Capital Flows and Currency Exchange

Posted by PITHOCRATES - March 10th, 2014

Economics 101

(Originally published July 30th, 2012)

Before we buy a Country’s Exports we have to Exchange our Currency First

What’s the first thing we do when traveling to a foreign country?  Exchange our currency.  Something we like to do at our own bank.  Before leaving home.  Where we can get a fair exchange rate.  Instead of someplace in-country where they factor the convenience of location into the exchange rate.  Places we go to only after we’ve run out of local currency.  And need some of it fast.  So we’ll pay the premium on the exchange rate.  And get less foreign money in exchange for our own currency.

Why are we willing to accept less money in return for our money?  Because when we run out of money in a foreign country we have no choice.  If you want to eat at a McDonalds in Canada they expect you to pay with Canadian dollars.  Which is why the money in the cash drawer is Canadian money.  Because the cashier accepts payment and makes change in Canadian money.  Just like they do with American money in the United States.

So currency exchange is very important for foreign purchases.  Because foreign goods are priced in a foreign currency.  And it’s just not people traveling across the border eating at nice restaurants and buying souvenirs to bring home.  But people in their local stores buying goods made in other countries.  Before we buy them with our American dollars someone else has to buy them first.  Japanese manufacturers need yen to run their businesses.  Chinese manufacturers need yuan to run their businesses.  Indian manufacturers need rupees to run their businesses.  So when they ship container ships full of their goods they expect to get yen, yuan and rupees in return.  Which means that before anyone buys their exports someone has to exchange their currency first.

Goods flow One Way while Gold flows the Other until Price Inflation Reverses the Flow of Goods and Gold

We made some of our early coins out of gold.  Because different nations used gold, too, it was relatively easy to exchange currencies.  Based on the weight of gold in those coins.  Imagine one nation using a gold coin the size of a quarter as their main unit of currency.  And another nation uses a gold coin the size of a nickel.  Let’s say the larger coin weighs twice as much as the smaller coin.  Or has twice the amount of gold in it.  Making the exchange easy.  One big coin equals two small coins in gold value.  So if I travel to the country of small coins with three large gold coins I exchange them for six of the local coins.  And then go shopping.

The same principle follows in trade between these two countries.  To buy a nation’s exports you have to first exchange your currency for theirs.  This is how.  You go to the exporter country with bags of your gold coins.  You exchange them for the local currency.  You then use this local currency to pay for the goods they will export to you.  Then you go back to your country and wait for the ship to arrive with your goods.  When it arrives your nation has a net increase in imported goods (i.e., a trade deficit).  And a net decrease in gold.  While the other nation has a net increase in exported goods (i.e., a trade surplus).  And a net increase in gold.

The quantity theory of money tells us that as the amount of money in circulation increases it creates price inflation.  Because there’s more of it in circulation it’s easy to get and worth less.  Because the money is worth less it takes more of it to buy the same things it once did.  So prices rise.  As prices rise in a nation with a trade surplus.  And fall in a nation with a trade deficit.  Because less money in circulation makes it harder to get and worth more.  Because the money is worth more it takes less of it to buy the same things it once did.  So prices fall.  This helps to make trade neutral (no deficit or surplus).  As prices rise in the exporter nation people buy less of their more expensive exports.  As prices fall in an importer nation people begin buying their less expensive exports.  So as goods flow one way gold flows the other way.  Until inflation rises in one country and eventually reverses the flow of goods and gold.  We call this the price-specie flow mechanism.

In the Era of Floating Exchange Rates Governments don’t have to Act Responsibly Anymore

This made the gold standard an efficient medium of exchange for international trade.  Whether we used gold.  Or a currency backed by gold.  Which added another element to the exchange rate.  For trading paper bills backed by gold required a government to maintain their domestic money supply based on their foreign exchange rate.  Meaning that they at times had to adjust the number of bills in circulation to maintain their exchange rate.  So if a country wanted to lower their interest rates (to encourage borrowing to stimulate their economy) by increasing the money supply they couldn’t.  Limiting what governments could do with their monetary policy.  Especially in the age of Keynesian economics.  Which was the driving force for abandoning the gold standard.

Most nations today use a floating exchange rate.  Where countries treat currencies as commodities.  With their own supply and demand determining exchange rates.  Or a government’s capital controls (restricting the free flow of money) that overrule market forces.  Which you can do when you don’t have to be responsible with your monetary policy.  You can print money.  You can keep foreign currency out of your county.  And you can manipulate your official exchange rate to give you an advantage in international trade by keeping your currency weak.  So when trading partners exchange their currency with you they get a lot of yours in exchange.  Allowing them to buy more of your goods than they can buy from other nations with the same amount of money.  Giving you an unfair trade advantage.  Trade surpluses.  And lots of foreign currency to invest in things like U.S. treasury bonds.

The gold standard gave us a fixed exchange rate and the free flow of capital.  But it limited what a government could do with its monetary policy.  An active monetary policy will allow the free flow of capital but not a fixed exchange rate.  Capital controls prevent the free flow of capital but allows a fixed exchange rate and an active monetary policy.  Governments have tried to do all three of these things.  But could never do more than two.  Which is why we call these three things the impossible trinity.  Which has been a source of policy disputes within a nation.  And between nations.  Because countries wanted to abandoned the gold standard to adopt policies that favored their nation.  And then complained about nations doing the same thing because it was unfair to their own nation.  Whereas the gold standard made trade fair.  By making governments act responsible.  Something they never liked.  And in the era of floating exchange rates they don’t have to act responsibly anymore.

www.PITHOCRATES.com

Share

Tags: , , , , , , , , , , , , , , , , , , ,