Foreign Currency Markets and Exchange Rates
Every country has some kind of money. Usually a country’s money, also referred to as its currency, is called by its own unique name. For example, the United States has money called the U.S. Dollar. Japan has money called the Japanese Yen. Germany has money called the Deutsche Mark. Colombia has money called the Colombian Peso.
In most cases, it’s easy to trade one currency for another. Just as you can trade the goods you own–that is, you can trade corn for rice or high-tech steel knives or computers–you can trade one kind of money for another. All you have to do is find someone with whom to trade. Markets in which you can trade one kind of money for another are called currency markets or foreign exchange markets.
The price at which you trade one currency for another is called the exchange rate. If you can trade $1 U.S. dollar for 20 MXN (Mexican Pesos) that means you can receive 20 MXN for each U.S. dollar. Or, for each Mexican Peso, you can receive $.05. Thus, for each pair of currencies, there are two ways to describe the exchange rate. In our example, the exchange rate is either MXN20/$1 or $.05/MXN1. The exchange rate is usually quoted in terms of U.S. dollars, so the exchange rate is $.05 per Mexican Peso.
Currencies traded in markets–as they are presently for most countries–have prices that change by the minute, depending on whatever people will buy or sell them at. Such exchange rates are called flexible or floating. Historically–up until the early 1970s–exchange rates were not flexible market rates, but instead were set by governments. Government-set exchange rates are called fixed.
For example, the government of Mexico could fix its exchange rate by simply declaring that anyone who wants Mexican pesos can buy them for $.04 per peso, instead of $.05 per peso. The Mexican central bank–a government-run bank such as the Federal Reserve in the United States, which is the U.S. central bank–would guarantee the new fixed exchange rate by guaranteeing that it will buy and sell pesos at $.04 each. Compared to the market rate, that would be a great deal! Certainly, if I wanted to buy pesos, I would buy from the Mexican central bank rather than the market.
In fact, I could make a lot of money buying pesos from the Mexican central bank at $.04 each and selling them to people who couldn’t get there for $.05 each. That activity is an example of what is called arbitrage, which means that if there are two different prices for the same item, there is money that might be made by buying low and selling high so long as the transportation or transactions costs don’t eat up the difference. The upshot is that the Mexican central bank, because it is charging a rate lower than the market rate, would start accumulating dollars. If it ran out of pesos, it would have to print more in order to maintain the government guarantee.
Alternatively, were it to start to run out of pesos, the Mexican central bank could break its promise and change the rate at which it is fixing the peso to $.05/peso–the market rate. People would no longer clamor at its doorstep trying to arbitrage the peso and the government would no longer be under pressure to print up more pesos. When a government changes a fixed exchange rate, it is said to be devaluing or revaluing its currency, depending on whether the value of its currency goes down or up. In our example, the Mexican government revalued the peso: its price or value went up from $.04 each to $.05 each.
Another example of a fixed exchange rate system is the gold standard. Under a gold standard, a government fixes not the price at which people can buy and sell currencies, but the the price at which people can buy and sell gold. Doing this historically led to crises called balance of payments crises, which happened when a government started to run out of the gold it had to keep on hand to maintain its price guarantee.
Under a flexible exchange rate system, there can be no balance of payments crises; but the exchange rate can fluctuate widely from day to day, making it hard to write long-term contracts with foreigners. Both fixed and flexible exchange rate systems have pros and cons.
Definitions and Basics
Foreign Exchange, from the Concise Encyclopedia of Economics
The foreign exchange market is the market in which foreign currency–such as the yen or euro or pound–is traded for domestic currency–for example, the U.S. dollar. This “market” is not in a centralized location; instead, it is a decentralized network that is nevertheless highly integrated via modern information and telecommunications technology….
Exchange Rates, from the Concise Encyclopedia of Economics
Under the “floating” exchange rates we have had since 1973, exchange rates are determined by people buying and selling currencies in the foreign-exchange markets….
Floating and Fixed Exchange Rates, from Investopedia.com
There are two ways the price of a currency can be determined against another. A fixed, or pegged, rate is a rate the government (central bank) sets and maintains as the official exchange rate….
