So far, we've examined three of the seven main reasons why exchange rates move. These include, differing rates of GDP growth between countries, differing rates of inflation, and a change in relative interest rates. Now in this module, we need to continue with this important analysis. So let's move on to reason number four. In many ways, current account deficits and trade imbalances between countries, represent the single most important reason why exchange rates move. So, to wrap our heads around this reason, here's your next question. When Country A runs a trade deficit with Country B, does its currency tend to appreciate or depreciate, and why? Take a minute now to jot down some ideas before moving on. So when country A runs a trade deficit with Country B, this deficit will tend to depreciate the currency of country A. As to why this is so, I'm going to provide you with the long version of an answer when we discuss the oddly named, but incredibly interesting, gold specie flow adjustment mechanism in the next module. For now however, let me simply observe that when one country runs a trade deficit with another, that country is spending more on foreign trade than it is earning. And more importantly, that country is supplying more of its own currency than foreigners are demanding for its products. This increase in supply in turn weakens the value of the currency, through the forces of supply and demand. In this key definition, the terms of trade represents the ratio of export prices to import prices. Let me repeat that. The terms of trade is simply, the ratio of export prices to import prices. As to why a country's terms of trade is important, it provides a measure of the amount of import goods, than an economy can purchase for a unit of export goods. For example, suppose one country exports automobiles, and another country exports oil. If the price of oil falls, the terms of trade for the country exporting automobiles improves, because it now has to export fewer automobiles to pay for the same amount of oil. More generally, if the prices of a country's exports rise, its terms of trade are said to be more favorable, because the country can now receive more imports for each unit of goods, that it exports. So here's the question. What do you think will happen to the value of a country's currency, if its terms of trade do indeed improve? That is, if its export prices rise at a faster rate than its import prices. Take a minute to think this through, and jot down your answer before moving on. Okay, so what do you think will happen to the value of a country's currency if its terms of trade improve? That is, if its export prices rise at a faster rate, than its import prices. The answer is that the currency should strengthen. Here's the basic logic. If export prices rise at a greater rate than import prices, the result will be higher revenues. That is, exporters will be taking in more foreign currency. This, in turn, will result in a higher demand for the domestic country's currency, and therefore an increase in its currency value. The result is an appreciation of its exchange rate. In foreign exchange markets were currency values freely float and currencies are freely traded, currency speculation has become a modern part of the global landscape. To see how such speculation works, suppose you work as a currency trader for a major European hedge fund. And suppose further, that your macroeconomic research indicates that the Central Bank of Brazil is likely to raise interest rates very soon to fight inflation. As a currency trader, will you want to buy or sell Brazil's currency, the real? Take a minute to think about this, and then jot down your answer before moving on. Well, in this case, if Brazil's Central Bank raises interest rates, this rise in relative interest rates will likely attract more foreign investment into Brazil. This in turn should boost the demand for the Brazilian real, therefore, a currency speculator such as yourself, is likely to buy the Brazilian real before the move, so as to benefit from a rise in the currencies price. In effect, you are betting that the Brazilian real's exchange rate will appreciate. And through the process of buying and selling currencies in anticipation of currency movements, currency speculators actually do indeed move the value of currencies. The more unstable a country's political system becomes, the less attractive that country is to foreign investors. Of course, as the level of foreign direct investment declines, the domestic currency must decline as well, for the very simple reason, there is less demand for that currency. By the same token, if a country faces an increased risk of war, or even some lesser form of conflict, that country may likewise see a reduction in its foreign direct investment and a fall in its exchange rate, as foreign investors respond to such heightened geopolitical risk with the so-called, flight to safety to other financial markets. Of course, the same kind of negative pressure on a currency can result with a natural disaster like a major earthquake, or tsunami, or even longer term issues, such as flooding, that can accompany climate change in some countries. Again, as the level of foreign investment declines, so too will let country's exchange rate depreciate. Okay, that was indeed a good bit of fun, learning about how exchange rates move, and there were surely a lot of meat on that particular macroeconomic bone. So if you need to, go back now and review the material in this module. Then, and when you're ready, let's move on to explore at a deeper level, how current account deficits and trade imbalances can indeed move exchange rates.
