Question

If a currency becomes overvalued in the foreign exchange market, what will be the likely impact on the home country's trade balance? What if the home currency becomes undervalued?

Short answer

If a country's currency becomes overvalued, it is likely that their trade deficit will increase, as exports will drop and imports will rise due to cost disparities. If the country's currency is undervalued, their trade surplus may increase, as more foreign countries will probably buy their cheaper exports and fewer costly imports will be purchased.

Step-by-step solution

Understanding Currency Overvaluation

Overvaluation of a currency can be understood as a situation where the value of a country's currency is higher than its comparative value, based on market exchange rates. This means that goods and services of this country are more expensive compared to the rest of the world.

Impact of Overvaluation on Trade Balance

An overvalued currency makes exports more expensive and imports cheaper. This leads to a decrease in exports and an increase in imports, thereby negatively affecting the country's trade balance. The trade balance might go into a deficit if exports fall below imports.

Understanding Currency Undervaluation

Undervaluation of a currency can be seen as a scenario where the value of a country's currency is lower than its market-determined comparative value. This means that goods and services of this country are cheaper compared to the rest of the world.

Impact of Undervaluation on Trade Balance

An undervalued currency makes exports cheaper and imports more expensive. This leads to an increase in exports and decrease in imports, thereby positively influencing the country's trade balance. The trade balance might go into a surplus if exports exceed imports.

Key concepts

Trade Balance

The trade balance is an essential concept in understanding a country's financial stability and economic health. It represents the difference between the value of a country's exports and imports over a certain period. A positive trade balance, known as a trade surplus, occurs when a country exports more than it imports. Conversely, a negative trade balance, or trade deficit, happens when imports exceed exports.
Factors that can influence a country's trade balance include:

• Exchange rates
• Inflation rates
• Economic growth
• Government policies

Changes in the value of a country's currency can significantly impact its trade balance by making imports cheaper or more expensive and affecting the competitiveness of exports in the global market.

Currency Overvaluation

Currency overvaluation occurs when the exchange rate makes a country's currency stronger than what market conditions would suggest. It usually results from government intervention or speculative flows that artificially inflate the currency's value.
How does currency overvaluation affect the economy?

• Exports become more expensive, leading to a decline in foreign sales.
• Imports become cheaper, increasing domestic consumption of foreign goods.
• The trade balance often deteriorates as the country imports more than it exports, resulting in a trade deficit.

A trade deficit can pose challenges as it may lead to increased foreign debt to purchase goods and maintain consumption when there is not enough currency inflow from exports.

Currency Undervaluation

Currency undervaluation is the opposite scenario, where a country's currency is cheaper than its market value would anticipate. This can be due to various factors, including government policies designed to boost exports by keeping their currency low.
Benefits of currency undervaluation include:

• Exports become cheaper and more attractive to the foreign buyers.
• Imports become more expensive, encouraging the consumption of local goods.
• Overall improvement in the trade balance, potentially leading to a trade surplus.

A surplus caused by undervaluation can strengthen an economy by improving domestic production and employment, though it might strain relations with trade partners who find their own exports less competitive.