You know, to understand exchange rates, you really need to grasp one concept: foreign
exchange, i.e., foreign money, is really just another commodity to be bought and sold.
This is where the term foreign exchange market comes from.
It’s a market, so there must be those who want to buy the currency, and those who supply
it.
On the demand side, what reason (or reasons) could people possibly have to want to purchase
foreign exchange?
Well, there are three major reasons really: First, people want foreign money for travel
and tourism; second, foreign money is needed for trade, to buy foreign goods and services;
third, foreign money is needed for investment purposes, be it financial investment, like
purchase of foreign-denominated financial assets, or real investment, like building
a new factory overseas.
A change in any of these three components will alter the demand for foreign exchange.
For example, a lot of recent Hollywood blockbuster movies have been filmed in New Zealand; what
if this creates a sudden surge in tourists going to New Zealand?
These tourists will need New Zealand dollars, creating an increase in demand for that currency.
Similarly, if US companies decide they’d like to build factories in New Zealand (real
investment), or purchase NZ$-denominated financial assets (financial investment), the demand
for the New Zealand dollar would increase.
Now let's go back to the idea of the foreign exchange market, with the New Zealand dollar
being the foreign exchange.
Initially, there is a certain supply of New Zealand dollars, and a certain demand.
The equilibrium price in this market is called the exchange rate.
OK; now let's throw the increase in demand for the New Zealand dollar into the picture.
What happens to the value of the New Zealand dollar as more tourists travel there, or as
more US companies invest?
As with any commodity, when the demand for the New Zealand dollar increases, its value
increases.
We see the exchange rate, in terms of the US dollar per New Zealand dollar, increase.
This is called an appreciation of the New Zealand dollar.
When dealing with bilateral exchange rates like this one -- that is to say, the relative
value of two currencies – it is necessarily the case that is one currency becomes stronger,
or more valuable, relative to the other -- in this case, the New Zealand dollar is increasing
in value relative to the US dollar -- the other currency is decreasing in value, or
depreciating.
In this example, as the New Zealand dollar appreciates, the US dollar is getting relatively
weaker, or depreciating.
OK, so changes in demand for currency will affect the exchange rate.
What about changes in supply?
Well, ultimately who is it that controls the supply of foreign currency?
The foreign government.
If the US wanted to drive the value of its own currency up, it would decrease the supply
of dollars.
If it wanted to drive value down, it would increase the supply of dollars.
Why would a country one manipulate its own currency value?
Let me give you an example.
Suppose you are a US furniture producer, and government protection for the spotted owl
means you can’t get the lumber that you need domestically.
So you call up a Canadian lumber mill, tell them you’d like to place an order, and they
tell you that the lumber is going to cost CAN$50,000.
I don’t know about you, but my bank account doesn't happen to have any Canadian dollars
in it.
This is where the exchange rate comes in.
If I can figure out how much one Canadian dollar costs, then I can use that to calculate
how much 50,000 Canadian dollars will cost.
The price of one Canadian dollar, in terms of US dollars, is the exchange rate (dollars
per Canadian dollar).
I checked the dollar per Canadian dollar exchange rate for April 7, 2010 on x-rates.com, and
found that CAN$1 was equivalent to US$.998.
Just as a side note, this nearly one-to-one parity between the two country’s currencies
is highly unusual.
More on that in a minute.
So if one Canadian dollar costs 99.8 cents US currency, how much will CAN$50,000 cost?
In the end, it will cost you US$49,900 to purchase the Canadian lumber.
Now let’s take a little trip back in time, and figure out how much that same C$50,000
worth of lumber would've cost in April of each year for the previous 20 years.
When would you most like to have purchased that lumber?
You can see by looking at the data, that when the foreign currency is the cheapest, in this
case 2001, at $.64 per Canadian dollar, the foreign imports are the cheapest -- US$32,000.
Even if the Canadian lumber mill sees the same CAN$50,000 every year, the price to the
US importer changes as the exchange rate changes.
When the Canadian dollar depreciates, the lumber is cheaper, and US importers will buy
more lumber.
On the flip side, as the Canadian dollar depreciates, the US dollar is getting stronger relative
to the Canadian dollar, or it’s appreciating.
While US consumers are enjoying a strong dollar and buying lots of Canadian goods, Canadians
are seeing the US dollar, and therefore US goods, as more expensive.
Canadians import fewer US products if the Canadian currency is weak.
A weak Canadian dollar is good for Canada's trade balance, as Canada's exports rise and
imports fall.
At the same time, the US trade balance gets worse -- we are importing more and exporting
less.
The effect of the currency value on the trade balance takes me back to the question: why
would a country want to manipulate its own currency value?
You now know the answer to this; if a country can keep its currency cheap, then it keeps
its products cheap, and foreign products expensive -- both of which are good for the balance
of trade.
The US has certainly been after China during the first decade of the 21st century; China
keeps its currency value artificially low in order to keep favorable trade balance.
NEXT TIME: Comparative advantage and trade TRANSCRIPT00(MACRO) EPISODE 33: EXCHANGE RATES