Foreign Currency is Money... and it's Not Money
May 23, 2014
Foreign Currency is money. Also called Foreign Exchange, Forex, and FX among others, it is the money used in other countries for daily life.
Why would anyone want foreign currency?
Sam: Hey, Louis, I need to purchase a lot of French wine. You said the shipment is one thousand Euros, €1,000. What are you going to do with all of those Euros?
Louis: I'm going to pay my workers in France. They need to purchase normal things like cars, potatoes, and books.
Sam: OK, but I only have US dollars. If today's exchange rate is $1.35=€1.00, then I will need to pay you $1,350 plus the banking fees to exchange the money. That will come to $1,450. How about if I pay you $1,400 in US dollars? I save some money, and you get a little extra!
Louis: No, thank you. I need Euros to pay my workers. I need money that I can use.
So, what is money anyway? Money is the one thing that can be traded for anything.
Jack: Hey, Jill, I'll give you 2 bushels of corn if you fix the faucet in my house.
Jill: OK, that sounds good to me. (Jill has a hog to feed at home.)
Jack: Hey, Peter, I'll give you 2 bushels of corn for a haircut.
Peter: No thanks, Jack.
Jack: OK, how about $10.
Peter: That'll do just fine.
While Jill is willing to trade corn for plumbing services, Peter is willing to trade only dollars. The reason is simple—Peter can trade that $10 for anything else he needs whether it is a new pair of scissors, three pounds of bacon, or fixing a leaky faucet. The key point here is that money can be traded for anything. As a result, money has a clearly defined value. One dollar is worth exactly $1.00. It is not worth $1.01 and not worth $0.99. It is the only thing whose value stays absolute. Why is it absolute? Because it is used for exchange—exchange of goods and services. People say, “Money is power.” The truth is money has no power except the ability to trade for things and services.
But, money has an absolute value? Well, kind of. Within one country and one economic system, yes, a dollar is worth one dollar. But when it comes to Foreign Currency, money begins to act a little bit differently. In the example above, Louis was unwilling to accept what Sam thinks is normal money—US dollars. The reason is that Louis cannot exchange US dollars for everything in France. His workers don't want dollars—they want Euros. So Sam's money (something you can exchange for anything in the USA) is not Louis' money (something you can exchange for anything in France).
But, for international finance, Sam's money and Louis' money begin to look very much alike because the exchange is so easy. Let's say the Wall Street Journal publishes the exchange rate at $1.35 to the Euro, €1.00=$1.35. To a banker trading millions of euros a day, 1 Euro may be worth $1.34. To an ATM, 1 Euro may be worth $1.30. To an exchange desk in an airport, 1 Euro may be worth $1.20. To a retailer on the streets of the USA, 1 Euro may be worth $1.00. The value may be different for each transaction, but the Euro is being treated like money.
OK, but if it is money, then why does foreign exchange change so much? There are many reasons why exchange rates change, and here are a few:
- World prices of commodities. As the demand for timber goes up, the Canadian economy gets stronger and the Canadian dollar goes up. Canadians can buy more Australian wine.
- Relative economic Performance. As Chile does well in agricultural production, tourism, and mining, the Chilean Peso goes up. Chileans can buy more Japanese cars.
- Relative inflation rates. As Brazilian inflation rates went down, the Brazilian Real (and total confidence in the economy) went up. Brazilians could buy more American movies.
- Interest rates, Trade and Current Account Balances, Capital Flows and many other financial considerations play into the foreign exchange fluctuations.
- Domestic political turmoil. When Egypt has political problems, fewer people demand the Egyptian Pound, and their currency value goes down. Egyptians could buy fewer Chinese electronics.
Enough already! The bottom line question is: how does currency affect your world? In your day-to-day activities, foreign exchange has a small role. You still need to purchase bread with local currency, pay the telephone company in local currency, and collect your paycheck in local currency. Your customers, your suppliers, and your business associates in other countries all have to do the same. Aside from currency questions affecting international transactions, it also affects business aspirations—where you want to go. If you want to expand into new markets in other countries, you will need to have to trade in other currencies, either directly (accepting Canadian dollars, for example) or indirectly (currency conversion done by your bank). Learning specific foreign markets, customs, and needs include swimming in the money flow currents you share—exchanging currency. Foreign exchange is just one more consideration, in addition to considerations like material costs, labor rates, and taxes, for the company who aspires to move into new markets.
In the end, then, foreign exchange acts like money, and it does not act like money. It can be exchanged sometimes and not exchanged other times. This dichotomy can make discussion about foreign exchange go around in circles as a speaker shifts from one side to the other, thus thoroughly confusing his audience. Your difficult job as the shrewd listener is to hold both ideas in your head simultaneously. When you can do this, the conversation becomes much simpler.