Question

Trade theory tells us to expect an improvement in a nation's trade balance (surplus) when the real exchange rate depreciates. On what is that conclusion based? And why is it often not the case? Explain briefly.

Answer 1

This conclusion is based upon the premise that depreciation in exchange rate, will make the exports cheaper and more products will be sold in the international market. It will make a net export to be increase that will improve the trade balance situation and move it towards the surplus. For example, Japan is the case, where depreciating Yen, has shown Japan's trade balance to be in surplus.

It may not be the case, because depreciation in exchange rate may be due to excessive demand of foreign currency and or supply of domestic currency, inflation in the economy and imports getting bigger than the export. In all these circumstances, domestic products & services may not be good enough to compete in international market. So, trade balance may not improve.