I am a bit confused in interpreting the correlation between a trade deficit/surplus & currency depreciation/appreciation. Considering BOP always equals 0 and a outflow in the current account is balanced out by an inflow in the capital/financial account and vice versa then why would a trade imbalance cause any change in the exchange rate between two currencies?


Ignoring net errors and omissions and the official reserve account, it is indeed just the current account and capital account and the BoP always balances.

However, under floating FX rates, the exchange rate is largely determined by supply and demand in the FX market. A country borrows internationally if a current account deficit is financed by a capital account surplus. This increases the demand for foreign currency, which means the foreign currency appreciates relative to the domestic currency.

In fixed FX rate regimes, this tendency will be offset by the central bank supplying this foreign currency via its reserves (as long as it doesn't run out of it). In this case, the current account and capital account actually do not balance and foreign reserves offset the imbalance.

It's only one model to explain FX rates though (float approach). You can read some more details here.


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