Toolkit

If you want to review the definition of an exchange rate, you will find more details in the toolkit. If we think of two currencies—euros and dollars, for example—then there are two exchange rates to keep in mind: the price of euros in dollars and the price of dollars in euros. (You might suspect, correctly, that these two prices are linked; we return to this shortly.) In a world of 3 currencies, each has a price in terms of the other two currencies, so there are 6 (= 3 × 2) different prices. And in a world of 100 currencies, then for each one, there are 99 prices for the other currencies. So there are 100 × 99 = 9,900 prices to quote! A Zambian traveling to Armenia wants to know about the kwacha price of drams, a Malaysian traveling to Oman is interested in the ringgit price of rials, and so on. Foreign Exchange Markets Imagine a series of three visitors traveling from the United States to Europe. First, we have someone arriving on vacation. Chances are that she will want to exchange dollars for euros to have money to spend on hotels, meals, and so on. She also buys souvenirs in Europe—goods that she imports back to the United States. Our second visitor spends a lot of time in Europe for work purposes. He might open a bank account in, say, Germany. If he wanted, he could use this bank account to keep some of his wealth in Europe. He would buy euros with his dollars, deposit these euros in the bank to earn interest, and then—at some point in the future—he would take his money out of the bank in Germany and exchange the euros for dollars. (Later, we will consider how you can decide if this is a good investment strategy. For now, our point is that this type of financial investment is another source of demand for euros.) Our third visitor to Europe is a professional wine buyer who wants to purchase wine to sell in a US restaurant. She travels to the wine-growing regions of Europe (France, Spain, Italy, Germany, Portugal, etc.) and must exchange dollars for euros to pay for her purchases. Our three visitors represent a microcosm of the transactions that take place in the foreign exchange market every day. Households and firms buy euros to pay for their imports of goods and services (souvenirs, wine, etc.). Many different goods and services are produced in Europe and sold in the United States. Some are imported by retailers, others by specialist import- export firms, and still others by individuals, but in all cases there is an associated purchase of euros using dollars. The demand for euros also arises from financial investment by households, firms, and financial institutions. For example, a wealthy private investor in the United States may purchase stock issued by a company in Europe. To buy that stock, the US investor sells dollars and buys euros. In practice, such transactions are typically carried out by financial institutions that undertake trades on behalf of households and firms. Most exchanges of dollars for euros do not actually entail someone traveling to Europe. Think about the foreign currency needs of a large multinational firm that produces goods and services in Europe but sells its output in the United States. The company naturally needs euros to pay workers and suppliers in Europe. Since it sells goods and thus earns revenues in dollars, the company must convert from dollars to euros very frequently.