Why does a trade deficit weaken the currency?
To answer this question recall that the trade deficit means that the United States is buying more goods and services than it sells abroad (imports exceed exports). Just like an individual or a firm needs credit to spend more than its income, the trade deficit requires financing by foreigners. Foreigners
finance the trade deficit by lending to Americans or by investing in the
United States (buying property or businesses). However, at some future
date, the trade deficit must turn into surplus, so that the foreigners
get paid back.
For the trade deficit to turn into a surplus, imports must fall and exports
must rise. One way this adjustment can take place is if the dollar depreciates,
making imports more expensive for Americans and exports cheaper for foreigners.
If trade deficits are sufficiently large and unsustainable, economists
believe that they will be associated with a weakening dollar at some future
The U.S. economy has been doing very well for many years now, making
it an attractive place for foreigners to invest in. As a result, they
have been willing to finance growing U.S. trade deficits in the 1990s
(Chart 1). While the deficits have reached
unprecedented levels, the dollar has shown no consistent signs of weakening
over this decade (Chart 2). Thus, trade deficits
can be sustainable for a very long time, making the short run relationship
between trade deficits and the dollar very tenuous.
To conclude, in the long run, trade deficits may be expected to contribute
to a weaker dollar, as the economy adjusts to create the surpluses needed
to repay foreign investors. However, in the short run, the relationship
between the trade deficit and the dollar is weak, and the value of the
dollar is determined largely by investor preferences for U.S. dollar assets.