Lesson 7: International Monetary Exchange

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Concepts

• Currency exchange
• Exchange rate
• Floating exchange rates
• Demand
• Supply
• Market clearing price
• Transaction cost

Content Standards

Standard 6: Students will understand that: When individuals, regions, and nations specialize in what they can produce at the lowest cost and then trade with others, both production and consumption increase.

• Transaction costs are costs (other than price) that are associated with the purchase of a good or service.  When transaction costs decrease, trade increases.

Standard 11: Students will understand that: Money makes it easier to trade, borrow, save, invest, and compare the value of goods and services.

• As a unit of account, money is used to compare the market value of different goods and services.
• Money encourages specialization by decreasing the costs of exchange.

Lesson Overview

International trade in the 21st century is most accurately perceived as the process of billions of consumers trading with millions of producers in over a hundred countries, each producer and consumer seeking to increase the wealth necessary to improve his personal well-being, however he defines it.  “Millions of producers and billions of consumers” raises the question of how trade takes place across the borders of nations with different currencies.  In theory, consumers the world over are trading their productive efforts, or labor, for the goods and services made by producers the world over.  In actuality, of course, what consumers offer producers is currency.  Thus, an efficient mechanism of currency exchange is a necessity if nations are to take advantage of the wealth-enhancing benefits of trade.

