Exchange Rates & International Finance - The flow of currencies around the world

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I'm On burrow On, the director and distiller of More
Irish Gin. We're based here in Ireland and we export
mainly to the US and to the UK. We import
our glass for the book from the UK and our
corks from Portugal.
You may remember our gender stiller friend, Owen Bara from Ireland.
He was in our recent episode on Investment telling us
about how his business is really booming.
Owen's business hasn't just been booming at home in Ireland, though,
because More sells a lot of their delicious gin in
the US and in the UK. All of this is
good news, but it also means that Owen has to
make decisions involving different currencies in Ireland. He's used to
thinking about the Euro, but his customers in the United
States use US dollars and folks in the UK use pounds,
which they also call sterling.
We take a look at the currency markets because we've
treated in sterling, and because sterling has been so volatile,
and the same with the US dollar, it's been a
little bit nuts, so we've had to take sort of
strategic views on both.
A lot of businesses are like Owen's. They have to
factor in exchange rates when making decisions. That could be
because they're selling their products abroad or because they import
their inputs, like when Owen buys glass and cork for
his gins.
Most of us buy goods from abroad every day. We
also may work for companies who sell stuff to people
in other countries. This international trade involves changing currencies in
dealing with exchange rates and international finance and exchange rates
are our subject on this week's episode of Think Like
an Economist with Me Betty Stevenson and.
I'm just a Wolfers, we're teaching you there's super tools
of economics that will transform your globalized life. Journalist and
former economic Studentnz Trean Tepaculi fires with us.
I know it's a cliche, but we are living in
an increasingly global and integrated world, so so much of
the stuff I'm using right now while we're doing this
recording is imported from all over the world. My laptop
is from China, my microphone is from Denmark. The headphones
I'm using are Japanese and they're all made with materials
which were sourced from different countries around the world.
Co hosts, I'm an import from Australia and I'm.
From the United States. And now as you're in the
UK making a podcast for him a laya who are
in the US and are owned by a company in China.
Now it's your journalist who works for companies all over
the world. Do they always pay you in your currency pounds?
Yeah.
I get paid in a lot of different currencies, including
US dollars, and I try to be a bit strategic
about when I convert my money into pounds sterling because
sometimes fluctuations could make a difference of even a few
hundred pounds on my end.
Yeah, so that can be really significant. Last season we
were focusing on microeconomics. We looked at this through the
lens of international trade and how so many people can
benefit from trading with people in other countries.
Yes, and this was related to the theory of comparative advantage,
which is about doing a task at the lowest opportunity cost.
Right.
Remember that people should focus on producing what they are
good at and buying what they aren't so good at making,
and sometimes that means crossing international borders.
Yeah. So, say, if Japanese automakers produce cars at the
lowest opportunity cost and American farmers grow corn at the
lowest opportunity cost, then on average, people in both countries
will be better off if Americans grow corn and exchange
it for Japanese made cars.
That's right, But let's remember in reality, Americans don't directly
trade corn for Japanese cars. I mean, that would be
kind of silly, right. Instead, Americans sell corn to Japanese
buyers and use the money to buy cars from Japanese
car companies like Toyota. In all this, there's a lot
of money exchanging hands, including both US dollars and Japanese yen.
What American farmers sell corn to japan they list the
price of their corn and US dollars like right, Now,
corn currently sells for around two hundred and thirty dollars
per ton. That means that Japanese corn buyers will need
two hundred and thirty US dollars if they want to
buy a ton of corn, So the demand for corn
translates into a demand for US dollars.
A similar thing happens when Toyota is selling it's Japanese
cars to American wholesalers. They demand to be paid in yen,
which is Japan's currency, So in each case they're going
to be foreign exchange transactions involved, as people have to
convert dollars to yen or yen to dollars.
And what happens if the exchange rate changes so the
Japanese yen becomes more expensive.
It's a great question, and it really matters because even
if the price of a Toyota doesn't change, so a
Prius is fixed at say three hundred thousand yen, then
the car has still become more expensive to Americans because
it'll cost more US dollars to buy those yen to
buy that car. So maybe some Americans will switch to
cars made in the US, or buy cars from Germany
or France or somewhere else.
Yes, And so let's be clear what we mean by
the Japanese yen becoming more expensive. If the yen becomes
more expensive, this means you can buy fewer yen with
your dollars.
That's right, And it can be hard to keep this
stuff straight. So right now a dollar will buy one
hundred and six yen. If tomorrow a dollar buys you
a few a yin, say only one hundred yin, then
we'd say the yen's gotten more expensive. Or we might
say that it takes more dollars to buy any specific
number of yin, so it takes more dollars to buy
something priced in yin.
