The creation of currency was one of the great steps in the history of human economic development. Without a widely recognized currency, trade is limited to the barter variety, which is limited as the two parties must be able to provide a good or service the other desires. Currency leads to a situation where nearly anyone can trade if they find it beneficial to do so, with those currency types standing in as a medium for the exchange. In the modern world, this is easily the dominant form of trade, but one issue arises in the area of international trade, varying currencies between different countries. This can create a problem as two parties who may otherwise trade with one another now find each other with different exchange media. One solution to this has been the creation of common currency zones, such as the euro zone, where many nations in Europe are on the euro. Another, more widely usable solution is to use foreign exchange markets, where one currency can be exchange for another.
The reason currency works to facilitate trade is because nearly everyone values the currency used in their area. Dollars can be used to purchase nearly everything, meaning anyone can accept them as payment knowing that they will be able to use them to purchase something of their own. However, this does not work in international trade, as countries tend to have separate currencies. An American businessman who plans on spending his money locally has little use for Canadian dollars themselves, as he is unlikely to be able to buy anything he desires from local merchants with a foreign currency. If there was no way to convert one into the other, each countries’ dollars would be worthless in the other country. An option would be for the two countries to combine their currencies. However, this plan is the source of major issues in the euro zone currently, and unless a global currency is adopted, this issue will continue to exist. The foreign exchange market steps in to allow parties in separate countries to convert their wealth into a common currency and use that for their exchange.
The foreign exchange market is just like any other market in that people come together looking to exchange currency for a good. In this case, the good people are trading for is a different currency from a foreign country. American dollars in the foreign exchange market can buy Canadian dollars, euros, Japanese yen, and just about any widely used medium of exchange in the world. The foreign exchange market is not ran by any government as a way of facilitating trade, but is a collection of self interested participants who combine to form the market that serves this global purpose. As it functions like a normal market, it should be no surprise that prices are determined the the supply and demand of respective currencies.
Prices in the foreign exchange market are referred to as exchange rates, meaning the amount of one currency you will receive for giving someone a unit of another currency. There are two types of exchange rates, real and nominal. The nominal exchange rate is the more basic of the two, referring to how much currency one can buy with another currency. For example, if one American dollar can be exchanged for two British pounds, then the nominal exchange rate is two, or from the perspective of someone in Britain, one half. The nominal exchange rate is concerned entirely with how much of one currency another can buy, while the real exchange rate focuses on price levels in the two currency zones (Pianni, 2001).
The real exchange rate is a measure of how many goods can be purchased in a foreign country with a domestic currency. If the two countries in question have the same price level, then the real exchange rate and the nominal exchange rate will be equal. The real exchange rate is calculated as the nominal rate multiplied by the quotient of the domestic price level over the foreign price level. A high nominal exchange rate suggests that a domestic currency can buy great deals of the relevant foreign currency, but a high real exchange rate suggests that a domestic currency can buy great deals of goods in the foreign country. Since currency itself is worthless, its value coming from its ability to purchase other things that do benefit a person directly, the real exchange rate is more insightful about the result of trading one currency for another.
The exchange rate is usually largely set by the purchasing power parity of the two countries. The purchasing power parity measures how much money it would take to buy the same baskets of goods and services in different countries. The nominal exchange rate should end up at this point, meaning that both parties are exchanging bundles of money that have approximately the exact same purchasing power. The purchasing power parity can be used to convert both currencies into the same value, as a certain unit of the ability to purchase, at which point the price levels should be equal according to the law of one price. In this situation, the real and nominal exchange rates are the same (Cheung, 2009).
If a situation exists in which there is a difference in price levels between two countries, the two exchange rates may differ. This could occur through government interventions such as tariffs or currency manipulation. If a country must pay higher goods for imports, then they will demand fewer imported goods and that will lower the supply of the currency on the global market. If this is combined with a system of export subsidization, to lower the prices of their goods in foreign markets and increase demand, more people will demand that currency to buy the cheaper goods. If these two happen in conjunction, the value of the country’s money will increase and at this point the differences in price levels may no longer exist.
A policy with similar albeit opposite effect to tariffs comes with export subsidization from some countries. This is where a country directly supports its domestic firms, hoping to lower the price they can sell goods for on international markets. This often occurs in American agriculture, where American farmers are able to sell their goods below production cost to other countries, while still profiting due to government support. Lowering the price for American goods will increase the demand for them, and therefore increase demand for American dollars, as the medium for purchasing these goods. This means that American dollars will eventually be able to purchase more of other currencies. Yet, this will lower the increase the price for foreigners to buy American goods when they are denominated in the currency of the relevant foreigners, lowering the demand again.
Demand for one nation’s goods is determined by similar factors that determine demand in other areas. Things such as scarcity, utility, and the prevalence of substitute goods are all factors. For example, Saudi Arabian goods, such as petroleum, are determined by the scarcity of petroleum, the lack of good substitutes for it, and the extreme utility it has to everyone. For this reason, the Saudi riyal will become more demanded as people try to use it to buy oil. If an alternative fuel ever displaces oil, or more countries begin to produce petroleum, the demand for the riyal will fall as the demand for Saudi resources fall.
One of the insights of the field of economics has been into the value of international trade that allows further specialization. With benefits like these, there is increased importance on the foreign exchange market which facilitates international trade. A perfectly functioning exchange market between countries with perfectly functioning economies should end up with exchange rates at the price difference between the two. This means that both sides are exchanging their currencies for the exact amount of purchasing power, denominated in a foreign currency.
Cheung, Y. (2009). Purchasing power parity. In K. A. Reinert (Ed.), The Princeton Encyclopedia of the World Economy (p. 942). Princeton: Princeton Publishing Press.
Krugman, P. (n.d.). What determines exchange rates: Supply and demand for foreign exchange. Retrieved from http://web.mit.edu/14.02/www/krugman/1026LEC.pdf
Pianni, V. (2001). Exchange rate: A key concept in economics. Retrieved from http://www.economicswebinstitute.org/glossary/exchrate.htm