Balance of Trade and Currency Exchange Rates

If a country imports more than it exports, it is said to be running a trade deficit.  Samuelson and Nordhaus explain the accounting for international trade in chapter 34 of Economics: the deficit has to be financed either by debt or by an inflow of foreign currency (which might be in the form of inward investment or purchases in the currency exchange markets).

America has run a trade deficit for many years, but it has received substantial foreign investment which has increased its prosperity.  Dollars are still seen as safe.  In many countries with weaker economies, though, a trade deficit is more of a problem.  As they need to buy goods from other countries, they may have to increase their money supply to pay for them – which is inflationary, as described in the previous sub-section (  And the value of their currency will drift downwards in relation to other currencies ( – so their imports become more expensive, further fuelling inflation.

If a country tries to correct a trade deficit by applying tariffs, in an attempt to stem the level of imports, that also increases inflation: it increases prices and reduces the standard of living for consumers.  There is also a high risk of retaliatory tariffs and adverse effects on trade, as described later (

Purchasing power in international transactions depends on the relative strength of the currencies used, so a country can increase the competitiveness of its exports by allowing the value of its currency to drift downwards.  A depreciating currency, though, increases the price of a country’s imports so it also causes inflation – as the higher costs of supplies result in higher prices of finished goods in the shops.

Cutting wages and/or benefits increases a company’s competitiveness, but it is painful and unpopular.

Some countries have had to apply to the International Monetary Fund (IMF) for a loan to stabilise their finances.  This only provides a temporary respite and, as will be seen at the end of this chapter, there are other governance problems with these international transfers of funds (3.5.5).

Some governments try to control exchange rates, to boost exports, but most now accept that currency exchange rates have to ‘float’ according to economic circumstances and are beyond direct political control.  China’s policy of pegging the renminbi against the American dollar in the early 21st century was an egregious exception, but the resulting huge foreign currency inflows were described by The Economist as “An embarrassment of riches – noting that the excess money supply might eventually cause inflation.

The Eurozone operates as if it were a single country within the framework of international trade, but the individual countries within it cannot unilaterally manage currency exchange rates or external tariffs – so several have got into difficulties.  An Economist article, So hard to bend, described Spain’s problems in April 2010: noting that “As a member of the euro, it cannot address that problem by devaluing the currency” .



This page is intended to form part of Edition 4 of the Patterns of Power series of books.  An archived copy of it is held at https://www.patternsofpower.org/edition04/3384.htm