Like most other rates in economics, the exchange rate is essentially a price and can be analyzed in the same way we would a price. Take a typical supermarket price, say lemons are selling at the price of 3 for a dollar or 33 cents each. Then we can think of the dollar-to-lemon exchange rate as being 3 lemons because if we give up one dollar, we can get three lemons in return. Similarly, the lemon-to-dollar exchange rate is 1/3 of a dollar or 33 cents, because if you sell a lemon, you will get 33 cents in return.
So when we speak of an X-to-Y exchange rate of Z, this means that if we give up 1 unit of X, we get Z units of Y in return. If we want to know the Y-to-X exchange rate, we calculate it using the simple exchange rate formula:
Y-to-X exchange rate = 1 / X-to-Y exchange rate
Of course, the exchange rates we read in the paper or hear on radio or TV are not prices for X and Y or for oranges and lemons. Instead they're relative prices for different currencies, but they work in the same fashion. On February 26, 2003 the U.S.-to-Japan exchange rate was 117 yen, so this means that you can purchase 117 Japanese yen in exchange for 1 U.S. dollar. To figure out how many U.S. dollars you can get for 1 Japanese yen, we can just use the formula:
Japan-to-U.S. exchange rate = 1 / U.S.-to-Japan exchange rate
Japan-to-U.S. exchange rate = 1 / 117 = .00854
So this tells us that one Japanese yen is worth .00854 U.S. dollars, which is less than a penny.
Similarly if the Canadian dollar is worth .67 U.S. dollars, we have a Canada-to-U.S exchange rate of .67. If we want to know how many Canadian dollars we can buy with 1 U.S. dollar, we use the formula:
U.S.-to-Canada exchange rate = 1/Canada-to-U.S. Exchange rate
U.S.-to-Canada exchange rate = 1/0.67 = 1.4925
So one U.S. dollar can get us $1.49 in Canadian funds.
To see why these relationships must hold, we'll look at the wonderful world of arbitrage.
Suppose the Algerian dinars-to-Bulgarian leva exchange rate is 2. We would expect then that the Bulgarian-to-Algerian exchange rate would be 1/2 or 0.5. But suppose for a second that it wasn't. Instead assume that the current market Bulgarian-to-Algerian exchange rate is 0.6. Then an investor could take five Algerian dinars and exchange them for 10 Bulgarian leva. She could then take her 10 Bulgarian leva and exchange them back for Algerian dinars. At the Bulgarian-to-Algerian exchange rate, she'd give up 10 leva and get back 6 dinars. Now she has one more Algerian dinar than she did before. This type of exchange is known as arbitrage. Since our investor gained a dinar, and since we're not creating or destroying any currency, the rest of the market must have lost a dinar. This of course is bad for the rest of the market. We would expect that the other agents in the currency exchange market will change the exchange rates that they offer so these opportunities to get exploited are taken away. Still there is a class of investors known as arbitrageurs who try to exploit these differences.
Arbitrage generally takes on more complex forms than this, involving several currencies. Suppose that the Algerian dinars-to-Bulgarian leva exchange rate is 2 and the Bulgarian leva-to-Chilean peso is 3. To figure out what the Algerian-to-Chilean exchange rate needs to be, we just multiply the two exchange rates together:
A-to-C = (A-to-B)*(B-to-C)
This property of exchange rates is known as transitivity. To avoid arbitrage we would need the Algerian-to-Chilean exchange rate to be 6 and the Chilean-to-Algerian exchange rate needs to be 1/6. Suppose it was only 1/5. Then our investor could again take five Algerian dinars and exchange them for 10 Bulgarian leva. She could then take her 10 leva and get 30 Chilean pesos at the Bulgarian-to-Chilean exchange rate of 3. If she then exchanged her 30 Chilean pesos at the Chilean-to-Algerian rate of 1/5, she'd get 6 Algerian dinars in return. Once again our investor has gained a dinar and the rest of the market has lost one. For any three currencies A, B, and C, trading A for B, B for C and C for A is known as a currency cycle. The A-to-C exchange rate not only places restrictions on the C-to-A exchange rate, but it also places restriction on the A-to-B and B-to-C pair of exchange rates. Most of the time all the exchange rates on the market will be synchronized like this, but occasionally they'll become out of sync and arbitrageurs can make a profit from currency cycles.
The relative prices of currencies are not set just to ensure that profitable currency cycles do not exist. Arbitrageurs only play a small, but important, role in the value of a currency. Currencies are simply a commodity, like any other, which has a price. Since the exchange rate is simply a price, it has the same basic determinants that any other price has: supply and demand. First we'll look at supply.
Basic econonomic theory teaches us that if the supply of a good increases, and nothing else changes, the price of that good will decrease. If the supply of a country's currency increases, we should see that it takes more of that currency to purchase a different currency than it did before. Suppose there was a big jump in the supply of the Canadian dollar. We would expect to see the Canadian dollar become less valuable relative to other currencies. So the Canadian-to-U.S. Exchange rate should decrease, from 67 cents down to, say, 50 cents. Each Canadian dollar would give us less American dollars than it did before. Similarly, the U.S.-to-Canadian exchange rate would increase from $1.49 to $2.00, so each U.S. dollar would give us more Canadian dollars than it did before, as a Canadian dollar is less valuable than it used to be.
