I’m really having trouble understanding foreign exchange. Here is scenario I’m struggling with. I’m trying to break it down very simply for myself.
We have a “US bank” and a “Canadian Bank”. I (American) am going to Canada and want to buy some Canadian goods. I go to my bank and I give them $1,000 USD to exchange for CAD. The US bank sends my $1,000 to a Canadian bank and the Canadian bank then sends back $1,050 CAD. The US bank gives me the CAD and the Canadian bank keeps the $1,000 USD in their reserves. I go to Canada and spend all $1,050 CAD. So now the Canadian economy has the money they exchanged for me AND they have my original $1,000 USD in reserves.
So now my questions; how does this benefit a Canadian citizen? This also got me thinking about foreign charity too. I thought “how does bringing USD into a foreign economy help the people”? My answer was, “well although they can’t physically use USD as currency, as they have their own local currency, they CAN sell the money on a currency market or use the USD to buy goods from any other country that transacts in USD”. But here’s where I get tangled up. The BANK holds the USD reserves introduced into the country, not the citizens. Because when I change my USD to Baht or CAD or Yuan or whatever, the bank has the dollars, not the person I buy the goods from.
I’ve tried finding a book or online resource that explains how this works, but I haven’t come up with anything yet.
Let me follow this up with another overly simplified scenario/question which is similar to the one above. We’ll use a US bank and Canadian bank again, but shrink the economy way down. Say there are 10 people in Canada and they all deposited $1,000 in the Canadian bank. So now the Canadian bank has $10,000 of CAD reservers. I want to exchange $5,000 USD for CAD. Let’s assume a 1 to 1 exchange rate. So I give the bank $5,000 USD, they take $5,000 CAD out of their $10,000 CAD reserves and give it to me. I spend all $5,000 in Canada. The vendors I spend the money with all deposit that money into the Canadian bank. So the Canadian bank has $10,000 in CAD reserves again AND they have $5,000 USD (because I gave them that for the exchange). Who has claim to that $5,000 USD? Only the bank? That doesn’t seem to make sense as money was just traded and then the bank gets $5,000 USD.
So how is that USD money then used? In another currency going the other way? If a Canadian citizen wanted to buy US goods, they could trade money out of their Canadian bank account for the USD reserves that the bank already holds (?)…but then where does that CAD money go that was used in the exchange? Does it become part of the bank’s reserves? But wasn’t it already part of the bank’s reserves? And again, like the USD, who has claim to that CAD money?
Banks can act as money exchanges. The profit is what they charge for the exchange. Over the long-run, though, it doesn’t make sense for a Canadian to hold U.S. money, which is why inevitably U.S. money has to return to the U.S. economy (for example, China does not really hold large quantities of U.S. Dollars; they use those U.S. Dollars to buy U.S. securities).
How do the Canadians benefit? Obviously, the people who made the trade with benefited, otherwise the trade would’t have been made (both in the case of the money exchanger and the firm you bought the Canadian goods off of).
But who has claim to the USD reserves in my example? This is the question I feel like I’m having the most trouble with. To reiterate my example, I gave the bank $5k in USD, they gave me $5k in CAD, I spend all that money in Canada…the Canadian economy recoups the money exchanged to me AND the bank has $5k in USD reserves. Again, who has claim to those US dollars? Do they become the bank’s? That just doesn’t make sense to me though; they act as an exchanger, but then they keep the foreign money that was exchanged (?)
I didn’t really word my question right about benefiting; it should have been worded, “how do the Canadians benefit by holding USD reserves”? Which you already answered that with “Over the long-run, though, it doesn’t make sense for a Canadian to hold U.S. money”.
So now my questions; how does this benefit a Canadian citizen?
You bought canadian products, so the people who made them made a profit selling them to you.Plus, the bank who has the dollars lends them to someone who wants to buy US products in the USA.
This also got me thinking about foreign charity too.
To whom are you giving the charity? Whoever got the money will one way or another be able to buy something he could not before.
I thought “how does bringing USD into a foreign economy help the people”?
They can use the USD to buy American stuff if allowed to.
My answer was, “well although they can’t physically use USD as currency, as they have their own local currency, they CAN sell the money on a currency market or use the USD to buy goods from any other country that transacts in USD”. But here’s where I get tangled up. The BANK holds the USD reserves introduced into the country, not the citizens. Because when I change my USD to Baht or CAD or Yuan or whatever, the bank has the dollars, not the person I buy the goods from.
You give the USD to the bank, they give you local money, which you use to buy local products, so that the local merchants profit. Plus, the bank can lend the USD etc, as in above.
I’ve tried finding a book or online resource that explains how this works, but I haven’t come up with anything yet.
