What The Trade Balance Means For A Currency's Purchasing Power

In July this year, the US trade balance stood at a deficit of $63.6 billion against a deficit of $51 billion in July last year. Some commentators regard a widening in the trade deficit as an ominous sign for the exchange rate of the US dollar against major currencies in the times ahead.

For most economic commentators a key factor in determining the currency rate of exchange is the trade account balance. In this way of thinking, a trade deficit weakens the price of the domestic money in terms of foreign money while the trade surplus works toward the strengthening of the price.

By this logic, if a country exports more than it imports, there is a high relative demand for its goods and, thus, for its currency, so the price of the local money in terms of foreign money is likely to increase. Conversely, when there are more imports than exports, there is relatively less demand for its currency, so the price of domestic money in terms of foreign money should decline.

Similarly, following this way of thinking, if for some reason there is a sudden increase in the foreigners' demand for a country's currency, this will strengthen the currency's rate of exchange versus other currencies. If, however, there is a sudden decline in the foreigners' demand for a country's currency, this will weaken the currency's rate of exchange against other currencies. But this way of thinking is questionable. Here is why.

The Purchasing Power of Money and the Supply and Demand for Money

The currency rate of exchange is the price of one money in terms of other money. The rate of exchange of a given money with respect to something is the amount of money paid per unit of something. Alternatively, we can say that the price of something is the amount of money paid for something. The amount of money paid for something is the money's purchasing power with respect to something, such as a particular good. As with the prices of goods, the supply and the demand for money determine the amount of money paid for goods.

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