Trade balance affects the exchange rate through its influence on demand and supply of foreign currency. When the market account of the country is not zero – that is, when export is not equal to imports – there is more demand or supply for the currency of the country, which affects the price of currency on the world market.
Exchange rates specified as relative value; the price of one currency to another. For example, one dollar could be equal to 11 South African Rand. In other words, American business or the man changing dollars into rands would buy 11 Rand for every dollar sold, and South Africa could buy $1 for every 11 Rand sold.
These relative values are influenced by the demand for currency, which in turn affects trade. If a country exports more than it imports, there is a high demand for its products, and thus, its currency. Economics supply and demand dictate that when demand is high, prices are rising, and the Currency increases in value. On the contrary, if the country imports more than it exports, there is relatively less demand for its currency, so prices should decline. In the case of currencies, it depreciates and loses value.
For example, let’s say that bars is the only product on the market, and South Africa imports more candy from the US than it exports, so it needs to buy more dollars against the Rand for sale. Demand in South Africa for dollars exceeds demand in America in Rand, this means that the value of the Rand falls. In this situation we will assume that the Rand could fall to 15 in relation to the dollar. Now, for every $1 sold, American gets 15 Rand. Buy $1, in South Africa needs to sell 15 Rand.
The relative attractiveness of export from this country is also growing as the Currency is devalued. For example, suppose that the American candy costs $1. Before depreciation and amortisation, South Africa you can buy American Candy for 11 Rand. After that, costs the same chocolate 15 Rand, a huge price increase. On the other hand, in the South African chocolate bar cost 5 Rand has become much cheaper in comparison: $1 now buys three South African chocolates instead of two.
South Africans can start to buy fewer dollars, because American chocolate bars have become quite expensive, and Americans can start buying more, because the South African Rand candy is now cheaper. This, in turn, begins to affect the trade balance; South Africa begins exports and reduces imports, reducing the trade deficit.
Our example assumes that the Currency is on a floating mode, which means that the market determines the value of a currency in relation to others. In cases where one or both currencies are fixed or pegged to another currency, the exchange rate does not move so readily in response to the trade imbalance.