How does a trade deficit affect floating exchange rates?

Explanation

A negative balance of trade is referred to as a trade deficit. In simple terms, trade deficit is the excess of imports over the exports between two countries. A floating rate system is based on bilateral trade between two countries. Thus, change in the quantum of trade deficit between countries changes the value of home currency in relation to the value of foreign currency, which ultimately affects the exchange rates. Importers need to convert their funds into foreign currency to make payment to foreign exporters. A situation of trade deficit, where imports of a nation are higher than its exports, leads to an increase in demand of foreign currency. When there is an increase in demand of foreign currency in the home country, the foreign currency value strengthens in comparison to home currency. This effect on the value of currency, changes the exchange rate between the two countries. Thus, the decline in the value of the home currency due to the trade deficit leads to a fall in the floating exchange rate.

Verified Answer

A trade deficit affects the exchange rate negatively. A situation of trade deficit weakens the value of home currency with respect to foreign currency.