Posted on by Art Powell

Foreign exchange and trade is hardly a sexy subject and it is one most of us would prefer not to think about. However, when people get excited about globalization or fear their jobs are threatened by trade, then we need to take it seriously.

Foreign exchange involves the financial transactions which go with trade with other countries. Economics is a social activity and involves relationships even if some are very fleeting. For any relationship to be satisfactory there needs to be a more or less equal two-way exchange. This applies to trade with people from other countries. Trade should be a two-way.

In analysing economic issues it is important to distinguish between physical transactions and financial transactions because sometimes the physical analysis gives a clearer picture than the financial analysis. If this world had a perfect market economy each physical trade with a foreigner would be matched by a financial transaction. Changes in prices would reflect changes in supply and demand and would be signals to producers to increase or decrease production or to even stop producing an item. This is true for domestic trade as well as international trade.

As exchange rates are based on supply and demand for currencies, financial only transactions distort the exchange rate and therefore distort prices. Not good.

An interesting approach to foreign exchange is the Big Mac index created by The Economist. I like this because it is based on a physical item, the big mac hamburger, sold around the world. If we had international perfect competition and everything were equal a big mac would cost the same in each currency. The Economist compares the costs at current exchange rates to determine if a currency is over or under valued.

Obviously the world is not equal. Different countries have different values, different resources and different access to energy and mineral resources.

What happens if money is loaned or gifted from one country to another. If the recipient uses the money to purchase goods or services from the first country, then the money becomes a part of the foreign exchange calculations. If it is kept in foreign currency reserves, it is removed from the money supply of the first country until it is used. If the money is exchanged and used to purchase local goods and services, it distorts the exchange rate. If the money is kept and used to purchase local goods and services, it adds the second country’s money supply and subtracts from that of the first country.

Another complication is that a lot of people speculate about what will happen to the price of one currency in terms of another. These transactions will be financial only in that they do not match exchanges of goods and services. It could be that speculation smooths out fluctuations or they could distort prices. It is hard to know as we do not know which transactions are speculative. We do know that the volume of foreign exchange trades is massive. This writer suspects that if all financial transactions matched physical trades there would be little fluctuations in exchange rates as changes would take time.

This blogger has spent a lot of time and effort in trying to understand the economics of money, including a degree at the University of British Columbia. Foreign exchange and trade are difficult probably because there are problems in the way in which we create money. For more on this please get a free copy of my e-book Funny Money: Adapting to a Down Economy. One of the problems is that our way of creating money gives some people a lot of power and control over others. Vested interests are difficult to deal with.

Share this: Facebook

LinkedIn

Twitter

Email

Print

Reddit

Tumblr

Pinterest

Pocket

Telegram

WhatsApp

Skype

Like this: Like Loading... Related

Filed under: Economics | Tagged: Big Mac index, Economics, finance, foreign exchange, money, relationships, speculation, trade |