Economics – International trade and globalisation - Foreign exchange rates | e-Consult

A country with a large trade deficit typically experiences a depreciation of its currency. A trade deficit occurs when a country imports more goods and services than it exports. This means that the country is paying more for foreign goods than it is earning from its exports.

Mechanism:

• To pay for the imports, individuals and businesses in the country need to sell their domestic currency and buy foreign currencies. This increases the supply of the domestic currency in the foreign exchange market.
• The increased supply of the domestic currency, with relatively constant demand, puts downward pressure on its value.
• This downward pressure causes the domestic currency to depreciate.

Diagram Explanation:

Note: The diagram should show a downward sloping demand curve (representing the demand for the currency) and an upward sloping supply curve (representing the supply of the currency). The intersection of these curves determines the exchange rate. A trade deficit shifts the supply curve to the right, leading to a lower exchange rate.

Example: If the UK has a large trade deficit, it means the UK is buying more Euros to pay for imports from the Eurozone than it is earning from exports to the Eurozone. This increased supply of Pounds Sterling and relatively stable demand for Euros will cause the Pound to depreciate against the Euro.

In summary, a trade deficit leads to an increased supply of a country's currency, causing it to depreciate.