This is one of my favorite topics. Many people have misconceptions about how currency exchange works. So here I'll try to explain how it works and try to make it easy to understand. Later in a second post to follow this one, I'll try to explain about what US government means when they say China is deliberately undervaluing its currency. What are the advantages to China and how it hurts US or other trading partners. However this is a very complicated subject, so some basic understanding of Economics principles is required. I will use "Economics: A Survey" as a reference and some real data that I will use is from this book. If I use an example or text from this book, it will be italicized.
To make currency exchange simple, I'll use an example of currency exchange between two countries. Let's say US and Japan. The reason I chose Japan is because both US and Japan are strong economies and both have a lower inflation rate. It will make things simple to understand. Although in recent years Japan has experienced a deflationary cycle but I think its still a good example. Inflation rates for different countries. Let's jump in.
Money is just a commodity like all other commodities that are traded. So the price of one currency in terms of another currency in foreign exchange market is determined by its supply and demand. There are three major components of supply of USD in foreign exchange market.
1. Individuals and companies seeking to buy foreign merchandise (US imports).
2. US citizens and institutions buying foreign financial assets, for example US investment banks buying German bunds or US companies setting up factories or acquiring companies in a foreign country.
3. Foreign owners of US based factors of production seeking to convert their dollar factor into foreign currency.
Similarly demand for dollar has three major components
1. Individual and companies based in foreign countries seeking to buy US merchandise (US exports).
2. Citizens of foreign countries and foreign institutions buying US assets, for example US treasury bonds or foreigners investment in US companies (either through stock market or foreign direct investment)
3. US owners of foreign based factors of production seeking to convert their foreign currency into USD. For example if Apple decides to bring its $85B cash to US it would need to convert money held in foreign currency into USD.
Basically the above mentioned factors decide the price of USD in foreign exchange market. Let's first analyze the affect of inflation on the value of currency in foreign exchange market. Assume two country economy with Japan and US. At 2% inflation rate in the US, all US goods will increase by two percent. So a $100 item would cost $102. Japanese demand for US goods will decrease due to higher prices ($2 more). This means Japanese demand for USD will decrease. Similarly assuming no price changes (inflation) in Japan it will now be cheaper for US citizens to buy Japanese goods. This happens because prior to inflation when US citizens were buying US goods they were giving up $100 worth of Japanese goods. But now they will be giving up $102 worth of Japanese goods (remember no inflation/price changes in Japan). So it makes Japanese goods cheaper. As US citizens seek to buy more Japanese goods, this will increase the supply of USD in foreign exchange market. This will depreciate the value of USD in foreign exchange market. Following tables shows how important the effect of inflation is in the foreign exchange market [source: Economics: A Survey]. Inflation alone accounts for most of the changes in the value of the currency.
Now, let's look at the affect of government borrowing on currency value. Let's say that US government decided to cut taxes but not its budget. Now it has to finance this budget by borrowing more. This will increase interest rates. Higher interest rates will attract foreign investors to invest in US. US citizens who were going to invest in foreign countries are now going to invest in US as they are also attracted by higher return. As foreigners try to invest in US, they will increase the demand for USD and US citizens investing more in US rather than a foreign country will reduce the supply of dollars. Both of these actions will result in dollar getting appreciated in foreign exchange market.
Now here is the fun part. An appreciation in USD means that relative price of US goods has increased for foreigners. Let's say if a Japanese was paying 100 Yen to buy a $1 in US goods, then he might now have to pay 105 Yens to buy $1 in US goods. This will result in a decrease in US exports. Also for US buyers imports will become cheaper.
What this means is that, starting with a balanced budget and trade balance, when government decides to increase borrowing to fund its budget deficit, it increases interest rates, which result in inflow of capital into the country, reduces the outflow of capital, but at the same time increases imports and reduces exports thereby increasing the trade deficit.
I can write pages and pages about this, but in a nut shell, the price of a currency in terms of another currency is determined by three main factors described above. To see whether a currency has appreciated against or depreciated one should look against a basket of currencies to see the real change. For example, to see if USD has really depreciated in foreign exchange market, one should compare USD against not only Yen, but also against Euro, Pound Sterling, Australian Dollar, Canadian Dollar and currencies from similar stronger economies.
