Imports, Exports, and Exchange Rates

 

Imports and exports may seem like prosaic terms that have little bearing on everyday life, but they exert a profound influence on the consumer and the economy. In today’s interlinked global economy, consumers are used to seeing products and produce from every corner of the world in their local malls and stores. These overseas products – or imports – provide more choices to consumers and help them manage strained household budgets. But too many imports in relation to exports – which are products shipped from a country to foreign destinations – can distort a nation’s balance of trade and devalue its currency. The value of a currency, in turn, is one of the biggest determinants of a nation’s economic performance. Read on to learn how these mundane staples of international trade have a more far-reaching influence than most people imagine.

Effects on the Economy

According to the expenditures method of calculating gross domestic product, an economy’s annual GDP is the sum total of C + I + G + (X – M), where C, I and G represent consumer spending, capital investment and government spending, respectively.

While all those terms are important in the context of an economy, let’s look closer at the term (X – M), which represents exports minus imports, or net exports. If exports exceed imports, the net exports figure would be positive, indicating that the nation has a trade surplus. If exports are less than imports, the net exports figure would be negative, and the nation has a trade deficit.

Positive net exports contribute to economic growth, something that is intuitively easy to understand. More exports mean more output from factories and industrial facilities, as well as a greater number of people employed to keep these factories running. The receipt of export proceeds also represents an inflow of funds into the country, which stimulates consumer spending and contributes to economic growth.

Conversely, imports are considered to be a drag on the economy, as can be gauged from the GDP equation. Imports represent an outflow of funds from a country, since they are payments made by local companies (the importers) to overseas entities (the exporters).

However, imports per se are not necessarily detrimental to economic performance, and in fact, are a vital component of the economy. A high level of imports indicates robust domestic demand and a growing economy. It’s even better if these imports are mainly of productive assets like machinery and equipment, since they will improve productivity over the long run.

A healthy economy, then, is one where both exports and imports are growing, since this typically indicates economic strength and a sustainable trade surplus or deficit. If exports are growing nicely but imports have declined significantly, it may indicate that the rest of the world is in better shape than the domestic economy. Conversely, if exports fall sharply but imports surge, this may indicate that the domestic economy is faring better than overseas markets. The U.S. trade deficit, for instance, tends to worsen when the economy is growing strongly. The country’s chronic trade deficit has not impeded it from continuing to be one of the most productive nations in the world.

But a rising level of imports and a growing trade deficit do have a negative effect on a key economic variable – the level of the domestic currency versus foreign currencies, or the exchange rate.

How Exchange Rates Work

Floating vs. Fixed Exchange Rates

A fixed exchange rate, sometimes called a pegged exchange rate, is a type of exchange rate regime where a currency’s value is fixed against either the value of another single currency, to a basket of other currencies, or to another measure of value, such as gold.

A floating exchange rate or fluctuating exchange or flexible exchange rate is a type of exchangerate regime in which a currency’s value is allowed to fluctuate in response to foreign-exchange market mechanisms. A currency that uses a floating exchange rate is known as a floating currency.

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