Ha, I’m still scratching my head trying to understand one country at a time.
U.S. Bank A gives Canadian Bank B $1,000, and in return they get CAD1050. Seems to me that the USD are held by the Canadian bank. They buy back Canadian dollars, and the recipient of the USD now spend it on U.S. products.
They can invest in the U.S., or buy U.S. goods. This is why international trade tends to balance out over the long-run.
Yes, the USD reserves are held by the Canadian bank. But who has claim to it? Who “owns” those US dollars? The way I see it, Canadian citizens deposited their money into the bank. The CAD reserves in the Canadian bank is made up of the depositors’ money. The Canadian bank then uses the depositors money to exchange for US dollars. In essence, without the explicit permission of the depositors, the Canadian bank is taking the depositors money and giving it to me in exchange for my US dollars. I then spend the exchanged CAD money in the Canadian economy. Again, the Candian economy is made whole (they have all their CAD back that they exchanged to me) and now the Canadian Bank has USD reserves as well. So my question, who “owns” those US dollars? Is the answer “no one”? That the USD reserves just become part of the overall reserves? But that’s what doesn’t make sense.
The CAD reserves are made up of the Canadian depositors money, and the Candian depositors have claim to their deposits. The USD reserves seem to have no owner. I can’t claim the USD, as I exchanged them for CAD. The depositors can’t claim them, because I paid them in their local currency. The bank can’t claim them as their own, because I didn’t buy anything from the bank.
You mentioned “They buy back Canadian dollars, and the recipient of the USD now spend it on U.S. products”. But who is buying the USD from the Canadian bank? And how is it that the Canadian bank has the right to sell the US dollars? For instance, a Canadian citizen wants to exchange $1,000 CAD for USD. He takes $1,000 from his Canadian bank account and asks the Canadian bank to exchange it for US dollars. The Canadian bank does this with the USD reserves on hand. But then where does that $1,000 CAD money go after the exchange. Obviously the Canadian citizen requesting the exchange gets the USD, but the money he gives the bank…where does that go? And who “owns” it?
Agreed, but that’s not really the focus of my question. I was trying to make the point that the Canadians that deposit their money into the bank have claim on their money (the bank’s reserves). If the money is exchanged out for USD, then the depositors lose claim to their Canadian money, it seems, as the bank has in part USD instead. Then taking it a step further, when the money exchanged comes back into the economy (the CAD is used to buy goods), the bank is left with reserves it didn’t have prior to the exchange.
When I buy foreign goods I don’t go to a bank, nor do I travel to another country. What you’re talking about are merely inter-bank currency flows, which doesn’t really affect exchange rates.
At some level different currencies are moving from country to country. I’m trying to understand what goes on “behind the scenes”. I’m not talking about this from a entirely consumer view. And I’m not really interested in examining exchange rate impact with my question.
You don’t need to analyse ‘banks’, you need to imagine that there is a person that has foreign currency willing to sell it to you at some price, and that you may want to do this if you plan on spending money on goods which the retailer is selling denominated in that foreign currency. (and the retailer would require a greater quantity of your local currency to make the retail purchase directly in the local currency as compared to that other person that you know who is offering money changing service)
You want the fine details? How many phd’s do you think visit this blog?
All I can tell you is that the exchange ratio is determined by (a) current account balances, that is, the trade balance, and (b) interest rate parities. If nation A has a trade deficit with nation B, then the demand for nation B’s currency is greater than the demand for nation A’s currency (if you’re nation A, your demand for nation B’s goods is the demand curve for nation B’s currency, and B’s demand for your goods, is the demand for your currency, and the supply of his currency). If nation A’s trade deficit increases with nation B, then there will be a right-ward shift (increase) in the demand for B’s currency (causing it to appreciate relative to nation A’s currency), and corresponding left-ward shift (decline) in the purchasing power of nation A’s currency relative to nation B. Current account deficits mean capital account surplus’s, and all of this is linked by the balance of payments.
If nation A has a lower interest rate than nation B, short-term capital will flow from nation A to nation B, increase the purchasing power of B relative to A. People will also borrow nation A’s currency (at low interest rate), and then sell it for nation B’s currency (or what is known as a carry trade). This puts further downward pressure on currency A, allowing for capital gains.
You should try to picture the series of exchanges at the most basic level. Imagine these transactions merely take place between a web of individuals.
