How Do Currencies Work In The New Global Economy? Flashcards
What determines the price of a currency?
Law of supply and demand.
The more a currency is sought after by importers, foreign travelers and speculators, the more the value goes up
When a country imports significantly more than it exports, currency value tends to go down
What is a current account?
A country’s current account measures a country’s international trade in goods and services over a given period.
Current accounts measure visible trade (rice, tv sets etc) and invisible trade (banking services etc), including financial transfers such as money sent home by citizens working abroad and interest paid on foreign debt.
The current account is balanced by the country’s capital account, which includes all transfers of money related to the sale of goods and services abroad
What is mercantilism?
The idea of mercantilism is to encourage exports while restricting imports. This usually leads to an increase in foreign reserves which can be invested abroad.
The idea is to use the money to pay for a better life for the citizens at some point in the future.
Some mercantilist countries (Japan in 1980s and china in 21st century beginning) have been forced ( by both economic and political pressure) to increase value of currency on world market by mainly changing their currency’s pegged value.
What is a pegged currency?
By intervening periodically in the currency markets, countries are able to keep their home currency trading roughly in line with the value of another currency or basket of currencies.
Most countries peg their currencies to the euro or the US dollar
Currency crashes
The power of speculators can bring down a currency by selling enormous amounts of that currency on the world’s foreign exchange markets.
Governments with weak currencies are limited in what they can do as they don’t have enough foreign reserves to support the currency by buying it back on the foreign exchange markets. And if they raise interest rates to attract investment in the country and the currency, it can bring the country’s economy to a screeching halt.
Chinese Yuan
To keep speculators from driving the yuan’s price up, china can lower interest rates. This may bring unwanted inflation but even that would spoil speculators attempts to make the yuan rise in value.
Instead of using the markets to devalue the Chinese yuan, USA and other trading partners used political pressure to convince china to “voluntarily” lower the currency’s value. This is in hopes of eradicating American trade deficit with China.
However, by calling for a rise in the yuan’s value, US was calling for a decline in the dollar’s value.
Interest rates and a currency’s relative value, and how a central bank can support a weak currency
Interest rates = major factor
High interest rates generally occur when economic growth is strong - which implies increased demand for a currency, driving up the currency’s price.
Raising interest rates attract new buyers but may have a disastrous effect on the home country’s economy, stifling growth and sending the economy into a tail-spin - which may cause the currency to decline even more.
Another option would be for the central bank to let the currency fall so that imports - made more expensive because of the local currency’s declining purchase power on the world markets - decline drastically and the trade deficit is reduced.
Unfortunately, this also leads to increase in inflation. Inflation would in return give the market another reason to sell the currency (who wants to hold a currency that’s declining in value?). This is often a vicious cycle.
Trading currencies - reasons and ways
Reasons: 1) Arbitrage 2) find safe haven in periods of economic turmoil (eg Swiss franc)
How to:
1) buy a pile of foreign currency and wait for its value against your home currency to go up
2) invest in a fund that invests in foreign stocks
3) buy American Depository Receipts (ADRs) (repackaged shares from foreign stock markets that are sold in USA as dollar-denominated shares) . Advantage is that everything is accounted for in dollars, even dividends, and the ADR’s value fluctuates with the foreign currency value of the underlying shares
3) buy certificates of deposits (CDs) denominated in foreign currencies.
4) invest in currency- related funds (often called hard currency funds) with no risk from movement in underlying securities like stocks and bonds
5) buy shares in companies that benefit from currency moves abroad
Strong currency problems
Example is the Dutch disease, where a local currency becomes overvalued because of temporary economic windfalls.
In holland, the discover of natural gas eventually led to the decline in the competitiveness of Dutch exporters. The strong currency caused a steep drop in sales abroad and lead eventually to job losses.
What is a gold standard?
A currency’s value used to be linked to an item of value (eg silver or gold)
19th century: gold standard used in Britain where gold coins in circulation could be melted down freely and exported and imports without restriction. System broke down during WWI.
1920s: system returned and collapsed again during 1930s great depression
After WWII: most countries pegged their currencies to USD or gold. In the 1950s, counties could still convert local currencies to a fixed amount of gold
1973: Smithsonian agreement of fixed exchange rates collapsed mainly because of catastrophic inflation and subsequent devaluation of the dollar following the 1972 oil shock
Currencies eventually allowed to “float” on international market, an hence mainly markets decide what the world’s currencies are worth now.
