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How Does the Exchange Rate Exactly Works?

The exchange market mechanism can be pretty confusing for a person who doesn't have specialised knowledge in this area. The connection between the exchange rate of a currency and its trade deficit may seem like an undecipherable mystery. In order for you to understand the hidden mechanism of the exchange market and the trade deficit, we'll discuss and explain the American-Canadian Trade and Exchange relationship.

The first thing you should know, in order for you to have an accurate idea of this matter, is that Canada is USA's largest trading partner with 20% of the US foreign trade.

Whenever you are analysing a trade relationship between 2 countries, you should look at the exchange rate and international trade data. Make sure you are analysing the data concerning at least 2 years of trade, in order to draw the right conclusions. For instance, if you were to analyse the data for 2002 and 2003, you would notice that the CDN DOL column is displaying the number of Canadian Dollars that can be bought in exchange for one US Dollar. A bigger number on this column means that the US Dollar is appreciating; it gets stronger and can buy more Canadian Dollars. On the other hand, whenever the number is decreasing, it means that the US Dollar is depreciating, it gets weaker, and it can buy less Canadian Dollars.

You should also pay attention to the second column, named CDN DEF, which is displaying the amount of the trade balance between the United States of America and Canada. If you find only negative numbers in this column, you should know that this

fact means that US is facing a trade deficit when it comes to its Canadian trade relationship. You should also keep in mind that the numbers in this column are usually expressed in millions of US Dollars.

A quick look on the data for 2002 and 2003 will instantly tell you that the US Dollar has depreciated quite fast compared to the Canadian Dollar. For instance, the data for October 2002 shows that 1.58 Canadian Dollars were bought for 1 US Dollars. But the data for October 2003 shows that 1.32 Canadian Dollars were bought for 1 US Dollars, meaning that the US Dollar's strength has weakened.

Nevertheless you will notice that the trade balance remained the same over that period.

If you wonder about the connection between the exchange rate and the trade balance, well, here it is. The relationship between these two is quite simple: whenever the exchange rate goes up, the trade is going down, and the other way around. A positive number shows that the trade deficit increases when the exchange rate is going down.

In conclusion, whenever you analyse the relationship between the exchange rate and the trade balance, you will come across the numbers for the trade deficit. Always keep in mind that things aren't as simple as they look, so, in order to reach an accurate conclusion, you have to analyse a lot more numbers than these.
About the Author

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Risk Disclosure: Trading foreign exchange on margin carries a high level of risk, and may not be suitable for all investors. The high degree of leverage can work against you as well as for you. Before deciding to invest / trade in foreign exchange you should carefully consider your investment objectives, level of experience, and risk appetite. The possibility exists that you could sustain a loss of some or all of your initial investment and therefore you should not invest money that you cannot afford to lose. You should be aware of all the risks associated with foreign exchange trading.

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