Key Points

1. The Mechanism of Monetary Exchange – Currency Markets:  People want the currency of the nation in which they live.
   • The pay of a Nebraska schoolteacher is in dollars, U.S. currency.  If she wants to buy a Japanese television set, will she pay in dollars?  The practical answer is “yes;” the local electronics store only accepts dollars.
   • The electronics store, however, must purchase the television from the Japanese producer in yen.
     • The Japanese producer’s workers and suppliers expect to be paid in yen
     • Like the Nebraska teacher, they want the currency accepted in their community.
2. To purchase foreign goods, the retailer must first purchase foreign money.
   • The process of currency exchange in international trade is a transaction cost.
     • Economists recognize transaction costs as dead-weight costs.  That is, the cost borne by the buyer confers no benefit on the seller.
   • Markets generate incentives to reduce transaction costs because they inhibit exchange.
     • Currency markets facilitate international trade by reducing the cost of the exchange of currency that is necessary for trade across national borders.
     • The international currency market is very active and includes a number of large exchange banks that specialize in the buying and selling of currencies.
3. The exchange rate is the price of one nation’s currency in terms of another nation’s currency.
   • Currency markets work on the same principles of supply and demand as markets for goods and services.
   • An increase in the demand for or a decrease in the supply of a currency exerts upward pressure on the price.
     • In this situation, those wishing to purchase that currency must then pay for it with more of their own.
       • In practical terms, for the American retailer this would mean giving up more dollars for the same number of yen.
   • A decrease in the demand for or an increase in the supply of a currency exerts downward pressure on the price.
     • Thus, those wishing to purchase that currency will find themselves able to pay for it with less of their own.
       • In practical terms, the American retailer would find that it takes fewer dollars to buy the yen he needs to purchase televisions for his store inventory.
4. The exchange rate directly affects the price and quantity of a nation’s imports and exports.
   • If the price of the American dollar falls relative to the yen, Americans must use more dollars to purchase the yen that they would use to buy an imported Japanese television.  Thus, the price of the television to the American buyer has changed even though the price tag in Japan did not.
     • Suppose the price of a small TV in Japan is 10,000¥.
     • If the exchange rate is $1 = 100¥, the TV costs the American buyer $100.
     • If the exchange rate is $1 = 50¥, the TV costs the American buyer $200.
5. In the current system of flexible exchange rates and readily available information, the exchange rate of currencies reflects the relative values of goods and services in the economies of the trading countries.
   • Suppose it takes $1 to buy 2 euro or 100 yen.  In that case $1, 2 €, and 100 ¥ will buy roughly the same goods in the U.S., France, and Japan.
6. Changes in relative purchasing power affect the demand for currency, and thus, the exchange rate.
   • Suppose $1 can be exchanged for 100¥.
   • Suppose $1 buys 1 loaf of bread in the U.S., but 100¥ buys 2 loaves in Japan.  Dollar holders will want to buy yen in order to buy more bread (or other goods and services) for their money.
   • This increased demand for yen by dollar holders will bid up the price of yen.
     • Dollar holders will have to pay more than $1 to get 100¥.
     • (And yen holders will be able to get more than $1 for 100¥.)
7. Expectations also play a large role in determining the demand for, and therefore the price of, various nations’ currencies.  The predictions of the future by individual buyers and sellers of currency, cause changes in exchange rates that cannot be explained by relative values of goods and services.
   • The demand for the currencies of nations with stable economies and governments tends to remain high compared to the demand for the currencies of nations undergoing serious political unrest or economic instability.
   • Catastrophic events or evidence of major progress may change expectations and decrease or increase the demand for various currencies.
   • Expectation of inflation in a nation is likely to decrease the demand (and therefore the exchange rate) of that nation’s currency.
     • Inflation reduces purchasing power of currency and therefore reduces willingness to hold or store assets in the form of that currency.
     • Suppose that the U.S. is expected to have a higher rate of inflation than the European Union in the coming year, meaning that the purchasing power of the dollar is expected to decline faster than the purchasing power of the euro.
       • The demand for euro will increase, and the current price of the euro will rise relative to the dollar.
       • The demand for dollars will decrease, and the current price of the dollar will fall relative to the euro.
8. The History of Currency Exchange and the Issue of Fixed vs. Floating Rates:  From the end of WWII until 1971, all the major world economies operated under the Bretton Woods System of fixed exchange, under which exchange rates were set by governments rather than through currency markets.
   • Under this system, countries were to intervene in the exchange market to keep their own currencies trading at the agreed upon fixed rate.
     • “Intervention” in the currency market is simply the government or central bank of a nation buying and selling its own currency in currency markets in order to maintain the fixed exchange rate.
9. The advantages of a fixed exchange rate include the stability and predictability of future exchanges.
   • Fixed exchange rates stabilize the prices of imports and exports, allowing more confident future planning on the part of sellers of imports and producers for the export market.
     • Under floating exchange rates, a rate change directly affects the price and, therefore, the quantity of imports and exports.
     • Suppose the dollar rises relative to the yen, meaning that the dollar will purchase more yen.  The price of goods imported from Japan will fall, resulting in increased competition to domestically priced goods.
     • The rising dollar also means that Japanese will have to pay more for dollars, so the price of American exports will rise in Japan, resulting in a decrease in the number that Japanese people will buy.
     • Neither those U.S. companies producing for the domestic market nor those producing for export likes to deal with the uncertainties of frequent and unpredictable movements in the exchange rate.
   • The Bretton Woods System worked well for many years and international trade expanded at roughly twice the rate of domestic production.
     • In addition, this managed and predictable system contributed to international specialization and a substantial rise in levels of real income.
10. Nonetheless, the disadvantages of the Bretton Woods System outweighed the advantages.  By 1971, the combination of managing domestic monetary policies and maintaining fixed exchange targets proved too burdensome.  The U.S. was the first to abandon the system and most other major countries quickly followed.
    • Fixed exchange rates offer no effective way to deal with the differences in relative growth rates, rates of inflation, and uneven domestic policies among countries.
      • A nation might find, for example, that its effort to increase employment by developing export industry jobs is hampered by the buying and selling of currency necessary to maintain the fixed exchange rate.
      • As the United States pursued domestic policies designed to deal with the Vietnam war and high inflation, the requirement of managing monetary policy to maintain a fixed exchange rate burdened the effort to pursue domestic policy goals, and the Nixon administration announced that the U.S. would allow the dollar to float on the international exchange.
11. Fixed vs. Floating exchange:  While the debate continues in some quarters, there is little likelihood of return to a fixed rate system.
    • Countries still intervene from time to time to help keep currency exchange rates relatively stable, but they usually will not fight too hard to keep the rates from moving to new levels that more accurately reflect current relative prices and expectations.
    • Currently, the Peoples Republic of China is the only major economy on a fixed rate system.  Although the Chinese government occasionally gives into pressure from the U.S. and other developed countries to revalue its currency to more accurately reflect purchasing power, there is no indication that China will adopt a floating exchange rate in the near future.
12. Currency Exchange in Current Events:  The EU and Transaction Costs:  Currency exchange is a transaction cost, one of the “hassles” of buying or selling beyond the costs represented by the money price.
    • The $1 million price paid by an importer for a shipment of cars does not reflect the currency transaction cost.
      • The true cost of the deal is the $1 million price + the transaction cost – in this case, the cost of changing dollars for a foreign currency
      • Transaction costs inhibit exchange, reducing the total volume of trade, and consequently the creation of wealth.
13. The formation of the United States under the Constitution eliminated some key transaction costs, promoting economic growth in the process.
    • Transaction costs in domestic trade among the states are reduced by:
      1. use of a single currency in all states, and
      2. governing a vast area and population by the same laws and policies.
14. The European Monetary Union is, in a very important sense, an effort to create similar conditions in order to foster economic growth throughout Europe.
    • The perceived benefits of economic unity have provided a strong incentive for the formation of the European Monetary Union.
      • Monetary policy for all member nations is centralized through the ECB, or European Central Bank.
      • Adoption of a single currency is an effort to reduce transaction costs of exchange and thereby foster specialization and trade among member nations just as the common use of the dollar fosters growth in the states of the U.S.
      • On January 1, 1999, the euro (€) became the currency for the (then) 11 member nations of the European Monetary Union:
        • Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal, and Spain
        • Greece joined in 2000 and adopted the euro in January, 2001.
    • Currently in use for all electronic transactions, the euro has also completely replaced the domestic currencies of the 12 European nations.
      • January 1, 2002, the following steps to implementation of the euro were in place:
        • Euro banknotes and coins were placed into circulation.
        • Member states completed the changeover to use of the euro in public administration.
        • Member states began withdrawing from circulation all national banknotes and coins.
    • By February 28, 2002, all national banknotes and coins were finally withdrawn from use, ending the period of dual (national currencies and euros) circulation.
      • For a full timetable of the introduction of the euro and information about upcoming adoptions of the euro, see http://ec.europa.eu/economy_finance/euro/our_currency_en.htm (10/03/06)
    • If successful, the Euro will more accurately reflect the relative value of goods and services in European countries, eliminate expectation factors in the demand for currency and, most importantly, eliminate the need for currency sales and purchases among member nations.
    • The number of nations in the European Monetary Union remained at 12 in January of 2006.
15. Preliminary indications are that the euro has helped the EU lower transaction costs, but the introduction is far too recent to draw any overall conclusions as to its success in fostering European economic growth.
    • Complicating factors still include the realities of dealing with individual countries with independent cultures, laws, and domestic policies.

Lesson 7 Activity:  Foreign Currency and Foreign Exchange