How do import and export relationships influence exchange rate developments in a free exchange rate system?

This is a very complex issue that focuses on entire sections of the economy. There are inconceivable many articles, doctoral thesis and conferences on the topic…

Simple example: Germany with its own currency and export surpluses vs. Foreign countries with import surpluses

• Germany exports more than it imports. The foreign country buys German goods and needs a German currency (D-Mark 2.0).
• Foreign countries have trade deficits. In order to finance imports from Germany, foreign countries must sell their own currency and buy DM2.0. This leads to an increase in the exchange rate of DM2.0 (currency appreciation).

This appreciation of the DM2.0 implies the following:

• German goods become more expensive for foreign countries.
• Imports to Germany are becoming cheaper at the same time.
• In the long term, German exports would be slowed down and imports would be encouraged, which would compensate for the trade imbalance.
• Such a constant state of equilibrium is in fact not to be reached in the real world, especially if there are many more countries, foreign exchange, complex supply chains and political conquests (protectionism, hegemonic state monopolies etc.) in play.

Debt from abroad

• The foreign country finances deficits by debt (logical consequence of the gross accounts). The increased demand for German loans continues to increase the appreciation pressure on DM2.0.
• In the long term, foreign countries could have problems repaying debts in the upgraded German currency, which can affect the economic stability of foreign countries.

So…

… Germany’s export surplus leads to a Evaluation of DM2.0, as demand for the German currency increases. This makes German products more expensive for foreign countries and could contribute in the long term (theoretically) to a balance of the trade balance. But the complex dynamics and external effects in our real world would not lead to a lasting balance.

Instead of a trade balance, capital flows such as investments in foreign assets stabilize the imbalances, but strengthen the dependence of the deficit countries. This leads to growing debt, increased risk of financial crises and political tensions between export and import countries in the long term.

You could continue this infinitely. If DM2.0 was the world’s leading currency, Germany could lead many countries to insolvency and/or bondage by increasing its central interest rates, etc.