by Peter Schiff, Schiff Gold:
With trade wars popping in and out of headlines during the Trump presidency, there are no guarantees when it comes to foreign exchange. As tariffs, bailouts, and central banks all affect exchange rates, it’s worth revisiting what causes the international economy to demand the almighty US dollar.
Often various factors are perceived to be important in determining a currency rate of exchange. For instance, for some commentators an increase in the government foreign debt is regarded as pointing to a likely deterioration in economic fundamentals ahead. This provides the rationale for the selling of the currency of concern.
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For many economists, the state of the balance of trade is a key factor in the currency exchange rate determination. On this way of thinking, all other things being equal, an increase in imports, which leads to a trade deficit, causes an increase in the demand for foreign currency. To obtain the foreign currency, importers sell the domestic currency for it. As a result, this causes a strengthening in the exchange rate of the foreign currency against the domestic currency (i.e., more domestic money is sold per unit of a foreign currency). Conversely, all other things being equal, an increase in exports leads to a trade surplus. Once exporters exchange their foreign currency earnings for domestic money, this leads to a strengthening in the domestic money exchange rate against the foreign money (i.e., more foreign money is sold per unit of domestic money).
Alternatively, consider the case when the central bank tightens its interest rate stance. The increase in the domestic interest rate, all other things being equal, attracts foreigners’ demand for domestic money. The holders of the foreign currency are now exchanging it for the domestic currency which is going to be placed in the domestic currency deposits in order to earn higher interest rates. Consequently, this lifts the price of the local currency in terms of foreign currency. It would appear that various factors such as the government debt, the interest rate differential, the state of the economy, and the balance of trade are important factors in the currency exchange rate determination. We can also add to these various psychological factors that would appear to be important in the currency exchange rate determination. Thus, a change in individuals’ perceptions regarding the state of the economy is likely to influence the currency rate of exchange.
Rather than focusing on these many factors, it would make more sense to identify the key or the essential factor that determines the currency rate of exchange, that is, to identify the essence that dictates the currency rate of exchange determination.
The Relative Purchasing Power of Money (PPM): The Essence of the Exchange Rate
The essence of the currency exchange rate is the relative purchasing power of various monies. In a non-monetary barter economy, the “price” of goods has to do with what trades individuals are willing to make in terms of units of goods or services (e.g., 100 apples might be exchanged for shoes). A price of a good, in monetary terms, is the amount of money exchanged for it. The “price” of money is determined in what units of goods and services will be exchanged for it. We can also say that the amount of money exchanged for goods is the purchasing power of money (PPM) with respect to goods and services.
If, in the US, the price of a good is one dollar and in the Eurozone an identical good is sold for two euros, then the rate of exchange between the US dollar and the euro is likely to be two euros per one dollar. An important factor in setting the purchasing power of money is the supply of money. Now, let us say that, over time, the growth rate in the US money supply exceeds the growth rate of European money supply, all other things being equal.
Since a price of a good is the amount of money per good, this now means that the prices of goods in dollar terms will increase faster than prices in euro terms, all other things being equal. As a result, an identical good is priced now, for example, at two dollars against the one dollar previously, while in the Eurozone, 2.5 euros against 2 euros previously. This would imply that the exchange rate between the US dollar and the euro should be now 1.25 euros per one dollar and not 2 euros per one dollar.
Another important factor in driving the purchasing power of various moneys and the exchange rate is a change in the demand for money. For instance, with an increase in the production of goods, the demand for money is likely to follow suit. The demand for the services of the medium of exchange is likely to increase since more goods are now going to be exchanged. As a result, for a given supply of money, the purchasing power of money will increase, all other things being equal. Less money will be chasing more goods now.
Originally Posted at https://www.sgtreport.com