Chapter 18: Foreign Exchange
In addition to managing the money supply to stabilize the national economy, the federal reserve must also consider the performance of the dollar on the foreign exchange market.
To the average consumer, the exchange rate seems largely inconsequential, and may be considered when toying with the idea of taking a vacation abroad because it affects how cheap or expensive the things they will buy (hotel, meals, souvenirs) will be when they trade US dollars for the local currency. However, it impacts every American consumer significantly in the marketplace: most goods that Americans buy were made abroad and imported, and the strength of the US dollar makes foreign goods more affordable than domestic. It also is important to them as investors in US corporations, many of which have significant overseas operations (in addition to purchasing supplies on the international market). And it is very significant to workers, as entire industries may move "offshore" where the cost of labor and other factors is less than it is in the domestic market, or the firm may ramp up domestic production (hiring more labor) to manufacture goods to sell abroad.
(EN: Through the early industrial era, there was constant conflict between nations over trade, trying to protect domestic jobs, to prevent currency from leaving the country, etc. While free trade is becoming the norm, there are still many instances in which the attitude of competition and protectionism can be seen.)
Determining the Exchange Rate
During the time when all currency was backed by specie, the exchange rate was straightforward: coins and notes were valued for the amount of metal they represented. If one coin by weight or alloy contained half an ounce of silver, it was exchanged for as much of another coin as it took to represent the same weight of the same metal. But in the era of fiat currencies, determining how much of one currency is equal in value to a given amount of another is more complicated - and given that central banks are constantly adjusting their money supplies, the proportions constantly change.
The primary driver for foreign exchange is international commerce: companies generally prefer to be paid in their own domestic currency, so a foreign customer who purchases goods must obtain local currency to make payment - and because the currencies are always shifting, it must decide whether to obtain that currency in advance of purchase or take its chances on the currency exchange market when its payment is due. The exchange of one currency for another follows the rules of supply and demand: where a country is doing a lot of exporting, many foreign companies have a demand for its currency, and those who are willing to supply that currency can demand more for it.
The differences in exchange rates also provide opportunity for speculators, who attempt to exchange currency at auspicious times - they can buy low and sell high. This also creates a market for future exchanges, as a firm can purchase the option to exchange currencies at a given rate on a future date, rather than trading them immediately.
The day-to-day exchange of currencies can be done by anyone with money to trade, but the large wholesale trades ($1M or more) are handled by a few sizeable international banks, which have assets in various denominations and can simply journal amounts from one account to another rather than having to maintain a significant stock of cash. To get a sense of the volume, the author suggests that over $1 trillion of wholesale-level foreign exchange transactions take place daily.
A Few Words of Caution
The author mentions that there are a number of myths, superstitions, and specious beliefs about currency.
First, there is the belief that a "strong" currency is always better than a "weak" one. In truth, it is a trade-off. When the dollar is strong, Americans can buy more goods from abroad (good for consumption), but American goods are not attractive to foreign buyers (bad for production), and the situation is the reverse when the dollar is weak. And then, the laws of supply and demand kick in: foreigners are eager to have dollars when they are strong, but eventually they will have as many dollars as they care to possess and will not be interested in having any more, making the dollar weaker.
And so, the strength of currencies increase and decrease over time. What is really valued by holders of currency is a currency that is stable, because it will maintain its value (as opposed to volatile currencies, that gain and lose large amounts of value unpredictably).
Second, keep in mind that a currency is only good for one thing: trading for merchandise in its local market. Americans in particular are often upset that people make such low wages in foreign countries and, at the same time, amused at how cheap goods are in those same economies. But to the people in those economies, they make enough from their jobs to obtain the things they need to support their families (if they did not, there would be widespread famines and waves of immigration): the worker who makes a dime an hour can feed his family for twenty cents. If he had American wages, he would be paying American prices, and would be no better off than before.
