International Trade and Globalisation – Foreign Exchange Rates
International Trade and Globalisation – Foreign Exchange Rates
Objective
Explain how changes in the demand for exports and imports cause fluctuations in foreign exchange rates.
Key Concepts
Foreign exchange rate (FX rate): The price of one currency expressed in terms of another.
Demand for exports: Foreign buyers’ desire to purchase a country’s goods and services.
Demand for imports: Domestic buyers’ desire to purchase foreign goods and services.
How Export Demand Affects the FX Rate
When foreign demand for a country’s exports rises, foreign buyers need to obtain the exporting country’s currency to pay for those goods. This increases the demand for that currency in the foreign exchange market.
The relationship can be expressed as:
\$\text{Demand for Currency} \uparrow \;\Longrightarrow\; \text{FX Rate (domestic currency per foreign currency)} \downarrow\$
In other words, the domestic currency appreciates relative to the foreign currency.
How Import Demand Affects the FX Rate
When domestic demand for imports rises, domestic consumers must exchange their own currency for the foreign currency of the goods they wish to buy. This raises the supply of the domestic currency in the FX market.
The effect is:
\$\text{Supply of Domestic Currency} \uparrow \;\Longrightarrow\; \text{FX Rate (domestic currency per foreign currency)} \uparrow\$
Thus the domestic currency depreciates.
Combined Effect of Export and Import Demand
Fluctuations in the FX rate are the net result of simultaneous changes in export and import demand.
Change in Trade Demand
Effect on Currency Demand/Supply
Resulting FX Rate Movement
Export demand ↑, Import demand unchanged
Higher demand for domestic currency
Appreciation (FX rate falls)
Import demand ↑, Export demand unchanged
Higher supply of domestic currency
Depreciation (FX rate rises)
Export demand ↑ and Import demand ↑ (export growth larger)
Net increase in demand for domestic currency
Appreciation, but magnitude depends on relative changes
Export demand ↓ and Import demand ↓ (import decline larger)
Net decrease in supply of domestic currency
Appreciation, as fewer domestic units are offered
Illustrative Diagram
Suggested diagram: Supply‑and‑demand curves for the domestic currency in the foreign exchange market. Show a rightward shift of the demand curve when export demand rises, and a rightward shift of the supply curve when import demand rises. Indicate the resulting movement in the equilibrium exchange rate.
Real‑World Example
During a boom in the global oil market, demand for oil from Country A (an exporter) surges.
Foreign buyers need Country A’s currency to pay for oil, shifting the demand curve for that currency to the right.
The domestic currency appreciates, making other exports from Country A relatively more expensive.
If, at the same time, domestic consumers in Country A increase their purchases of imported electronics, the supply of the domestic currency also rises, partially offsetting the appreciation.
The net FX movement depends on the relative magnitude of the two forces.
Other factors (interest rates, speculation, government intervention) can also influence the FX rate, but this note focuses on trade‑related demand changes.
Practice Question
Country X experiences a sudden increase in tourism from abroad. Explain, using the concepts above, how this will affect the exchange rate of Country X’s currency, assuming no other changes.
Answer Outline
More tourists mean higher demand for Country X’s goods and services → higher export demand.
Tourists need Country X’s currency → demand for the currency rises.
Supply of the currency is unchanged in the short run.
Result: the domestic currency appreciates (FX rate falls).
Potential secondary effect: if tourists also spend on imported goods, a small increase in supply may offset part of the appreciation.