Why would the supply of a currency increase?
Currencies are traded on the foreign exchange market, and the supply of a currency on that market will change over time. There are a few different organizations whose actions will cause a rise in the supply of the foreign exchange market:
Export Companies
Suppose a South African farm sells the cashews it produces to a large Japanese firm. It is likely that the contract will be negotiated in Japanese yen, so the farm will receive its revenue in a currency with limited use outside of Japan. Since the company needs to pay it's employees in the local currency, namely the South African rand, the company would sell its yen on a foreign exchange market and buy rands. The supply of Japanese yen on the foreign exchange market will increase, and the supply of South African rands will decrease. This will cause the rand to appreciate in value (become more valuable) relative to other currencies and the yen to depreciate.
Foreign Investors
A German automobile manufacturer wants to build a new plant in Windsor, ON, Canada. To purchase the land, hire construction workers, etc., the firm will need Canadian dollars. However most of their cash reserves are held in euros. The company will be forced to go to the foreign exchange market, sell some of its euros, and buy Canadian dollars. The supply of euros on the foreign exchange market goes up, and the supply of Canadian dollars goes down. This will cause Canadian dollars to appreciate and euros to depreciate.
Foreign investment does not have to be in tangible goods such as land. If German investors buy Canadian stocks, such as stocks listed on the Toronto Stock Exchange or purchase Canadian dollar bonds, we will have the same situation as above.
Speculators
Like the stock market, there are investors who try to make a fortune (or at least a living) by buying and selling currencies. Suppose a currency investor thinks that the Mexican peso will depreciate in the future, so it will be less valuable than other currencies than it is now. In that case, she is likely to sell her pesos on the foreign exchange market and buy a different currency instead, such as the South Korean won. The supply of pesos goes up and the supply of won goes down. This causes pesos to depreciate, and won to appreciate.
Note the self-fulfilling nature of the beliefs investors hold. If investors feel that a currency will depreciate in the future, they will try to sell it today. Since the currency is being sold by investors, the supply of it will go up, and the price of it will decrease. The investor thought that the currency would depreciate, she acted on that belief and sold her currency, and the act of selling caused the depreciation to take place. Self-fulfilling prophecies such as this one are quite common in economics.
Central Bankers
The central bank of the United States is the Federal Reserve, more commonly known as "The Fed". One of the responsibilities of the Fed is to control the supply, or the amount, of currency in a country. The most obvious way to increase the supply of money is to simply print more currency, though there are much more sophisticated ways of changing the money supply. If the Fed prints more 10 and 20 dollar bills, the money supply will increase. When the government increases the money supply, it is likely some of this new money will make its way to the foreign exchange market, so the supply of U.S. dollars will increase there as well.
A central bank will often directly increase the supply of money on the foreign exchange markets. Central banks like the Fed keep a supply of most (if not all) currencies in reserve and will often use them to influence the exchange rate. If the Fed decides that the U.S. dollar has appreciated in value too much relative to the Japanese yen, it will sell some of the U.S. dollars it has in reserve and buy Japanese yen. This will increase the supply of dollars on the foreign exchange market, and decrease the supply of yen, causing a depreciation in the value of the dollar relative to the yen. Of course, the Fed cannot do this as much as it would like, because it may end up running out of some currencies. As well, the Japanese central bank (named the Bank of Japan) could decide that the Fed is manipulating the price of the yen too much and the Bank of Japan could counteract the Fed by selling yen and by buying dollars.
Why would the demand for a currency increase?
Not surprisingly pretty much the same organizations who caused supply changes will cause demand changes. They are as follows:
Import Companies
A British retailer specializing in Chinese merchandise will often have to pay for that merchandise in Chinese yuan. So if the popularity of Chinese goods goes up in other countries the demand for Chinese yuan will go up as retailers purchase yuan to make purchases from Chinese wholesalers and manufacturers.
Foreign Investors
As before a German automobile manufacturer wants to build a new plant in Windsor, ON, Canada. To purchase the land, hire construction workers, etc., the firm will need Canadian dollars. So the demand for Canadian dollars will rise.
Speculators
If an investor feels that the price of Mexican pesos will rise in the future, she will demand more pesos today. This increased demand leads to an increased price for pesos.
Central Bankers
A central bank might decide that its holdings of a particular currency are too low, so they decide to buy that currency on the open market. They might also want to have the exchange rate for their currency decline relative to another currency. So they put their currency on the open market and use it to buy another currency. So Central Banks can play a role in the demand for currency.
Supply and demand are often thought of as being two sides of the same coin. Here we see that this is the case, as in every transaction there is a buyer and a seller, or in other words, a demander and a supplier.
Now we know what agents can cause price changes and for what reasons. We can use our knowledge to analyze what happens in the "real world".
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