Study Finds No Relationship Between Currency Exchange Rate and Trade Imbalance

Economic theory tells us that a falling dollar helps American exports by making them cheaper for foreign buyers and slows imports by making them more expensive.  Thus, a falling dollar helps domestic manufacturing and improves our balance of trade A stronger dollar has the opposite effect.  It seems to make sense, but the theory isn’t supported by the facts.

My study of the currency exchange rates between the U.S. and its fifteen largest trade partners (and one other) has found no relationship between exchange rates and the balance of trade.  I studied the total balance of trade for these nations for the period from 1990 through 2008, and the balance of trade in manufactured products from 2001 through 2008 against the rise and fall in exchange rates for the currencies of each nation in question.  (Data for manufactured products not available for years prior to 2001.) 

The study finds that, for total trade, there is absolutely no relationship between exchange rate and balance of trade.  The U.S. balance of trade was just as likely (or slightly more likely) to worsen in response to a weaker dollar as it was to improve, and vice versa.  A year-by-year analysis shows that the balance of trade responded to exchange rate changes as economic theory would predict almost exactly (but slightly less) than half of the time.  When the 19-year period is taken as a whole and compared to the change in exchange rate for each country, the balance of trade behaved as economic theory would predict in less than half of the cases.  And it seemed to make no difference whether the trade partner was more or less densely populated than the U.S.

If we narrow our scope to manufactured products only, the story is exactly the same except that if Singapore (the tiniest of America’s 15 largest trade partners) is removed from the data set, then population density does seem to matter.  For trade between the U.S. and nations less densely populated, the balance of trade does seem to respond to changes in currency exchange rates as economic theory would predict.  But that tendency decays with rising population density and, for trade with nations more densely populated than the U.S. by a factor of two, a weakening dollar has no effect on improving the balance of trade.  If anything, in trade with densely populated nations, the balance of trade tends to worsen regardless of a weakening dollar.

The population density of the trade partner is a far better predictor of the balance of trade in manufactured products.  (The population density theory applies only to manufactured products and not trade in natural resources.)  For trade partners less densely populated than the U.S., the theory correctly predicts a surplus of trade in every case.  For those nations more densely populated, the theory correctly predicted a trade deficit in 9 out of 11 cases.  (Since the theory doesn’t apply to tiny city-states, Singapore is excluded from the data set.) 

Here’s a summary of the study’s findings:

Theory Correlation Score

Conclusisons and comments regarding total trade:

  1. Among the trade partners less densely populated than the U.S., the balance of trade responded to changes in currency exchange rate as predicted by economic theory, year-by-year, only 47% of the time.  Taking the 19-year period as a whole, the balance of trade responded as predicted by economic theory for only two out of five nations – 40% of the time.
  2. Among the trade partners more densely populated than the U.S., the balance of trade responded to changes in currency exchange rate as predicted by economic theory, year-by-year, only 46% of the time.  Taking the 19-year period as a whole, the balance of trade responded as predicted by economic theory for only five out of twelve nations – only 42% of the time.
  3. This lack of correlation between total balance of trade and currency exchange rate may be partly explained by the fact that, aside from manufactured products, the remainder of total trade is dominated by oil.  Since oil is priced in dollars, there is no exchange rate involved in the trade of oil. 

Conclusions and comments regarding trade in manufactured products:

  1. Among the trade partners less densely populated than the U.S., the balance of trade in manufactured products responded to changes in currency exchange rate as predicted by economic theory, year-by-year, 49% of the time.  Taking the 19-year period as a whole, the balance of trade responded as predicted by economic theory for three out of five nations – 60% of the time.  Thus, there’s at least some slight indication that currency exchange rate does play a role in trade in manufactured goods with less densely populated nations.
  2. Among the trade partners more densely populated than the U.S., the balance of trade in manufactured products responded to changes in currency exchange rate as predicted by economic theory, year-by-year, only 48% of the time.  Taking the 19-year period as a whole, the balance of trade responded as predicted by economic theory for six out of twelve nations – 50% of the time.  Thus, for densely populated trade partners, currency exchange rate plays no role in determining the balance of trade.
  3. On the other hand, population density plays a powerful role.  In every case in the study, the U.S. enjoys a surplus of trade in manufactured products with less densely populated nations.  Conversely, the U.S. has a surplus of trade with only three out of twelve more densely populated nations.  One of these three, Colombia is only very slightly more densely populated than the U.S.  Both of the remaining two share a common trait – they are tiny nations that serve as a port of entry for the larger surrounding countries. 

In conclusion, other than some slight indication of a correlation for trade in manufactured products with less densely populated nations, currency exchange rate has absolutely no effect upon balance of trade, especially with densely populated nations. 

Clearly, those who are pinning their hopes on a weaker dollar to rebalance the global economy, especially trade with China, are barking up the wrong tree.

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2 Responses to Study Finds No Relationship Between Currency Exchange Rate and Trade Imbalance

  1. […] posted here: Study Finds No Relationship Between Currency Exchange Rate and … Related Posts:Foreign currency exchange rates converter – Currency exchange rate … With any […]

  2. […] I’ll be the first to admit that a one-year move in currency exchange rate may not be enough to change the momentum of trade imbalances.  However, I’ve previously conducted a similar study of the effect of 18-year changes in currency exchange rates and found exactly the same thing.  (See https://petemurphy.wordpress.com/2010/11/17/study-finds-no-relationship-between-currency-exchange-rat….) […]

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