Unlike the fixed rate, a floating exchange rate is determined by the private market through supply and demand….
Balance of Payments, from the Concise Encyclopedia of Economics
The balance-of-payments accounts of a country record the payments and receipts of the residents of the country in their transactions with residents of other countries. If all transactions are included, the payments and receipts of each country are, and must be, equal. Any apparent inequality simply leaves one country acquiring assets in the others. For example, if Americans buy automobiles from Japan, and have no other transactions with Japan, the Japanese must end up holding dollars, which they may hold in the form of bank deposits in the United States or in some other U.S. investment….
In the News and Examples
Monetary Union, from the Concise Encyclopedia of Economics
When economists such as Robert Mundell were theorizing about optimal monetary unions in the middle of the twentieth century, most people regarded the exercise as largely hypothetical. But since many European countries established a monetary union at the end of the century, the theory of monetary unions has become much more relevant to many more people….
European Union, from the Concise Encyclopedia of Economics
The European Union (EU) includes twenty-seven countries and 490 million people. In 2005, the EU had a $13 trillion (€11 trillion) economy, a single market, and for some member countries, a single currency. A growing number of political and economic decisions are made on a pan-European level in Brussels….
Capital Flight, from the Concise Encyclopedia of Economics
There is no widely accepted definition of capital flight. The classic use of the term is to describe widespread currency speculation, especially when it leads to cross-border movements of private funds that are large enough to affect national financial markets. The distinction between “flight” and normal capital outflows is thus a matter of degree, much like the difference between a “bank run” and normal withdrawals. The most common cause of capital flight is an anticipated devaluation of the home currency. No one wants to be caught holding assets that lose 20 or 30 percent of their value overnight, so everyone tries to buy gold or foreign currency….
Nothing New on the Euro Front, by Wolfgang Kasper.
Most people around the world–laymen and seasoned investors alike–seem confused and bemused by the unfolding saga of the troubled Euro. Though I’m a distant observer of the Euro experiment, nothing has surprised me so far. …
Cowen on the European Crisis. EconTalk podcast.
Tyler Cowen of George Mason University talks with EconTalk host Russ Roberts about the European crisis. Cowen argues that Greece is likely to default either in fact or in spirit but that the key question is which nations might follow–whether Italy and Spain can find a road to economic health and honoring past debts. Cowen gives his best guess as to what is likely to happen to the euro and the European Union and the implications for the rest of the world. He explores some less likely scenarios as well. He is pessimistic about Greece and the short-run prospects for preserving the status quo, but he is optimistic in the long-run about the European Union though it may have a different structure down the road….
A Little History: Primary Sources and References
Gold Standard, from the Concise Encyclopedia of Economics
The gold standard was a commitment by participating countries to fix the prices of their domestic currencies in terms of a specified amount of gold. National money and other forms of money (bank deposits and notes) were freely converted into gold at the fixed price. England adopted a de facto gold standard in 1717 after the master of the mint, Sir Isaac Newton, overvalued the silver guinea and formally adopted the gold standard in 1819. The United States, though formally on a bimetallic (gold and silver) standard, switched to gold de facto in 1834 and de jure in 1900….
William Jennings Bryan’s “Cross of Gold” Speech: Mesmerizing the Masses, at History Matters. Transcript and audio.
The most famous speech in American political history was delivered by William Jennings Bryan on July 9, 1896, at the Democratic National Convention in Chicago. The issue was whether to endorse the free coinage of silver at a ratio of silver to gold of 16 to 1….
“You shall not crucify mankind upon a cross of gold.”
Robert Mundell, a biography from the Concise Encyclopedia of Economics
Robert Mundell was awarded the 1999 Nobel Prize in economics “for his analysis of monetary and fiscal policy under different exchange rate regimes and his analysis of optimum currency areas.”…
Studies in the Theory of International Trade, by Jacob Viner on Econlib
Economic history of international trade with a focus on mercantilism, the gold and silver bullion standards, and comparative advantage.
The History of Bimetallism in the United States, by J. Laurence Laughlin on Econlib
Economic history of the gold and silver standards at the end of the 19th century.