Whether you know it or not, foreign exchange is a part of your everyday life. From the products you buy to the vacations you take, foreign exchange affects much of what you do. The flow of currency between nations is also a matter of record keeping. The balance of payments records all of the inflows and outflows of currency from a country. The sum of net exports, net foreign factor income, and net transfers is the current account balance, while net foreign investment and official reserves make up the financial account.
What determines the price of apples? If you answered supply and demand, then you would be correct. What determines the foreign exchange price of a dollar? Once again, if you said supply and demand, then you are right on target. Whenever one currency is exchanged for another, foreign exchange has occurred and an exchange rate has been paid. The exchange rate is nothing more than the current price of a currency in terms of another currency. For example, $1 may buy you €0.73, £0.64, ¥89.41, or SFr 1.07.
Exchange rates are determined in the world’s largest market, the foreign exchange market. Annual trade volume approaches $1 quadrillion (a thousand trillion), with transactions occurring twenty-four hours a day. The foreign exchange market is dominated by the British, Americans, and Japanese with the vast majority of trades occurring in the U.S. dollar. The euro (€), pound sterling (£), Japanese yen (¥), and Swiss franc (SFr) are the other hard currencies most often traded.
Who’s involved?
When traveling, you can often find the best exchange rates on your credit card or by accessing an ATM. Banks are the major players in the foreign exchange market and are able to grant their customers some of the most competitive rates.
Exchange rates are subject to the forces of supply and demand. As exchange rates rise, people are more willing to sell their currency, but others are less willing to buy, and vice versa. Appreciation occurs when an exchange rate increases, and depreciation occurs when exchange rates fall. Changes in exchange rates can wreak havoc on businesses and entire economies. Economists and policymakers must therefore consider the implications of their actions on exchange rates. Tastes, interest rates, inflation, relative income, and speculation affect exchange rates and thus economies as a whole.
As consumers’ tastes for imported goods change, so does the exchange rate between the countries involved. The popularity of cars and consumer electronics from South Korea among American consumers necessarily creates a demand for South Korea’s currency, the won (W). In order for American importers to acquire South Korean products, they must supply dollars and demand won in foreign exchange. The result of this change in tastes is a depreciation of the dollar and appreciation of the won.
Over time, appreciation of a country’s currency may reduce the popularity of its products as they become relatively more expensive. Given that people often prefer relatively cheaper goods, foreign manufacturers that export goods to the United States might choose to price their products directly in dollars as opposed to their domestic currency. This helps to insulate the manufacturer from changing exchange rates, which might reduce their product’s competitiveness on the American market. German automakers engage in this practice to offset the effects of the euro’s relative strength against the dollar.
Changes in real interest rates also affect the foreign exchange market. Unlike trade flows, which tend to be rather stable, changing interest rates can cause sudden fluctuations in exchange rates. Savers are attracted to high interest rates, so when one country’s real interest rate rises relative to another country, savings flow toward the higher interest rate. With all other things equal, increases in American interest rates relative to Japanese interest rates will cause an increased supply of yen and increased demand for dollars as Japanese savers seek to earn higher American interest rates. The result is an appreciated dollar and depreciated yen. Eventually, the dollar’s appreciation relative to the yen will offset any gains made off of the interest rate difference. This is referred to as interest rate parity.
Foreign exchange has a definite cost attached to it. If you choose to participate in the foreign exchange market, know that you will likely face different exchange rates in buying and selling currencies. So before you open up a CD in a French bank, consider the cost of purchasing and selling your euros before cashing in on a higher interest rate.
The presence of inflation in an economy provides an incentive for its people to exchange their currency for one that is more stable. Zimbabwe’s inflation has reduced the value of its currency to the point where a sheet of paper is more valuable than a single unit of its currency. Rational Zimbabweans trying to store value will eagerly supply the Zimbabwe dollar for any available currency like South Africa’s rand. The result of inflation is to not only reduce the value of the currency domestically but also in foreign exchange.
Probably the most counterintuitive outcome results from differences in economic rates of growth. As an economy’s income increases relative to another country, the exchange rate between the two changes. For example, if Canada’s income increases relative to the United States’ income, the Canadian dollar weakens relative to the U.S. dollar. Why? As Canadians experience higher incomes, their propensity to import also increases. In other words, as you get richer, you go shopping more often and supply more currency in foreign exchange. The counterintuitive outcome is that as an economy strengthens, its currency weakens, and as an economy weakens, its currency strengthens.
Over the course of a year you might hear experts lamenting the size of the trade deficit, while later others might complain of a weak dollar. Actually, a weak dollar is the remedy for a trade deficit. Depreciated dollars encourage exports and discourage imports. Words like strong and weak can be misleading. They do not necessarily mean good or bad.
Banks, companies, and individuals attempting to profit from foreign exchange will speculate in the market. For example, a speculator may suspect that European interest rates will rise faster than American interest rates, so she will purchase euros and hold them until they have appreciated enough to show a profit. For most people, however, speculating in foreign exchange is about as profitable as playing craps in Las Vegas.
Although speculating is risky, speculators do perform an important economic function by bearing exchange rate risk. Risk-averse companies engaging in foreign exchange would rather know exactly what exchange rate they will be paying or earning when conducting transactions. These companies will purchase a futures contract that guarantees a specified exchange rate in order to avoid sudden shifts in exchange rates that might reduce the profitability of the underlying transaction.
Specialization and trade are based upon comparative advantage, differences in capital and labor, and diversity in consumption. Exchange rates, however, should not determine specialization. According to the economic law of one price, or purchasing power parity, after accounting for the exchange rate, the prices of similar goods should be the same regardless of where they are purchased.
Assume that the exchange rate between the U.S. dollar and Swiss franc is such that $1 = SFr 1.10. In the long run, a pair of snow skis that sell for an average price of $500 in the United States should therefore sell for an average of SFr 550 in Switzerland. What if the skis were selling in Switzerland at an average price of SFr 600? Swiss consumers would benefit from importing the skis from America, supplying Swiss francs and demanding U.S. dollars in foreign exchange until the exchange rate reflected purchasing power parity.