The exchange rate is the price of one country’s currency in terms of another country’s currency. For example, an exchange rate of 100 Japanese yen to the U.S. dollar means that you can exchange a single U.S. dollar for 100 Japanese yen. The exchange rate is important for international trade because changes in exchange rates often alter the prices of imported and exported goods between countries. For example, if the U.S. dollar appreciates with respect to the Japanese yen, Japanese consumers have to give up more Japanese yen to buy the same dollar value of U.S. goods exported to Japan. In other words, appreciation of the dollar implies that U.S. goods become more expensive to foreigners. On the other hand, appreciation of the dollar tends to make goods imported from other countries cheaper for U.S. consumers. Because of these changes in relative prices, appreciation of the dollar tends to increase imports and decrease exports, thereby deteriorating the trade balance. The trade balance is the total value of imported goods minus the total value of exported goods. Depreciation of the dollar has the opposite effect, likely improving the trade balance.
The graph above shows this relationship between the trade balance and the exchange rate. The green line plots the trade-weighted U.S. dollar index, which is “a weighted average of the foreign exchange value of the U.S. dollar against the currencies of a broad group of major U.S. trading partners.” A higher value of the index indicates a stronger dollar. The blue line is the trade balance-to-trade volume ratio. The trade volume is the sum of the total value of imports and exports. We look at the ratio instead of the trade balance directly because globalization has led to higher volumes of international trade over time. The ratio gives the difference between exports and imports as a share of total trade, thereby controlling for higher volumes.
Over the past three decades, the trade-weighted dollar index has varied significantly. For example, from the second quarter of 1995 to the first quarter of 2002, the index increased from 90 to 127, an appreciation of the dollar of over 40 percent. The corresponding trade balance-to-trade ratio drops from around –6 percent to –16 percent. In general, we see a negative relationship between the exchange rate and the trade balance.
However, the influence of the exchange rate on the trade balance varies over time. The recent appreciation of the dollar of 20 percent from 2014 to 2016 worsened the trade balance ratio only slightly. The trade balance’s tepid response is likely because of other changes to trade conditions, such as tariffs and regulations. The persistence of the U.S. trade deficit is also noteworthy. Throughout the 22-year span covered in our sample period, the U.S. continuously ran a trade deficit despite the large variation present in the exchange rate. In other words, adjustments to the exchange rate have not removed the U.S. trade deficit even in the long run.
How this graph was created: Search for and add “Trade Weighted U.S. Dollar Index: Broad (TWEXB)” to the graph on the left axis. From the “Edit Graph” tab, add “Exports of Goods and Services (EXPGS) and Imports of Goods and Services (IMPGS) as Line 2. To do this, enter the formula (a-b)/(a+b) in the Line 2 tab. Finally, change the starting date to “1995-01-01.”
Suggested by Yili Chien.