7/24/2016
FOREIGN EXCHANGE MARKET
Significance:
Students need to understand that there is a “market” for currencies in the same way that there is a
market for vegetables, stocks, gold, or other commodities. When an importer in America
purchases Japanese goods, the importer must determine from the world exchange market the
exchange rate between the US dollar and the Japanese yen. The Japanese exporter expects to be
paid for the cars or cameras he exports in his countries’ currency. The more Japanese goods that
an exporter sends to the US, the greater demand there will be in the world exchange market for
yen. So, if the exchange rate today is $0.01 for 1 yen and there is greater demand for yen, then
the exchange rate will move upward from $0.01 for 1 yen to perhaps, $0.02 per 1 yen. This
means that the Japanese car or camera will double in price. This is an extreme example in that we
know the price of Japanese goods don’t double in price overnight. But, if you’ve shopped for
Japanese cars at a time when they are in great demand, you know that American Honda or Toyota
dealers don’t discount the cars much at all. In fact, there are times when these cars sell at a
premium above the retail asking price. Part of this pricing has to do with the weakened dollar
versus the yen and part has to do with supply and demand.
Application:
Now, students must understand that American monetary philosophy in recent years has been to
let the dollar depreciate against foreign currency. This means that we let the other nation’s
currency demand higher and higher numbers of American dollars. That is why if you visited
Great Britain about 7-8 years ago and you wished to purchase a woolen sweater, you would have
been buying at a time when the British Pound was equal to about $1.40. Today the exchange rate
is British Pound equal to $1.48. A British woolen sweater, costing 20 Pounds that you purchased
at Harrods in London 7-8 years ago, would have cost $28 US dollars (20 times $1.40). Today, if
you bought that same British sweater for 20 Pounds, you would pay $29.60 (20 times $1.48). So,
even if there had been no inflation in the price of the sweater (the price stayed at 20 Pounds), you
would have to pay more today just because the dollar had depreciated against the Pound.
A weaker US dollar, results in other countries’ currency getting stronger or appreciating. The
natural result is that goods and services produced in foreign countries cost Americans more
money to buy. This means that more Americans turn away from foreign goods and buy American
goods. At the same time, more foreigners buy cheaper American goods. The bottom line is that
America exports more goods and services and imports less goods and services if the US dollar is
weak. This leads to trade surpluses.
The other side of the coin is that if the US dollar strengthens, then foreign currency exchange
values will become comparably weaker. This means foreign goods become cheaper for
Americans to buy while American goods become more expensive for foreigners to buy. This
results in more imports and less exports and resulting trade deficits.
Think of currency fluctuations as acting like a seesaw. If the US dollar goes down in value, the
foreign currency goes up in value. In this scenario, the US dollar weakens or depreciates while
the foreign currency strengthens or appreciates. If the US dollar increases in value, the foreign
currency goes down in value. Under this scenario, the US dollar strengthens or appreciates while
the foreign currency weakens or depreciates.
JLG