Now I have a confession to make. I have to
say that international finance can start to sound really complicated.
And you know, I always imagine like guys sitting around
and trading currencies, But it's not really about something esoteric.
It's really about how much stuff can I buy and
how much are people going to pay me for my stuff?
So think about it. If the yen becomes more expensive
than in the goods you might buy from Japan become
more expensive, that means you're going to have to spend
more of your hard earned dollars to buy Japanese stuff.
If Japanese stuff becomes more expensive, then you're gonna want
to buy fewer things from Japan. So that means America
will import fewer toyotas and other goods.
By the way, when a currency gets stronger, we say
it appreciates.
And let's remember we can also talk about the exchange
rate in another way. If we say that one dollar
today buys US one hundred and six yen, we could
also say that one yen buys US one one hundred
and six of a US dollar.
That's right. Let's cut through the numbers here to get
to the bottom line. A stronger yin means Americans will
buy fewer imports from Japan, or from the Japanese perspective,
it means they'll have fewer exports from Japan to the US.
There's actually something that is really important here. Politicians all
over the world, I think, get themselves tied up in
knots because they like the word strong. So they say, hey,
we want a strong currency, but realize it's a two
edged sword. A strong currency means that it's going to
be harder to sell your stuff abroad, so it's tough
on your exporters. It's good on your importers. You get
to buy stuff cheaper.
So some win and some lose.
I feel like people sometimes worry about other countries using
exchange rates to manipulate foreign marketplaces.
The biggest example of this is probably China, which was
accused of manipulating their exchange rate so that their currency
would be cheap. And if their currency is cheap, then
we can buy a lot of Chinese stuff really, really cheaply,
and they're hoping that gives them an edge as they
try to sell their things around the world.
So basically, Chinese manufacturers can sell more stuff because their
stuff is so cheap. American manufacturers hated this.
Yeah, it feels like anti competitive. It's no fair there's
stuff so cheap.
But remember there's always two sides to a story.
Yeah, so that means American consumers are like, whoo, everything's
really cheap, so my paycheck's going further.
This was wonderful news for people who need to buy
kids toys, for instance.
I always found it kind of funny, like we don't
usually walk into a store and say how the store
put everything on sale.
But that's what the US was saying to China. It
was saying that because the US is the store around
the corner that was losing all that business.
Yeah, that's the way to think about it, right, Who
complains about a store putting everything on sale the store
next door that doesn't want to put everything on sale?
And so the consumers were benefiting, the producers were hurting.
And that explains a lot of the politics about complaints
about China's exchange rate. Now I should add the accusation
that China was keeping its currency too cheap artificially, the
government was getting involved and pushing its exchange rate down.
There was probably a lot of evidence for that a
few years ago. It's much less clear whether they're doing
it right now.
Should we bring in our trusty friends Supply and Demand.
I figure they're going to turn up at some point.
They always do. They're so helpful, and they're so helpful
for thinking about extratrates. Supply and demander lurking in the
background here. So now, as if I'm an American farmer
selling my corn to someone in Japan, what's happening exactly?
Well, you sell your corn for two hundred and thirty
dollars per ton, and so they will need to pay
you in dollars. That means your buyer will have to
exchange their yen for dollars, which is like saying that
they're demanding US dollars on the currency markets.
That's right. So the demand for dollars comes from foreigners
looking to buy stuff in the United States. Partly this
will be stuff we export, like corn. It could also
come from foreigners looking to buy new companies or other
financial assets in the United States.
So now, now, what if the price of dollars were
really high.
If the price of the dollar were really high, then
it's going to take more yen to buy the two
hundred and thirty dollars for each ton of American corn. Therefore,
for someone in Japan, it's as though goods made in
the US are suddenly super expensive. So they're going to
buy a lot less American goods, which means they're going
to demand fewer dollars.
That's right. So there's less demand for US dollars when
the price of the US dollar is higher.
And to understand the supply side the supply of US dollars,
let's think about an American car wholesale who wants to
buy a Toyota Prius from Japan.
So they'll need to pay in yen in order to
buy that prius. So they'll supply their US dollars to
the foreign exchange market in order to buy those yen.
So the supply of US dollars comes from Americans wanting
to buy stuff from abroad.
It's all supply and demand. As and to return to
Betty's earlier question, what would change if the price of
the dollar were really high?
Okay? In that case, that means a dollar can buy
a lot more yen. So now the price of buying,
however many yen a prius costs, is a lot fewer dollars.
If the cost of Americans of buying stuff from abroad
is lower, it's like everything made abroad is on sale.
So Americans are going to want to buy a lot
more of the stuff, which means they'll be supplying a
lot more dollars exactly.
