How Does the Exchange Rate Exactly Works?
The exchange market mechanism can be pretty confusing for a
person who doesn't have specialised knowledge in this area. The
connection between the exchange rate of a currency and its trade
deficit may seem like an undecipherable mystery. In order for
you to understand the hidden mechanism of the exchange market
and the trade deficit, we'll discuss and explain the
American-Canadian Trade and Exchange relationship.
The first thing you should know, in order for you to have an
accurate idea of this matter, is that Canada is USA's largest
trading partner with 20% of the US foreign trade.
Whenever you are analysing a trade relationship between 2
countries, you should look at the exchange rate and
international trade data. Make sure you are analysing the data
concerning at least 2 years of trade, in order to draw the right
conclusions. For instance, if you were to analyse the data for
2002 and 2003, you would notice that the CDN DOL column is
displaying the number of Canadian Dollars that can be bought in
exchange for one US Dollar. A bigger number on this column means
that the US Dollar is appreciating; it gets stronger and can buy
more Canadian Dollars. On the other hand, whenever the number is
decreasing, it means that the US Dollar is depreciating, it gets
weaker, and it can buy less Canadian Dollars.
You should also pay attention to the second column, named CDN
DEF, which is displaying the amount of the trade balance between
the United States of America and Canada. If you find only
negative numbers in this column, you should know that this fact
means that US is facing a trade deficit when it comes to its
Canadian trade relationship. You should also keep in mind that
the numbers in this column are usually expressed in millions of
US Dollars.
A quick look on the data for 2002 and 2003 will instantly tell
you that the US Dollar has depreciated quite fast compared to
the Canadian Dollar. For instance, the data for October 2002
shows that 1.58 Canadian Dollars were bought for 1 US Dollars.
But the data for October 2003 shows that 1.32 Canadian Dollars
were bought for 1 US Dollars, meaning that the US Dollar's
strength has weakened.
Nevertheless you will notice that the trade balance remained the
same over that period.
If you wonder about the connection between the exchange rate and
the trade balance, well, here it is. The relationship between
these two is quite simple: whenever the exchange rate goes up,
the trade is going down, and the other way around. A positive
number shows that the trade deficit increases when the exchange
rate is going down.
In conclusion, whenever you analyse the relationship between the
exchange rate and the trade balance, you will come across the
numbers for the trade deficit. Always keep in mind that things
aren't as simple as they look, so, in order to reach an accurate
conclusion, you have to analyse a lot more numbers than these.