen for a dollar. So they're going to have to give up more of their currency to buy US goods. So the US, there will be fewer exports. There's going to be less demand from Japan because things got more expensive for them. So the exports decrease. So notice what happens to our net exports. Our exports are decreasing and remember, net exports is equal to exports minus imports, right? Imports being "M", how we usually abbreviate it. So if exports went down and imports went up, well then net exports really went down, right? Because our first number went down and what we are subtracting from it went up. So net exports decrease when the US dollar appreciates. So a stronger dollar leads to a bigger trade deficit, we say, right? Net exports decrease. Trade deficit, we'll say. Now it doesn't necessarily mean a trade deficit. It just shows it is a decrease, but it leads to a trade deficit as this dollar gets stronger and stronger because of this relationship. Now, let's see the opposite relationship with depreciation. So when currency depreciates, well now your currency can buy less of the foreign currency. So before, the bank was offering 108 yen per dollar. Now, you go to the bank and they only offer you 100 yen per dollar, right? So you go to the bank and you were expecting to get 108, they only hand you 100. So you're getting less for your money, right? The US dollar has depreciated in this example relative to the foreign currency. So now, the US dollar can afford less Japanese goods, right? By that same logic, you're now able to get less yen for each dollar, so you can afford less stuff. So imports are going to decrease. And the opposite happens for the yen. Right? The yen, now they only need to go to the bank with 100 and they get a full dollar. Before, they needed to go into the bank with 108 yen to get a dollar. So now they're getting dollars for cheaper. So the US goods just became cheaper for them and they can afford more US goods and exports increase. So when the when the US dollar depreciates, well, we have this the opposite scenario, right? The exports, the exports now have increased. The imports have decreased. So net exports go up, right? Net exports are going to increase here. And this kind of leads to our trade surplus, okay? So it's kind of an interesting relationship there. The dollar gets stronger. That sounds like a good thing, right? The dollar is appreciating but how does that affect our trade situation? Exports go down and when the dollar gets weaker, that sounds kind of like a bad thing, but it helps exporting companies, right? We sell more things overseas with a weaker dollar. Alright? So there's a trade surplus there. And one note, I mentioned this before already, excuse me, is that when one currency appreciates, the other currency depreciates always. There's always this relationship just like we saw. When the the dollar got weaker, the US dollar could only get 100 yen. Well, that 100 yen is stronger for the Japanese people, right? Because they're able to afford more dollars with their currency. So if the US dollar can buy more yen, then the yen can buy fewer dollars and vice versa. Cool? So that's the relationship there with the currency exchange rates and net exports. Alright? Let's go ahead and move on to the next video.

Here’s what students ask on this topic:

What is the relationship between exchange rates and net exports?

The relationship between exchange rates and net exports is inverse. When a currency appreciates, it becomes stronger, making foreign goods cheaper and increasing imports. However, this also makes domestic goods more expensive for foreign buyers, reducing exports. Consequently, net exports (exports minus imports) decrease, potentially leading to a trade deficit. Conversely, when a currency depreciates, it becomes weaker, making foreign goods more expensive and reducing imports. Simultaneously, domestic goods become cheaper for foreign buyers, increasing exports. This results in higher net exports and possibly a trade surplus. This dynamic highlights how currency strength directly impacts a country's trade balance.

How does currency appreciation affect a country's trade balance?

Currency appreciation affects a country's trade balance by making its currency stronger relative to others. This means that the country's goods become more expensive for foreign buyers, leading to a decrease in exports. Simultaneously, foreign goods become cheaper for domestic consumers, increasing imports. The combined effect is a reduction in net exports (exports minus imports), which can lead to a trade deficit. Therefore, while a stronger currency might seem beneficial, it can negatively impact the trade balance by reducing the competitiveness of domestic goods in the global market.

What happens to imports and exports when a currency depreciates?

When a currency depreciates, it becomes weaker relative to other currencies. This makes foreign goods more expensive for domestic consumers, leading to a decrease in imports. Conversely, domestic goods become cheaper for foreign buyers, resulting in an increase in exports. The overall effect is an increase in net exports (exports minus imports), which can lead to a trade surplus. Depreciation thus boosts the competitiveness of domestic goods in the international market, benefiting exporting companies.

Why does a stronger currency lead to a trade deficit?

A stronger currency leads to a trade deficit because it makes domestic goods more expensive for foreign buyers, reducing exports. At the same time, it makes foreign goods cheaper for domestic consumers, increasing imports. The net effect is a decrease in net exports (exports minus imports). Since net exports are a component of the trade balance, a reduction in net exports can result in a trade deficit. This inverse relationship between currency strength and trade balance highlights the complexities of international trade dynamics.

How do exchange rates impact international trade?

Exchange rates impact international trade by influencing the relative prices of goods and services between countries. When a currency appreciates, it becomes stronger, making imports cheaper and exports more expensive. This leads to an increase in imports and a decrease in exports, reducing net exports. Conversely, when a currency depreciates, it becomes weaker, making imports more expensive and exports cheaper. This results in a decrease in imports and an increase in exports, boosting net exports. These changes in net exports affect a country's trade balance, highlighting the critical role of exchange rates in international trade.