For quite a while I had wondered about what the news published every day meant when they talked about Exchange Rates between currencies. With confusing word games like: The Dollar “slides”, “falls”, “rises”, “drops”, “gains”, up and downs, etc., I found it very difficult to understand what that was. But after some necessary Economics lessons I think I finally got the point and now I think that, either certain writers in newspapers don’t what they are talking, or they just have the firm objective that people must not be able to understand what they write about.
To elaborate on this small exercise I will use a model, meaning a simplified version of reality, and for that purpose we will assume that there are only two countries: USA and Europe (the countries with Euro as currency). Now, to understand a bit the context and the macroeconomic factors that affect exchange rates we have to keep in mind the following…
First… broadly speaking the situation is as follows: there is Foreign Exchange Currency Market, which is an entity where you can buy “wholesale” currency. Customers of this market are Governments that buy foreign currencies for their international reserves, Corporations, Investors, etc. And on the other side for the mortals there are exchange houses and banks where let’s say we can buy “retail” currency. For explanatory purposes we will refer to ourselves as INVESTORS y assume we account for transactions of large amounts of money.
Second… each country’s has in circulation a certain amount of money in diverse forms . Just as a curious fact, USA´s physical currency in circulation (bills and coins) accounts for roughly 3% of the total amount of their money supply in the system. The larger slice of the pie exists in “virtual” form distributed among computer transactions between Central and Commercial banks. Here we are actually getting into the concept that money can be created out of thin air and with no back up, that although indeed interesting, for purposes of explaining Exchange Rates it´s not necessary to know for now. Let’s be happy with knowing that in a given country there is a certain amount of money in circulation issued by Central Banks like Banco de México, Federal Reserve of the USA (which is not more federal than FedEx is), European Central Bank, etc. and that this amount is fixed.
Third… one of the most common ways in which Governments rise capital is by issuing Bonds, which is nothing else than an IOU. I mean that as INVESTORS, we give money to a given Government and they give us a paper stating that they will pay back our invested capital + an interest due in a certain period (could be months or years). This mechanism is similar, perhaps identical, to how public corporations raise capital, although for purposes of keeping the model simple we will talk of the context of countries and as agreed, to the figure of INVERSTORS that can place enormous amounts of currency in any of the two countries of our model.
This is when things start to turn interesting… let’s think about the mortgage problem in the USA that started the current economic crisis, that created uncertainty among INVERSTORS, and in attempts to reduce the risk of their investments turned to other markets like Europe that seemed more solid (I mean that it would provide higher returns or simply higher payback certainty). As INVERSTORS, let’s say we have dollars in the pocket or Treasury Bonds of the USA that we can cash and with no intention of reinvesting because of the situation described. So we think it could be more convenient to invest (that when I say INVEST, I mean nothing but selling a currency to buy another one) let’s say in Euro. Why Euro?, of course because in our model there are only two countries, but real reasons could be for example that the economy shows more stable of favorable balance than in the USA, industrial output is increasing, etc, etc, etc.
Now that we decided to invest in Euro, what happens is the following… watch out, the trick is here and is the most simple supply and demand reason in the world… If we imagine we walk into a bar where there are more men (Dollars) than women (Euro), for men it would be more “expensive” get any of the woman in there, so woman would be appreciated in relation to men. While from the woman’s perspective, it would be more “cheap” to get any of the men, meaning that men in respect to women are depreciated. But let’s look a little professional and use this Symbols that took me hours to make in PowerPoint.
As illustrated in the next image, we as INVESTORS take the paper (Bond) that we bought from the USA Government and they will give us our money back + the interest gained from lending them, needless to say they will give us Dollars. Note that at this moment the money only changes hands, and in some way, its form (like cashing a check).
Now that we have Dollars in our hands, we go to the Foreign Exchange Market and we SELL those Bonds denominated in Dollars. In that precise moment what we are doing is increasing the quantity of Dollars available in the market for the rest of the INVESTORS, so by simple market rule, as Dollars supply increases, their price will decrease. While, on the other hand, when we BUY Euro, we reduce the available quantity for the rest of the INVESTORS, provoking an increase in the price for that available quantity. The following table illustrates the operation and how the available amount of Dollars increases, while the Euro’s decreases.
Since in this model there are only two countries, the currency we immediately purchase is Euro, but in reality any currency like Swiss Francs, Yen, Pound, etc. can be bought, even metals like gold (note how price of gold has reached record prices because investors are turning to it as a secure reserve in the current crisis times). This makes that permanently, virtually every second there are fluctuations among the Exchange Rates between currencies.
Currently in the crisis in Greece is provoking concerns among Investors about the returns and Governments capabilities to meet their Bond obligations in Europe, contrary to the situation of the example on the model I described. So in the first two weeks of May 2010 there has been an increase in demand for Dollar, causing it to appreciate in respect to Euro, in fact reaching levels not seen since at around 7 years ago. In respect to Mexican Peso for example, the Euro is reaching a lowest level roughly above $15 MXP per Euro, when during 2009 it reached levels of almost $20 MXP per Euro. The historical lowest and highest levels are described in the following charts with the correspondent dates.
The whole point of writing this short essay is because for us, Mexicans, we always see in the news this word game on how USD drops and rises, but we don’t even know why. The only reason why we care about it is to know how often we can go travelling or shopping to the United States. The explanation is very simple; when Investors have Bonds or Stocks in Dollars and see better returns elsewhere, they will sell those bonds to get Dollars, and then sell the dollars in the Exchange Market, making greenbacks more available for us, resulting on a lower (cheaper) Exchange Rate. This is when on any random day we wake up in the morning and see the newspaper or the T.V. saying that the Dollar “dropped” and the first thing that crosses our minds is: HONEY, LETS GO SHOPPING!!!
 Money Supply (M1) = Paper Currency + Coins + Demand Deposits at commercial banks
May 14th, 2010