Hi all, Do you think you could walk me through this? There seems to be a number of opposing forces going on and I keep getting myself confused. Text from CFAI: “Let’s consider a country in which capital flows are restricted. A trade deficit would lead to a reduction the country’s reserves and ultimately to a depreciation of the home currency… Depreciation leads to improved trade terms, more balanced trade and stabilized currency.” Can someone explain the process by which the trade deficit leads to a depreciation of the home currency? I understand that the reduction in the country’s reserves is to balance the payments, however my mind begins to wander at that point… is there an increase/decrease in the supply of domestic currency?
- “Let’s consider a country in which capital flows are restricted”. This means that foreign capital can only come in thru trade and also domestic capital can only go out thru trades. 2. “A trade deficit would lead to a reduction the country’s reserves and ultimately to a depreciation of the home currency”. A trade deficit is when this country is importing more than it is exporting. It means, the demand for this country’s currency is less (less exports demanded) than its supply (since imports are higher, more of its currency is supplied in the trade market, to buy those import goods). This will depreciate that country’s currency, as supply of the currency in trade market is more than its demand. 3. “Depreciation leads to improved trade terms, more balanced trade and stabilized currency.” When a country’s currency gets depreciated, its exports become cheaper to foreign companies who are buying it. And at the same time, its imports become more expensive to domestic companies importing goods from abroad. This tends to balance out the deficit in trade and stabilizes the currency. Hope it helps.
Rus1boy pretty much summed it. they’re emphasising a closed economy for a reason. once its open, foreign cash inflows can sustain a CAD indefinitely through the capital account (theoretically) so long as its from the private sector. but as mentioned above, once these are cut off, then its up to the countries reserves to cover the deficit - if it can’t, a depreciation occurs. exports increase, imports decrease, reserves increase and the process continues.
Thanks guys - I appreciate it. That really helps! This was key for me "It means, the demand for this country’s currency is less (less exports demanded) than its supply (since imports are higher, more of its currency is supplied in the trade market, to buy those import goods). "