by Jurgen Brauer, August 2004
Copyright: J. Brauer. No reproduction without permission.

"The dollar is up” or “the dollar is down” drones the radio announcer on the morning news. It sounds like the weather report: should you take your umbrella to work?

What exactly does it mean to say that the dollar is “up” or “down”?

The truth of the matter is that economists do not fully understand the daily gyrations of the currency markets in which the equivalent of billions of dollars are bought and sold each trading day. But we do understand a good bit of it.

Consider an example. When you go on vacation in Canada, you will need to exchange U.S. dollars (US$) for Canadian dollars (C$). Even if you pay for everything with your credit card, the payment still arrives at the Canadian Rockies skiing resort in C$. Somewhere along the line, U.S. dollars are exchanged for Canadian dollars. Just as the exchange of labor hours for wages is ultimately determined by supply of and demand for labor, so the rate at which U.S. and Canadian dollars are exchanged is also determined by supply and demand.

Suppose, for example, that the current exchange rate is C$0.80 for US$1.00. If the skiing resort charges C$800, that would be equivalent to US$1,000.

After your vacation you brag how wonderful skiing in Canada was. Word of mouth spreads and more and more people want to emulate you and find out how wonderful skiing in Canada really is. That’s swell for the braggarts and the imitators, but what does this do to the value of the U.S. dollar? Will it go “up” or will it go “down”?

The mechanics work as follows. If more U.S. tourists vacation in Canada, they will have to supply more U.S. dollar to the foreign exchange market. The extra supply pushes the value of the U.S. dollar down. By the same token, the tourists demand more Canadian dollars. The extra demand for Canadian dollars pushes its value up. Now the exchange rate might be C$0.75/US$1.00. One U.S. dollar buys fewer Canadian dollars. The skiing resort might still charge C$800 but your credit card charge is now US$1,067. The vacation has gotten more expensive in terms of the U.S. dollar.

There is nothing mysterious about the foreign exchange markets at all. That for which there is increasing demand rises in value and that of which there is increasing supply drops in value.

The foreign exchange market works exactly like flea markets do. What I believe will rise in value, I will purchase. What I believe will fall in value, I will want to rid myself of.

Speculators understand these mechanics. The foreign exchange markets work exactly like flea markets do. If I believe that something is going to rise in value, I will purchase it now, hoping to sell it later at a higher value. If I believe that more U.S. tourists will visit Canada, I should sell US$ now and buy C$ and, later on, sell the C$ when its value has risen. So, as soon as you brag about your wonderful Canadian skiing vacation, I will sell US$1,000 to buy C$800 at the old exchange rate. A year later when all the new tourists have pushed the value of the C$ up, and that of the US$ down, I will sell my C$800 at C$0.75/US$1.00 and get US$1,067 for a tidy 6.7 percent profit on my trading strategy.

We learn that one of the factors that determines the ups and downs in currency markets is the actual trade between countries in the various goods and services they have on offer, such as tourism. Other determinants include differences in countries’ interest rates and productivity. For example, if the interest rates in Canada are exceptionally high, I might be tempted to take my US$, convert them to C$, and earn interest in Canada. To make this work, however, the extra supply of U.S. dollars would push its value down, and that of the Canadian dollar up. Real-world exchange rates already reflect interest-rate differentials across countries. If they did not, anyone could make instant risk-less profits.

Another factor influencing foreign exchange markets is rather intangible. It is the trust or confidence people have in the long-term value of a particular currency. One reason why the U.S. dollar is generally strong is because foreigners often (and rightly) believe that the dollar will hold its value more steadily than their own currency. For example, if I am a well-to-do Mexican, I know that on the whole the value of the Mexican peso tends to drop relative to the U.S. dollar. Suppose the value is P5/US$1 this year, and I expect it to drop to P6/US$1 next year (more pesos per dollar means that the peso has dropped in value). Also suppose that I have P500 of savings. It would be smart of me to sell my P500 and get US$100. Next year, my US$100 would be worth P600, should I need them. One retirement investment strategy by rich people in poor countries is to convert their earnings into U.S. dollars, as the dollar tends to hold and increase its value.

Of course, there is risk to this strategy. If the exchange rate of peso to dollars changes to P4/US$1, my US$100 would be worth only P400 next year. As always, unless you are really comfortable about a particular market, it’s best not to speculate. You could lose your shirt.