Wednesday, September 7, 2011

What are Currency Exchange Rates and Why do they Keep on Changing?

Economics – and anything remotely related to it – has always seemed to me like something that I ‘just don’t’ and ‘just won’t’ understand – and therefore, I just accepted it. I experienced it as a ‘big scary monster’ that I should try to steer away from as much as possible – and that’s exactly what I did. Consequently, I remained unaware of the mechanics of the economic system and interacted with it on a strictly ‘need-to-know’ basis.

And so – for instance – up until a few days, I had actually no clue of what ‘currency exchange rates’ are. As most people, I’m aware of how they play a role in calculating the value of a good or service from one currency to another – or how, when I go abroad and require cash in a different currency, the amount of foreign currency I receive, will be calculated according to these currency exchange rates. But – what they actually are and why they keep on changing: nope, no idea.

So – what are currency exchange rates? To answer that question – we first require to have a closer look at international trade – meaning: imports and exports.

As you are probably aware, not all products that are consumed within a certain country, are necessarily produced within that country. To gain access to goods and services that are not available – or not cheaply available – within the borders of one’s own country, products are imported from abroad.

As with any product being sold on a market – an exchange takes place. We exchange money for goods and services – and the same applies to imports (goods imported from abroad). Now, how does this work. Let’s illustrate it with a fictional example: when corn is imported from South Africa to Belgium, Belgium – or someone in Belgium – will require to pay for this corn in South African Rands. To be able to do that, the buyer will need to acquire South African Rands, because Euros are not a valid means of exchange in South Africa. And – like most things in this world: South African Rands can be acquired, through paying for them.

Indeed – what happens whenever one wishes to purchase goods from a country where your currency is not valid – is that you first have to buy the other country’s money, so that you’re able to use that money to make payments in the other country.

In the example of a Belgian buying corn from South Africa: The Belgian will first require to buy South African Rands with his Euros. Only once he has bought the South African Rands, can he proceed with purchasing the corn in South Africa.

‘Naturally’ – when we’re on holiday and we buy an ice-cream using our credit card, for instance, we don’t experience it as though we first buy foreign money and then, with the foreign currency, buy our ice-cream – both transactions, the exchange of currencies and the purchase of the ice-cream, happen simultaneously. However, it is important to understand that the exchange of one currency to another operates according to the same principles as any other purchase in the ‘free market’ economy. Currencies are goods that that are bought and sold – so, an exchange rate is really nothing else but the ‘price’ of a particular currency, expressed in a different currency. That wasn’t too bad, now, was it?

Now – the second question: why do exchange rates change all the time?

The answer to this question is implied within the answer to the question of what an exchange rate is: it is a price – and as such, it is subject to the two major ‘forces’ in the ‘free’ market economy, namely: supply and demand.

So – let us have a brief look at what is referred to by ‘supply’ and ‘demand’ and how those two act as ‘forces’ that influence prices. Again, I’ll illustrate with a fictional example:

Let’s say that on the market of apples, there are 5 available apples, but there are 10 people who each want to buy an apple. We say that 5 apples are supplied and 10 apples are demanded. How, within the ‘free’ market economy, is it determined who gets an apple and who doesn’t? Through the price of the apple. What is done in a situation where the quantity demanded exceeds the quantity supplied, is – the price is adjusted in such a way that the quantity demanded drops and becomes equal to the quantity supplied. In apple-terms: There are 5 apples supplied (quantity supplied) and 10 apples demanded (quantity demanded) – what the seller/supplier will do, is adjust the price in such a way that only 5 apples are demanded – thereby equalising the quantity of apples demanded (from 10 to 5 apples) to the quantity supplied (5 apples). (If you have to read the above paragraph a few times to understand it clearly: do so.)

How will the price be adjusted to drop the quantity demanded? The price will be raised. Why? Because the general rule is that at a lower price, the quantity demanded increases and at a high price, the quantity demanded decreases. You can relate this to your own experiences: when something is cheap, you’ll be inclined to buy more of it than when it is expensive. For instance, when there are sales on clothes, you may come home with 5 full bags of newly purchased clothes when, usually, you would maybe only buy a few items at a time. So, when 10 apples are demanded and 5 apples are supplied, the supplier will increase the price of an apple, until only 5 people are left who are willing to pay the higher price.

Logically – if 10 apples are supplied but only 5 apples are demanded, the opposite will happen. A supplier wants to sell all of his 10 apples. So – to get more people to be willing to buy his apples, he will lower the price of an apple, until 10 people are willing to pay the lower price. Again, herein equalising the quantity demanded (from 5 to 10 apples) to the quantity supplied (10 apples).

So – now you understand the principles of supply and demand and how they influence prices.

Since a currency exchange rate is nothing more than the price of a certain currency, exchange rates are subject to supply and demand as well – and that is why currency exchange rates change all the time; due to changes in the quantity demanded and the quantity supplied.

In our example:

The more foreign countries want to import corn from South Africa, the higher the quantity of South African Rands demanded (remember, they first have to buy the currency before they can pay for the corn with it), the more the price of South African Rands – or the exchange rate – will rise.

The less foreign countries want to import corn from South Africa, the lower the quantity of South African Rands demanded, the more the price of South African Rands – or the exchange rate – will fall.

There – doesn’t that make economy look a whole lot less scary already?

If you’re not satisfied with the current economic system and the consequence of it within the world, it is important to investigate how it works and to stand equal and one with those that are currently running the show. The first step herein is to educate ourselves on how the system operates and how they’re manipulating it to suit their needs. Even if economy seems like a big, scary monster: it’s not – it’s just another system.

3 comments:

  1. Awesome simple explanation - thanks Maite!

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  2. cool Maite, i finally understand chinese!

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