How do countries conduct trade in the global economy?
For countries to trade goods and services, they must also trade their currencies. If you have ever visited a foreign country, such as Mexico, you know that you must exchange your dollars for Mexican pesos in order to shop while you are there. The same is true for U.S. businesses that want to buy goods or services in Mexico. Likewise, a Mexican firm that wants to buy American goods must trade its pesos for dollars. The process of converting one currency to another is known as foreign exchange. Without the exchange of currencies, little or no global trade would take place.
Foreign exchange takes place on the foreign exchange market. This market is made up of major banks and financial institutions around the world that buy and sell currencies.
Each currency traded in the foreign exchange market has an exchange rate. This rate indicates the value of one currency in terms of another. For example, if you can exchange one U.S. dollar for 10 Mexican pesos, the dollar exchange rate is US $1 = 10 pesos. The Mexican peso exchange rate would be 1 peso = US $0.10.
Exchange rates typically fluctuate based on supply and demand. If Americans are buying lots of goods and services from Mexico, they will need lots of pesos. Because the price of something generally rises with demand, a strong demand for pesos tends to raise the price of pesos in terms of dollars. That is, it will take more dollars to buy the same number of pesos. The exchange rate might fall from US $1 = 10 pesos to US $1 = 9 pesos. The dollar would then be worth less in pesos. When one currency loses value relative to another currency, we say depreciation has occurred.
Conversely, if Mexicans are buying lots of U.S. goods and services, the demand for dollars in Mexico will increase. That, in turn, will cause the price of the dollar to rise relative to the peso. So, for example, instead of getting 10 pesos for one dollar, you might get 11 pesos. When one currency gains value relative to another currency, we say appreciation has occurred. Note that when comparing two currencies, the appreciation of one means the depreciation of the other.
When a currency appreciates in value, it is said to get stronger. When it depreciates, it is said to get weaker. Thus, a strong dollar has a higher exchange rate and trades for more foreign currency than a weak dollar.
Whether a country’s currency is strong or weak has important effects on its cross-border trade. When the dollar is weak, foreign goods and services cost more in dollars. This tends to discourage imports into the United States. At the same time, a weak dollar makes U.S. exports relatively cheap for other countries, since their currencies are strong relative to the dollar. Thus, a weak dollar is likely to boost U.S. exports. When the dollar is strong, the reverse occurs. Imports from other countries become cheaper, while exports become more expensive.
Although many people regard a strong dollar as good and a weak dollar as bad, it is really a matter of perspective. A weak dollar can be hard on consumers, who pay more for imports, but good for those producers who primarily export their products. When the dollar is strong, on the other hand, consumers may benefit and producers may suffer.
There are exceptions to this general rule. Producers who depend on imported parts for their products, for example, may not benefit from a weak dollar. And consumers whose jobs depend on exports may not benefit from a strong dollar. Generally, countries try to strike a balance between high and low exchange rates while achieving some stability relative to other currencies.
An exchange rate that fluctuates based on supply and demand is called a floating exchange rate because rates «float” up and down based on the market. This is the dominant system in the world today.
Some countries take a different approach, however. They establish a fixed exchange rate to keep their currency stable. Under a fixed system, the government typically fixes, or “pegs,” its currency to another major currency, such as the dollar. For example, Mexico might establish a fixed exchange rate of 10 pesos to the dollar and seek to maintain that rate rather than let the peso’s value float up and down on the open market.
Both types of exchange rates have their advantages and disadvantages. The main advantage of floating rates is that they reflect supply and demand in the financial markets. The main disadvantage is that they are unpredictable. An unexpected rise or fall in a currency’s exchange rate can have negative effects on a country’s economy by disrupting trade.
Fixed rates, on the other hand, are predictable. They allow businesses and the government to make economic plans based on a constant value for the currency. Nevertheless, a fixed rate system runs into trouble when a currency’s exchange rate no longer reflects what the market says it is worth. When this happens, a government may have to intervene in financial markets to preserve the value of its currency. It does so using reserves of currency, which it holds for this purpose.
For example, if the value of the peso compared to the dollar were to fall too low, the Mexican government could buy pesos on the open market. It would pay for them with dollars from its currency reserves. This would increase the demand for pesos while reducing their supply, thus increasing their value. At the same time, it would increase the supply of dollars on the market, decreasing their value. The result would be to push up the value of the peso.
Were the value of pesos to climb too high, the government could step in to devalue its currency. It would do so by selling pesos from its reserves for dollars. This action would increase demand for dollars while reducing their supply. And it would decrease demand for pesos while increasing their supply. The result would be a devaluation of the peso relative to the dollar.
