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The balance of trade influences currency exchange rates through its effect on the supply and demand for foreign exchange. When a country's trade account does not net to zero – that is, when exports are not equal to imports – there is relatively more supply or demand for a country's currency, which influences the price of that currency on the world market.
Currency exchange rates are quoted as relative values; the price of one currency is described in terms of another. For example, one U.S. dollar might be equal to 11 South African rand. In other words, an American business or person exchanging dollars for rand would buy 11 rand for every dollar sold, and a South African would buy $1 for every 11 rand sold.
However, these relative values are influenced by the demand for currency, which is in turn influenced by trade. If a country exports more than it imports, there is a high demand for its goods and thus for its currency. Supply and demand dictate that when demand is high, prices rise and thus the currency appreciates in value. On the other hand, if a country imports more than it exports, there is relatively less demand for its currency, so prices should decline. In this case, a currency depreciates or loses value.
For example, say that candy bars are the only product on the market and South Africa imports more candy bars from the United States than it exports, so it needs to buy more dollars relative to rand sold. Because South Africa's demand for dollars outstrips America's demand for rand, the value of the rand falls. In this situation, the rand might fall to 15 relative to the dollar. Now, for every $1 sold, an American gets 15 rand. To buy $1, a South African has to sell 15 rand.
As a currency depreciates, the relative attractiveness of exports from that country grows. For example, assume an American candy bar costs $1. Before the depreciation, a South African could buy an American candy bar for 11 rand.
Afterward, the same candy bar costs 15 rand, a huge price increase. On the other hand, a South African candy bar costing 5 rand has become much cheaper by comparison: $1 now buys three South African candy bars instead of two.
South Africans might start buying fewer dollars because American candy bars have become quite expensive, and Americans might start buying more rand because South African candy bars have become cheaper. This in turn begins to affect the balance of trade; South Africa starts exporting more and importing less, reducing the trade deficit.
Of course, this example assumes that the currency is on a floating regime, meaning that the market determines the value of the currency relative to others. In cases where one or both currencies are fixed or pegged to another currency, the exchange rate does not move so readily in response to a trade imbalance.
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