Why a current account surplus is bond to lead to an appreciation of a currency?

Question

I have got some confusion in trying to explain why a trade surplus is going to lead to an increase in the exchange rate. The usual logic goes as follows.

1. Export X > Import M
2. Demand for the country's currency increase
3. Appreciation happens

What confuses me is step 2. Why the demand for the country's currency increase? I know that there is certainly a high demand for the country's currency because money is needed to buy its exports, but the demand is high does NOT mean the demand is INCREASING. Why can't the demand for the currency just stay high, but constant, so foreigners can get their needed money to buy exports?

Answer 1

We have the following cases:

1) No capital mobility: If there is no capital mobility, the trade balance is necessarily zero in equilibrium i.e. exports equal imports. When there is a trade surplus, there is an excess of demand for domestic currency over supply of domestic currency. In equilibrium, this surplus must be eliminated to ensure that demand equals supply. So the exchange rate must appreciate, reducing exports and increasing imports for the domestic country until the trade balance is in equilibrium. It doesn't matter if the demand is increasing or not, any excess or deficit must be eliminated by a change in the exchange rate.

2) Capital mobility: In this case, the Balance of Payments must be zero in equilibrium. This includes the current account(exports and imports) and the capital account (trade in assets with the foreign country). Here a trade surplus or deficit can exist as long as the capital inflows balance it out. If there is a deficit, there must be net capital inflows (borrowing from abroad) and vice versa.

Hope this helps.