Since the 1970s, most industrialized countries, such as the United States and Japan, have allowed their currencies to float in a managed way. Other countries with less stable currencies have pegged them to a major currency, such as the dollar or the euro, the common currency of the European Union.
Another way countries try to manage the value of their currency is by regulating their balance of trade. Balance of trade is the difference between the value of a country’s exports and the value of its imports. Also known as net exports, it is calculated by subtracting imports from exports.
A country’s balance of trade can be positive or negative. If a country exports more than it imports, it has a positive balance of trade, or a trade surplus. If it imports more than it exports, it has a negative trade balance, or a trade deficit. Figure 15.5A shows the US. balance of trade in goods and services over time.
A trade surplus helps to strengthen a country’s currency. Think about what would happen if the United States had a trade surplus. The number of dollars coming into the United States from the sale of exports would exceed the number of dollars we send to other countries to pay for imports. As the supply of dollars held by people in other countries dropped, the value of the dollar would likely rise.
In the same way, a trade deficit tends to weaken a country’s currency. Again consider the situation of the United States, which has run a trade deficit for years. To pay for all of its imports, the United States has to send more and more dollars to its trading partners. As the supply of dollars held by people in other countries rises, the value of the dollar is likely to drop. Thus, by exporting more or importing less, a country can have some effect on the strength of its currency.
Just as a weak currency is not necessarily bad, a trade deficit does not necessarily signal a struggling economy. In 2007, the US. trade deficit amounted to more than $700 billion. Yet the United States also had tile world’s largest economy that year.
When the United States runs a trade deficit, it means that the country is buying more than it is selling in world markets. How does the country manage to do this year after year?
The United States finances its trade deficit by borrowing dollars from foreign lenders and by selling US. assets to foreign investors. In other words, foreigners enable the United States to run deficits. They are willing and able to do this because they have so many surplus dollars from selling us their goods.
Foreigners holding dollars can lend their dollars to the United States by buying Treasury securities or other types of bonds. In 2007 foreigners held more than $2.5 trillion in US. Treasury securities alone. This amounted to about 40 percent of all publicly held US. government bonds.
Foreign investors can also purchase stock in American companies or buy US. assets, such as farmland and office buildings. Some foreign companies use their dollars to buy American companies or to establish new businesses in the United States.
Investment by a firm in a business enterprise in a foreign country is known as foreign direct investment (FDI). A German or Japanese auto company creating an assembly plant in the United States is an example of foreign direct investment. In 2007, FDI in the United States was around $230 billion.
How concerned should Americans be about the steady rise in trade deficits since the 1980s? The answer depends on whom you ask. A 2005 Wall Street Journal editorial found little cause for concern: “On the list of economic matters to worry about, the trade deficit’ is about 75th-unless politicians react to it by imposing new trade barriers or devaluing the currency.” The New York Times, on the other hand, in reporting on the 2006 trade deficit, wrote, “A growing trade deficit acts as a drag on overall economic growth.”
Many Americans are understandably concerned about trade deficits. Such concern is rooted in personal experience and common sense. After all, if you spend more than you earn, you go into debt. If you borrow to finance your debts, you go deeper into debt. This endless borrowing can get a person into serious financial trouble.
Many people view the US. trade deficit in much the same way. The United States, they argue, cannot continue to run large deficits and finance them with foreign borrowing forever. At some point, we may have to pay off all that debt, which could prove painful. Moreover, many Americans do not like the idea of foreign firms owning and controlling US. land and businesses.
Economists differ on the significance of the trade deficit and the resulting US. debt owned by foreigners. Thomas Sowell notes that the United States has been a debtor country for much of its history. In the 1800s, foreign loans and investment helped finance the country’s economic development. “There is nothing wrong with this,” he writes, and continues,
Sowell and other economists point out that the trade deficit is not a problem as long as our economy grows. When times are good, foreigners view the United States as a safe place to invest their dollars. But the deficit and debt could become an issue if the economy falters. Foreigners may then become less eager to make new loans to the U.S. government. And old loans will have to be repaid-by taxpayers like you. As economists Robert Frank and Ben Bernanke note,
The trade deficit may not be high on your personal worry list. But the global economy is bound to play a large role in your life. You are already a participant in that economy every time you buy goods made in other countries. And whatever career you choose, it is likely to involve the global marketplace in some way. Understanding how global trade works will help you make better choices, whether you are hunting for the best deal or the ideal job.
