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 currencies – it 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 x-rates.com, 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