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Free «How Exchange Rates Impact International Trade» Essay Sample

Introduction

Exchange rates have a very important influence on international trade. Stability of international trade depends to a larger extent on the stability of the exchange rates. Thus, fluctuations in foreign exchange will have an adverse effect on the international trade. The currency exchange rates for various currencies fluctuate daily and sometimes frequently according to Machlup (45). In this paper I seek to examine the impact of foreign exchange in international trade.

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Demand and supply

Money just like commodities in the market is subject to the forces of demand and supply. International trade is largely influenced by a country’s exchange rate (Mankiw 89). When demand for country’s currency is high as a result of an upward surge in demand for its commodities in the international market, the exchange rate increases in the short run. If the level of exchange rate remains high while supply of that particular commodity remains fixed, the demand for that commodity will slow down as it becomes expensive to importers who shift to lesser expensive export commodities in the international market.  However, in the long run increased demand for the country’s domestic exports encourage domestic producers to increase their supply of commodities so as to take advantage of the incentives to produce as is often the tendency. The increase in supply offsets the increase in price level of the foreign currency and demand for the goods in the stabilized international market.

 On the other hand, if national currency’s demand decreases causing a decline in its exchange rate relatively to the importer’s currency, the currency becomes cheaper as well as the country’s exports. This is because the importing country experiences an appreciation of its currency due to a decreased supply of its currency in the international market which causes an appreciation of its price relative to the exporter. If country A’s exports are relatively more expensive to its imports, the country’s imports increases as  imported goods become cheaper than domestically produced commodities. The domestic citizens have incentive to import more from country B leading to depreciation of its exchange rate. On the other hand, the decrease in the rate of exchange makes exports cheaper hence encouraging international trade as importers find our exports cheaper.

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Thus, it can be argued that whenever the country’s exchange is high, the domestic price of goods become expensive relative to imports. It is easier to import as imported goods are cheaper than the domestic commodities. As a result the country’s exports decrease as its imports increase (Sparknotes 6).

Stability of the country’s exchange rate

Volatility in exchange rate leads to a decrease of international trade (Benard 1). If the country’s rate of exchange is stable meaning it experiences minimal rates of price fluctuations, it encourages international trade. This is because losses as a result of fluctuations are minimized acting as an incentive for traders to engage more in the international exchange. A fluctuating level of foreign exchange causes loss of confidence to the country’s currency causing traders to reduce their trade volumes while producers cut back their levels of output. On the other hand, a stable currency experiences lesser losses resulting from foreign exchange hence encouraging international trade. Stabilization of exchange rate is important in boosting international trade (McConnell, Brue & Campbell 384)

The rate of inflation

 
 
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The Country’s rate of inflation has a heavy impact on its exchange rate. A higher rate of inflation acts as a disincentive to investors as the currency become unattractive and is thus avoided. This lowers its exchange rate in the international market. As a result imports become cheaper while exports become expensive leading to an influx of imports into the country. This discourages local production due to competition from the cheaper foreign goods. As a result of reduced demand of the domestic commodities, producers respond by cutting down their production to cut their costs of production. Other firms are forced to shut down their operating cutting do3wn the domestic output further. This leads into a reduction of the trade volumes to the international market hence adversely affecting a country’s involvement in the international trade.

Economic speculation

People’s speculation about the economic performance of their country in the times ahead also influences its rate of exchange which in turn affects international trade.  If the economic players perceive that the economy is likely to register positive growth, investor appetite increases followed by capital inflow which in turn causes the country’s currency to appreciate in value as a result of the proportional increase in demand. This leads to an increase in the country’s output leading to an increase in international trade.

However negative speculation about the economic growth is manifested in the decline in the country’s foreign exchange as investors shy away from the currency. Those who had plans to invest defer their investment plans into the future leading to a lag in investments. Output falls and trade volumes in the international trade decline as increasingly more and more firms reduce their new investments due to their speculation about a decrease in demand. In addition the domestic citizens dispose more and more of the domestic currency in exchange of other currencies to shield themselves fro losses in currency exchange.

Conclusion

The rate of foreign exchange has a very great influence on the international trade. Stability of the rate of exchange is vital for smooth trading in the international market. The rate of inflation affects the rate of foreign exchange thereby affecting trade volumes while speculation about the performance of an economy will influence the exchange rates.

   

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