In the next post I'll explain what happens to USD that are used for oil trading in international markets and what will happen if countries decide to use a different currency for trading oil. I'll also write about how Chinese government controls the value of Yuan and US government's charge that it manipulates its currency to help its exports (I have already explained above how depreciated currency helps exports).
To make currency exchange simple, I'll use an example of currency exchange between two countries. Let's say US and Japan. The reason I chose Japan is because both US and Japan are strong economies and both have a lower inflation rate. It will make things simple to understand. Although in recent years Japan has experienced a deflationary cycle but I think its still a good example. Inflation rates for different countries. Let's jump in.
Money is just a commodity like all other commodities that are traded. So the price of one currency in terms of another currency in foreign exchange market is determined by its supply and demand. There are three major components of supply of USD in foreign exchange market.
1. Individuals and companies seeking to buy foreign merchandise (US imports).
2. US citizens and institutions buying foreign financial assets, for example US investment banks buying German bunds or US companies setting up factories or acquiring companies in a foreign country.
3. Foreign owners of US based factors of production seeking to convert their dollar factor into foreign currency.
Similarly demand for dollar has three major components
1. Individual and companies based in foreign countries seeking to buy US merchandise (US exports).
2. Citizens of foreign countries and foreign institutions buying US assets, for example US treasury bonds or foreigners investment in US companies (either through stock market or foreign direct investment)
3. US owners of foreign based factors of production seeking to convert their foreign currency into USD. For example if Apple decides to bring its $85B cash to US it would need to convert money held in foreign currency into USD.
Basically the above mentioned factors decide the price of USD in foreign exchange market. Let's first analyze the affect of inflation on the value of currency in foreign exchange market. Assume two country economy with Japan and US. At 2% inflation rate in the US, all US goods will increase by two percent. So a $100 item would cost $102. Japanese demand for US goods will decrease due to higher prices ($2 more). This means Japanese demand for USD will decrease. Similarly assuming no price changes (inflation) in Japan it will now be cheaper for US citizens to buy Japanese goods. This happens because prior to inflation when US citizens were buying US goods they were giving up $100 worth of Japanese goods. But now they will be giving up $102 worth of Japanese goods (remember no inflation/price changes in Japan). So it makes Japanese goods cheaper. As US citizens seek to buy more Japanese goods, this will increase the supply of USD in foreign exchange market. This will depreciate the value of USD in foreign exchange market. Following tables shows how important the effect of inflation is in the foreign exchange market [source: Economics: A Survey]. Inflation alone accounts for most of the changes in the value of the currency.
Now, let's look at the affect of government borrowing on currency value. Let's say that US government decided to cut taxes but not its budget. Now it has to finance this budget by borrowing more. This will increase interest rates. Higher interest rates will attract foreign investors to invest in US. US citizens who were going to invest in foreign countries are now going to invest in US as they are also attracted by higher return. As foreigners try to invest in US, they will increase the demand for USD and US citizens investing more in US rather than a foreign country will reduce the supply of dollars. Both of these actions will result in dollar getting appreciated in foreign exchange market.
Now here is the fun part. An appreciation in USD means that relative price of US goods has increased for foreigners. Let's say if a Japanese was paying 100 Yen to buy a $1 in US goods, then he might now have to pay 105 Yens to buy $1 in US goods. This will result in a decrease in US exports. Also for US buyers imports will become cheaper.
What this means is that, starting with a balanced budget and trade balance, when government decides to increase borrowing to fund its budget deficit, it increases interest rates, which result in inflow of capital into the country, reduces the outflow of capital, but at the same time increases imports and reduces exports thereby increasing the trade deficit.
I can write pages and pages about this, but in a nut shell, the price of a currency in terms of another currency is determined by three main factors described above. To see whether a currency has appreciated against or depreciated one should look against a basket of currencies to see the real change. For example, to see if USD has really depreciated in foreign exchange market, one should compare USD against not only Yen, but also against Euro, Pound Sterling, Australian Dollar, Canadian Dollar and currencies from similar stronger economies.
In the next post I'll explain what happens to USD that are used for oil trading in international markets and what will happen if countries decide to use a different currency for trading oil. I'll also write about how Chinese government controls the value of Yuan and US government's charge that it manipulates its currency to help its exports (I have already explained above how depreciated currency helps exports).
