Simply put Tariffs act like taxes against other countries goods or services. It adds to the cost of imported goods. The recent Trade War activity has stirred many investors so it's important to make sure all the Forex traders out there understand the impact of Tariffs on exchange rates.
Why are Tariffs even used?
Generally, in protective terms Tariffs are imposed to protect infant industries which are basically new industry which has a new product/ idea. However, developed economies and industries also use Tariffs.
Here's a list of reasons why countries impose tariffs:
Protect employment in the country
Retaliation (seen a lot currently US vs China)
Currently, in the US and China Trade War it's a constant back and forth tariff action between them resulting in hefty added costs.
How Tariff affect Currency Exchange Rates
It was mentioned by economist Robert Mundell that for floating exchange rate regimes, new import tariffs tend to reduce trade deficits. Which then causes the value of the domestic currency to increase. Although the tariffs encourages domestic businesses and consumers to purchase domestic goods the decline in global competitiveness due to higher exchange rates can cause less output and a decline in employment.
So, let's say the U.S. slaps a tariff of 10% on the value of all imports from China. In the U.S. all those goods from China would rise by 10%. What happens when businesses and consumers see higher prices? They likely cut back spending on goods purchased from China, and perhaps substitute it with a cheaper U.S. alternative.
How does this affect the importers in the U.S? Well, they'll end up ordering fewer goods from China. This is because the imports are now way more expensive and the excess dollars would just go to the Government.
U.S. importers would end up worse off nominally because their dollar revenue decreases, but now that value of the dollar has risen, in real terms they're no worse off than before. Similarly, Chinese exporters would receive fewer dollars for their products, but their dollars now buy back more Chinese Yuan. So essentially, U.S. importers and Chinese exporters have no real financial impact from import tariffs.
BUT... for U.S. exporters, a strengthening USD due to the new import tariffs could mean lower revenue and more risk. This is because in a global market their goods are now way more expensive.
This is why you tend to see these large sell offs in the stock market during trade war talks.
But for us Forex traders out there, what we can take from this is when a country starts imposing tariffs their domestic currency appreciates against the currency of the imposed country.