Exchange Rates and Net Exports

Net exports move with the exchange rate because the exchange rate is the price tag foreigners see on your goods and the price tag you see on theirs. When a currency depreciates, it takes less foreign currency to buy one unit of it, so buyers abroad find your exports cheaper and buy more. At the same time, it takes more of your own currency to buy foreign goods, so imports get pricier and people buy fewer of them. Exports up, imports down, net exports up. Appreciation runs the whole thing backward: your exports look expensive abroad and foreign goods look cheap at home, so exports fall and imports rise, pulling net exports down.

The mechanism is just unit conversion. If a euro costs 1.10 dollars, a 20,000 euro car costs 22,000 dollars. If the euro appreciates to 1.30 dollars, that same car now costs 26,000 dollars to an American buyer, with no change in the price a European pays. The dollar has depreciated against the euro, European goods got more expensive in dollar terms, so American demand for them falls — US imports fall and, by the same logic run in reverse, US exports to Europe rise because dollars are now cheaper for Europeans to acquire.

This is the payoff of the loop that runs through the whole unit: interest rates move loanable funds, loanable funds move the exchange rate, and the exchange rate moves net exports, which feeds back into GDP through aggregate demand. A central bank raising interest rates to fight inflation, for instance, strengthens the currency and drags net exports down, partly offsetting its own policy.