For the day-to-day life of most people, it doesn't matter how much of one currency is exchanged for another or how much foreign wages and goods are if priced in domestic currency. These are meaningless and can be misleading. The foreign exchange is only of immediate importance to companies that do business overseas, though it may have a secondary effect on the domestic economy (when foreign goods are available cheap or a factory closes and moves overseas to take advantage of cheap labor).
Determinants of Prices in Various Markets
In theory, identical goods should exchange at the same price no matter what unit of currency is expressed. If a pound of rice sells for one dollar here and fifty rupees in India, then one dollar is worth fifty rupees.
However, all products are priced according to their cost, and the cost of production can have an effect on prices:
- The cost of transporting the good from its source to its customer is added to the price of the good
- The cost of the materials used to produce the good will vary according to their scarcity/abundance near its source
- The cost of labor used to produce the good will vary according to the availability of labor near its source
So what makes most goods more or less expensive have nothing to do with currency. Rice is much cheaper to produce in India because of there are vast tracts of wetland suitable for raising rice and the massive population makes unskilled labor cheap.
Long-Run Determinants of Currency Value
Currency is valued for its purchasing power. The money a person earns by their productive effort must provide at minimum the goods they need to sustain their household (by purchasing necessities) and to remain reasonably comfortable (by purchasing luxuries). Essentially, this determines the amount of money that is needed in the domestic market.
Where there is inflation, more money is needed, and the supply of that money increases to meet the needs of the domestic population. Therefore, one of the determining factors in the exchange rate between countries is their comparative rates of inflation. Where one country experiences higher rates of inflation than another, its currency becomes worth less by comparison.
This is considered a long-term determinant of currency value because stable economies have relatively low rates of inflation.
Another long-term determinant of currency value is the balance of trade between nations. If one nation exports many goods to another, it obtains more of its currency. The central bank in that nation then notices that there is not enough currency for domestic trade and creates more, debasing its currency and making it worth less of foreign currencies. Because the trade between nations is also relatively established and stable (the Chinese are not going to triple the amount of their American imports in a day or a month), the changes in the relative value of their currency is also stable and gradual.
There's a mention of tariffs, quotas, and other measures that countries use to manage the cost of imported versus domestic goods to balance the trade between nations and keep their domestic currencies stable, but these have a limited effect and are not well tolerated by citizens when the learn their government is causing prices of goods to be higher or lower than they ought to be on the free market and they often elicit countermeasures and retaliations by the foreign markets they seek to exploit or penalize.
Short-Run Determinants of Currency Value
The exchange rates between currencies can be very volatile on a day-to-day basis because of the trading activity of foreign exchanges between companies that need currencies to pay for transactions and speculators who are constantly seeking to profit from the fluctuations (and even some who have sufficient power to manipulate the exchange markets).
Essentially, the company that needs money to pay a bill today will bid for enough of that currency to pay its bill, and may be motivated to pay more for the currency if failure to pay its bill will accrue interest and penalties. It is to some degree at a disadvantage, though if the holders of currency attempt to take advantage to a degree that the premium they demand exceeds the interest and penalties, then it is in the interest of the firm to accept those drawbacks as being less expensive than obtaining currency immediately.
The activity of speculators tends to exacerbate and mitigate the fluctuations caused by natural supply and demand of currency: when they expect that the value of a currency will increase, they will seek to obtain that currency, which prematurely increases demand and the price of that currency. In general, the first to move gets the greatest profit when the price peaks, so there is often a rush to obtain a currency that is expected to strengthen. It is, in fact, "the expectation of the future direction of the exchange rate" that has the greatest short-term influence on the actual exchange rate.
Ultimately, speculation is limited by the need to use money. A small-time investor may take a thousand dollars to the bank and exchange them for foreign currency, but he means to profit by selling back that foreign currency for dollars and hopes to get more than he paid for it. But because he will eventually need to spend his money, he may be compelled to buy back the dollars at a less favorable rate when the rent is due.