And so that's why there's more supply of US dollars
when the price of the dollar is high.
So the point is that the foreign exchange market is
much like any other market. The more expensive a currency
like the dollar is, the less of it will be demanded.
As Japanese buyers find American stuff to be too expensive,
and so they'll want to buy less American stuff and
hence fewer American dollars. However, on the flip side, the
more expensive the dollar is, the more Americans will want
to supply it so that they can buy foreign goods,
which now seem super cheap.
Yeah, so dollars are just like any other product. There's
less demand for them when they're expensive, and there's more
supply when they're expensive.
And our friends supply and demand a kind of get together.
It hit that equilibrium where supply equals demand.
So we've just started looking at our demand and supply
of currency and what that does to the exchange rate. Generally,
what a factor is the impact demand for a currency,
And let's stick with the dollars for now.
Well, what would make other countries want more dollars? Like
let's say we're asking what will make people in Japan
demand more US dollars.
I'm guessing that no one buys currencies for fun, So
Japanese people will buy more US dollars only if they're
planning or buying more things from the US. So anything
that will make them demand more American goods is going
to make them want more dollars.
If the world or the Japanese economy is booming, then
people in Japan are going to feel richer and they're
going to want to buy more stuff, including more American
corn and also American made computers and aircraft and so on.
And to do that, they need to buy more US dollars.
Learning trade barriers also affects exchange traits. Did you know
that Japan used to require American apples to be quarantined
for a period of time before they could be sold.
That basically the apples to spoil, which made the whole
enterprise of bust. Lifting these trade barriers meant that American
farmers started exporting their fruit to Japan.
Can you imagine putting an apple in quarantine. It took
me a long time to wrap my head around that
because obviously that apple is not going to do very well,
and that meant that, you know, Japanese people didn't really
demand American apples. But once we lifted those trade barriers,
what you saw was a big increase in demand for
American fruit like American apples.
Which meant an increase in demand for American dollars.
And what about the prices of goods in other countries.
Does that have an impact as well.
That's a huge factor. Say you're a Japanese consumer buying
corn from the US. Well, Brazil is also a big
exporter of corn. But if their corn suddenly becomes more expensive,
maybe they've had a drought or something, then people all
around the world will have to turn to buying American
corn instead. They'll have to buy more American dollars to
buy more American corn. Increase in the demand for dollars.
Yeah, so this is about the interdependence principle.
Exchange rates are all about the interdependence principle. They're about
global interdependence.
There's another form of interdependence that really matters, and that's
all about financial flows around the world.
Remember in our last we looked at financial markets and
stocks and bonds and all that stuff. It's really relevant
here because if foreigners buy US treasury bills, then they'll
need to buy US dollars to buy those treasury bills,
and so these financial flows are a huge part of
the demand for dollars.
So interest rates are really going to matter here. If
the US has high interest rates, well, savers from all
around the globe are going to want to try to
get at those high interest rates, so more foreigners will
want to put their money into US banks to get
a better return on their cash. So a higher interest
rate will lead to a rise in the demand for dollars.
And it's not just about putting money in the bank either,
it's about investing in companies and so therefore business profitability matters.
Anything that makes American business is more profitable will make
American companies more attractive to invest in. So anything like say,
lower business taxes will lead foreigners to want to invest
more in the United States. And to invest in the
United States means they'll have to buy more dollars.
And look, the investors want as little risk as passed,
which is why political stability is an important factor. The
US tends to be relatively stable politically compared to other countries.
It makes it really attractive for foreign investors.
And this helps solve one of those big mysteries of
international finance. Why is it that political developments in other
countries force the dollar up and down. Well, it's because
the US is regarded as a safe haven. So if
you don't like having your money in a country that's
in the midst of political upheaval. You might shift your
funds to the US, but to do that, you'll first
have to convert your money into dollars. So that's going
to increase your demand for dollars, driving up the US dollar.
Okay, so we've just talked about how political instability affects
exchange rates. I sense we may say something about expectations too,
because expectations keep coming up in microeconomics.
They absolutely do expect the changes in exchange rate really
matter because they also affect the demand for dollars. Think
about what the foreign exchange market is. In one sense,
it's thousands of speculators all trying to make a buck.
They're crunching numbers and downloading data, all trying to figure
out clues about whether the dollar is going to appreciate
or depreciate next in in news that the demand for
dollars might increase in the future will immediately send speculators
rushing to buy dollars as they anticipate that they're going
to be worth more in the near future.
I'm interested in how these exchange rate movements impact someone
like Owen, who's based in Ireland, where they use the Euro,
but he exports his gin to the US and the
UK where they use different currencies. I asked Owen what
he does to deal with all these exchange rate changes.
