Exchange Rates on International Trade

There are many effects of exchange rates on countries’ international trade and capital flow. Most of them are listed below.

Changing Prices of Currencies

Shifts in the supply and demand of products change the prices of those products. Similarly, constant shifts in supply and demand for foreign currencies cause changes in the prices of currencies. Likewise, as prices of money change, demand for foreign currencies changes.

Increase in Demand for Imports

An increase in the demand for imported goods happens when products of a foreign nation sell at lower prices than domestic products. When domestic income rises, demand for imports rises. Moreover, in capital markets, when returns on a nation’s investments are higher than the domestic interest rate, individuals choose to invest in other nations’ securities.

Expensive Products 

Many countries depend more on imports than domestically produced goods. This is because exchange rates play a significant role in the determination of the prices of imported products. If the domestic currency is weaker, consumers will have to pay higher prices in domestic currency for foreign goods.

They are Self-correcting over Time

When the supply of dollars in the international market grows, their values depreciate. As time goes by, exports become more attractive than imports, and vice versa.

Development of a Trade Deficit

If the interest rates of other nations are higher than those of dollar nations, the demand in foreign countries automatically falls. However, a stronger dollar means a decrease in exports because they seem expensive to foreign consumers. This leads to a trade deficit.

Effect on Standard of Living

Differences in currency values affect our ability to buy imported goods and export domestic goods. A currency crisis affects the lives and well-being of the citizenry in significant ways. For example, take Argentina, a country that has defaulted on its debt five times in the last 200 years. Every time this happens, their currency gets devalued. As a result, Argentineans cannot import goods from other countries cheaply for a few years. This hurts Argentina’s economic growth and its citizenry’s standard of living.

Question

Which of the following is least likely an effect of the strengthening of a domestic country’s exchange rate?

1. A fall in demand for imports.
2. Development of a trade deficit.
3. A rise in the general price level.

Solution

The correct answer is B.

Exchange rates cause an increase in the demand for imports, as well as the development of a trade deficit. It also leads to a general rise in price levels.

Strengthening of the domestic currency means that imports are more attractive while exports are less attractive for the citizenry of a country.

Economics – Learning Sessions