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  • You know, to understand exchange rates, you really need to grasp one concept: foreign

  • exchange, i.e., foreign money, is really just another commodity to be bought and sold. This

  • is where the term foreign exchange market comes from. It’s a market, so there must

  • be those who want to buy the currency, and those who supply it.

  • On the demand side, what reason (or reasons) could people possibly have to want to purchase

  • foreign exchange? Well, there are three major reasons really: First, people want foreign

  • money for travel and tourism; second, foreign money is needed for trade, to buy foreign

  • goods and services; third, foreign money is needed for investment purposes, be it financial

  • investment, like purchase of foreign-denominated financial assets, or real investment, like

  • building a new factory overseas. A change in any of these three components will alter

  • the demand for foreign exchange.

  • For example, a lot of recent Hollywood blockbuster movies have been filmed in New Zealand; what

  • if this creates a sudden surge in tourists going to New Zealand? These tourists will

  • need New Zealand dollars, creating an increase in demand for that currency. Similarly, if

  • US companies decide they’d like to build factories in New Zealand (real investment),

  • or purchase NZ$-denominated financial assets (financial investment), the demand for the

  • New Zealand dollar would increase.

  • Now let's go back to the idea of the foreign exchange market, with the New Zealand dollar

  • being the foreign exchange. Initially, there is a certain supply of New Zealand dollars,

  • and a certain demand. The equilibrium price in this market is called the exchange rate.

  • OK; now let's throw the increase in demand for the New Zealand dollar into the picture.

  • What happens to the value of the New Zealand dollar as more tourists travel there, or as

  • more US companies invest? As with any commodity, when the demand for the New Zealand dollar

  • increases, its value increases. We see the exchange rate, in terms of the US dollar per

  • New Zealand dollar, increase. This is called an appreciation of the New Zealand dollar.

  • When dealing with bilateral exchange rates like this one -- that is to say, the relative

  • value of two currenciesit is necessarily the case that is one currency becomes stronger,

  • or more valuable, relative to the other -- in this case, the New Zealand dollar is increasing

  • in value relative to the US dollar -- the other currency is decreasing in value, or

  • depreciating. In this example, as the New Zealand dollar appreciates, the US dollar

  • is getting relatively weaker, or depreciating.

  • OK, so changes in demand for currency will affect the exchange rate. What about changes

  • in supply? Well, ultimately who is it that controls the supply of foreign currency? The

  • foreign government. If the US wanted to drive the value of its own currency up, it would

  • decrease the supply of dollars. If it wanted to drive value down, it would increase the

  • supply of dollars. Why would a country one manipulate its own currency value?

  • Let me give you an example. Suppose you are a US furniture producer, and government protection

  • for the spotted owl means you can’t get the lumber that you need domestically. So

  • you call up a Canadian lumber mill, tell them you’d like to place an order, and they tell

  • you that the lumber is going to cost CAN$50,000. I don’t know about you, but my bank account

  • doesn't happen to have any Canadian dollars in it. This is where the exchange rate comes

  • in. If I can figure out how much one Canadian dollar costs, then I can use that to calculate

  • how much 50,000 Canadian dollars will cost. The price of one Canadian dollar, in terms

  • of US dollars, is the exchange rate (dollars per Canadian dollar). I checked the dollar

  • per Canadian dollar exchange rate for April 7, 2010 on, and found that CAN$1

  • was equivalent to US$.998.

  • Just as a side note, this nearly one-to-one parity between the two country’s currencies

  • is highly unusual. More on that in a minute.

  • So if one Canadian dollar costs 99.8 cents US currency, how much will CAN$50,000 cost?

  • In the end, it will cost you US$49,900 to purchase the Canadian lumber. Now let’s

  • take a little trip back in time, and figure out how much that same C$50,000 worth of lumber

  • would've cost in April of each year for the previous 20 years. When would you most like

  • to have purchased that lumber? You can see by looking at the data, that when the foreign

  • currency is the cheapest, in this case 2001, at $.64 per Canadian dollar, the foreign imports

  • are the cheapest -- US$32,000. Even if the Canadian lumber mill sees the same CAN$50,000

  • every year, the price to the US importer changes as the exchange rate changes. When the Canadian

  • dollar depreciates, the lumber is cheaper, and US importers will buy more lumber. On

  • the flip side, as the Canadian dollar depreciates, the US dollar is getting stronger relative

  • to the Canadian dollar, or it’s appreciating. While US consumers are enjoying a strong dollar

  • and buying lots of Canadian goods, Canadians are seeing the US dollar, and therefore US

  • goods, as more expensive. Canadians import fewer US products if the Canadian currency

  • is weak. A weak Canadian dollar is good for Canada's trade balance, as Canada's exports

  • rise and imports fall. At the same time, the US trade balance gets worse -- we are importing

  • more and exporting less.

  • The effect of the currency value on the trade balance takes me back to the question: why

  • would a country want to manipulate its own currency value? You now know the answer to

  • this; if a country can keep its currency cheap, then it keeps its products cheap, and foreign

  • products expensive -- both of which are good for the balance of trade.

  • The US has certainly been after China during the first decade of the 21st century; China

  • keeps its currency value artificially low in order to keep favorable trade balance.

  • NEXT TIME: Comparative advantage and trade

You know, to understand exchange rates, you really need to grasp one concept: foreign

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B1 US dollar canadian currency zealand foreign exchange

(Macro) Episode 33: Exchange Rates

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    張強 posted on 2015/08/04
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