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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?

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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.

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  • $\begingroup$ So you mean that if financial and capital account can be nonzero, then exchange rate CANNOT always correct a trade surplus or a deficit. Whether it can or not depends on the net capital flow. Am I right? $\endgroup$ – Ma Joad Mar 1 at 10:25
  • $\begingroup$ The exchange rate ensures that all transactions between two countries amount to zero. When there is capital mobility, there are two types of transactions, those in goods/services (current account) and those in assets (capital account). The exchange rate works so that the sum of these transactions is zero in equilibrium, but the individual components can be in surplus or deficit i.e. if the current account is in a deficit, the capital account must be in surplus. So the exchange rate still works, but in a broader sense. $\endgroup$ – Chetna Ahuja Mar 1 at 11:43

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