When the dollar is weak, because then we get more
dollars for our euros. We try and actually move money
into the States, and that's fund expansion into fund marketing
and things like that. But when the dollar is strong
against the euro, we try and move money back.
So Owen is saying, when the dollar is weak against
the euro, he's going to move his money into dollars
and spend it in the US on things that will
help grow his business in the US. This is because
when you can buy a lot of dollars with your euros,
it's going to make it cheaper for him to invest
in his business in the US, which will allow him
to promote his more Irish gin to the US market
and he'll be paying for them in US dollars.
Owen also said that he imports some of the things
used to make his gin. He talked about the glass
bottles he puts the gin in, and also the quarks
which seal the bottles. The glass bottles are from the
UK and the quarks are from Portugal.
Well, lucky for him, Portugal has the same currency as Ireland,
the euros, so he doesn't need to change any currency
to buy his clerks, but he does have to convert
his euros into pounds sterling to buy those glass bottles
from England.
Yeah.
But at the same time, Owen sells his gin in
the UK, and he told me something interesting. They do
so they're not converting money from one currency to another
all the time.
We use euros much like the rest of the Europe.
But when we sell in the UK, we sell them pounds,
and we use those pounds to buy our glass bottles
and we use them for marketing expenses for as much
as possible, so we don't try and convert back to euros. Yeah.
I think that's really interesting.
It is because whenever you change currencies, you have to
pay some fees for that service, and that costs money,
and you want to avoid that. He's pretty smart. He's
cutting out the middleman.
We're talking about all this money coming and going into
different countries with different currencies, So we're.
Going to keep track of all these inflows and outflows
through something we call a current account balance. If we
stick to the US, the current account balance will measure
all the income that Americans receive from abroad relative to
the income that Americans pay abroad, and.
So money people pay for American exports, that's got to
be a big chunk of the money coming into the US.
That's right, But it's not the whole story because there's
also investment income. So if you're an American who's bought
shares in a Japanese company like Toyota, for example, and
you get dividends from those shares, well, those dividends are
another source of foreign income into the US.
And in terms of income that Americans pay abroad, we're
talking about the money Americans spend on imports. Also, is
there investment income that goes to foreigners.
There is. Remember that foreigners might buy, say US Treasury
bills or put their money into American banks. Well, any
payout they get from those Treasury bills or those interest
payments will flow back out of the US to that
foreign investor.
It's easy to obsess about the money that's going out,
but realize there's a real benefit to Americans too. For instance,
foreigners might use their funds to build a factory in
the US. That factory employs Americans who will enjoy their
monthly pay, but the profits that factory earns go back
to its owner, who overseas. If that factory wouldn't it
have been built without foreign funding, then it's a pretty
good deal for the US.
More foreign funds, more factories.
Let's see justin there's a lot of money flowing around
in this episode. What are some exercises we can do
to really get to grips with all this.
Realize that if you're just thinking about the foreign exchange market,
it can be complicated. But the only reason whether buying
or selling foreign currencies is to do some real business
in that other country. So think about the real reasons
we're doing business with foreigners. Usually it's to buy goods
from abroad, or it's to sell goods to foreigners, and
sometimes it's also about investments. That's what drives the demand
and supply of currency.
The thing is understand that the reason why you might
see prices going up for some of the things you
buy might be because of the way foreign exchange markets
are changing. So if the dollar becomes stronger, you know,
it's actually a good time to buy the import you
like to buy. When that dollar becomes weaker, well those
things are going to be getting more expensive.
And realize, of course, that the currency is a two
edged sword. As strong a dollar is going to be
great if you're buying stuff from abroad, but you're going
to lose a lot of customers for your export markets
as well.
And what about all of these financial flows.
This is where people get tripped up a lot. They worry,
for instance, that the Japanese are buying all of America.
What's really happening is they're buying US dollars so that
they can invest in the US, perhaps putting money in
banks that will then lend that money to US businesses,
maybe building new factories. And while the profits from those
factories go abroad, the jobs those factories create will go
to Americans.
I feel like I'm going to have my eye on
a lot of foreign goods and see if their price
has changed.
Most of us knows think exchange rates only matter when
we're at the airport about to fly to another country,
but they shape the price of everything you're going to buy.
Justin's point is that it's so obvious to you when
you're you're traveling, but it's actually really shaping the underlying
things you're buying. Like, think about it, you walk into
the grocery store and it's the middle of winter in Britain,
and the fruits and vegetables you want to buy seem cheaper. Why, well,
that would mean maybe the pound got a bit stronger.
So that's letting you buy cheap fruit and vegetables in
the middle of winter, Betsy Justin, Thanks, thanks for listening.
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