By Jonny Lupsha, Wondrium Staff Writer
Why do exchange rates matter? Any time one country’s exchange rate increases, the prices of its goods and services go up in other countries. Varying rates affect import and export prices around the world.
Converting one currency to another is no constant or static matter. The comparative value of the U.S. dollar (USD) to the British pound sterling (GBP), for example, has changed greatly in the last several years. As one nation’s currency exchange rate increases, imports of goods to that country become cheaper while its exports become more expensive to other countries.
Some countries even hoard foreign currency because doing so can absorb some of the impact of exchange rate volatility. Hoarding foreign currency can also be used to promote resource mobilization. Recently, at the behest of leader Kim Jong-un, state-owned markets in North Korea have been accepting U.S. dollars as payment for imported goods—many of which are being sold despite being banned under U.N. sanctions against the nation—and offering customers their change in North Korea’s currency, the won.
How do exchange rates affect international trade? In his video series Money and Banking: What Everyone Should Know, Dr. Michael K. Salemi, Professor of Economics at The University of North Carolina at Chapel Hill, tackles the big questions of the global economy.
What Is the “Big Mac Index”?
When it comes to looking at the long term, exchange rates track relative prices. In order to understand this, let’s take a look at the Big Mac Index.
“The law of one price is behind the so-called ‘Big Mac Index’ constructed annually by the Economist magazine,” Dr. Salemi said. “The Economist prices Big Macs—I mean the hamburger—in many different economies, and then uses exchange rates to convert the Big Mac prices to the dollar. In 2010, the Economist used the index to estimate countries that had overvalued and undervalued currencies.”
Going by this oddly specific metric, Switzerland, Brazil, and Canada had overvalued currencies. A Big Mac purchased in Switzerland, using Swiss francs, converted to $6.78. On the other end of the spectrum, China, Thailand, Mexico, and South Korea all had undervalued currencies. A Chinese Big Mac only cost the equivalent of $2.18.
Why Hoard Foreign Currency?
Over 100 U.S. banks now operate in foreign countries, compared to just four in 1960. An economist named Fredrick Mishkin points to three forces driving the growth in international banking.
“First, there has been a tremendous growth in international trade in the past 50 years,” Dr. Salemi said. “Second, U.S. banks have found it profitable to enter the investment banking business in foreign countries; in particular, they like to help foreign corporations create and market new stock and bond issues.
“Third, U.S. banks want access to the Eurodollar market.”
The Eurodollar is a deposit made outside the United States but denominated in dollars. It began when the Soviet Union chose not to hold its dollar deposits inside the United States for fear that the money would be seized. However, they still wished to hold their deposits in USD because they viewed it as a more stable currency than francs or marks. London is currently the center of Eurodollar trading.
“The exchange rate is a very important economics price that affects the desirability of our exports and the cost of our imports,” Dr. Salemi said.
Money and Banking: What Everyone Should Know is now available to stream on Wondrium.