Canadian 1 decides that he wants to buy an American plow, because they are of better quality than any plow that nearby Canadian plow producers can supply. The American vendor of said plow is American 1. Unfortunately, Canadian 1 only has CAD, and American 1 is not interested in CAD. However, there is Canadian 2 who recognizes the demand for USD within Canada and decides to turn it into a business. Canadian 2 accumulates a large quantity of CAD, and buys USD off American 2, who is willing to sell his USD in exchange for CAD because he is (A) charging for the transaction and (B) thinks he can sell CAD to Americans looking to buy Canadian goods (or he can buy Canadian goods). Canadian 2, now holding USD, is approached by Canadian 1, who needs USD to buy his plow off American 1. Canadian 2 exchanges his USD for Canadian 1’s CAD (of course, at a price). Canadian 1, who now has sufficent USD to buy the plow does for, and he exchanges a certain amount of USD for one plow.
I don’t think this is correct. With monetary nationalism, that is, pure fiat currencies not linked to any commodity, there is no actual exchange of currencies. Goods and capital are exchanged, and the exchange ratio between currencies fluctuate. There is credit movement, but not actual movement of dollars, pounds, Euros, ect. The gold exchange standard has it so all international settlements are satisfied with gold flows, and currencies are fixed to gold–no fluctuations. But, we don’t really have pure monetary nationalism since the dollar is the world reserve currency, meaning all central banks keep a large supply of dollars. So if a Canadian wants to buy Japanese rice, he (a) trades CAD for USD, (b) trades USD for YEN, (c) buys the rice. It’s all very complicated since the current international system has never ever been attempted (fiat reserve currencies) and requires that the US has huge current account deficits, and other superpowers run current account surplus’s.
This is why I think it’s easier to understand the flow of money by looking at a very simple case. In a complex economy, the scenarios are countless. For example, when I come to the United States from Spain, I usually first go to my bank in order to exchange euros to dollars. My bank does not hold euros, as they probably do not see it very profitable, and so do not make exchanges beyond 500€. This shows that whey do conversions, what they do is that they buy your euros and they probably have a contract with an exchange service which will then do the exchange based on some rate (the rate the bank charges you to make the exchange is a fixed rate, depending on what they are charged by whoever they have the contract with—I think my bank basically does it as a service to me, as a client).
A bank that does hold a foreign currency to sell to their clients probably holds a certain amount (based on demand and price), but I don’t think many banks do.
In what I quoted, it seems to me that you believe that a bank can buy a foreign currency to sell using someone else’s deposit. I’m not sure this really happens, although it is possible that a client has a time deposit and the bank uses it to buy a certain currency (instead of loaning it out). The holder of the money is the bank until the time deposit is due to return to the client, in which the bank must sell the foreign currency they bought in order to make the original currency back, to pay back the interest on the time deposit (this is a simple and straightforward scenario, as a bank probably has a huge pool of earnings to make these payments and whatnot, without having to worry about supposedly related exchanges).
But, in any case, the owner of the currency is the one who partook in the transaction, until ownership is transferred.
This could occur, but is not implicit in the business of currency exchange. In fact, most currency exchange firms are not banks at all.
Between individuals, like myself, my scenario is actually true—that is how it works when I exchange euros for dollars, and vice versa. With the advent of credit, this may not be true when it comes to the immediate exchange of credit for capital-goods, but it ultimately becomes true when the owner of that capital-goods wants the currency he can use to purchase whatever he wants to purchase. Ultimately, the exchange will have to take place.
Like I said in the previous post, it can become complicated. Say the Bank of China accumulates a pool of U.S. Dollars, it has been shown that these do not really sit in vaults or anything of the like (or at least, exist electronically), they are simply used to buy U.S. securities. The exchanges still take place ,even if it’s all done electronically.
This is true, but the exchange of currency still takes place, even if it’s all electronically. It may not physically take place, but it still takes place. My example was necessarily simply, to just understand how exchange of currencies takes place.
I have not read this book, and will probably not read this book at any point in the near future, but if you’re really interested on the topic it seems like the best book on the subject (the only book on the topic on Mises.org, that is): http://mises.org/books/raguet.pdf.
Yeah, when you go to a bank and exchange currencies. But I don’t think this is what happens when you (in Spain), buys American products, for example. Hayek, in Monetary Nationalism and International Stability says that an international system with freely floating exchange rates, not tied to commodities, will have no actual transfer of national currencies. And this is consistent with what I learned in international economics. But, again, the fact that we have some kind of abomination as our international monetary system does confuse the matter, namely the dollar’s role as world reserve currency (as if it were gold).
Yea, there probably is not a physical transfer of U.S. Dollars. Sometimes I buy Spanish products from the United States. A few months ago, I bought a DVD for 20€. Of course, I personally did not go exchange my $ for €. Instead, the website offered me the price in dollars (it’s not the exchange rate, as there are hidden costs—the costs of the transactions for whoever actually commits to them). I paid with my debit card. I don’t know the exact steps which took place, since I don’t work for any of these institutions, but what I’m guessing what took place is the following. The company accepted the dollars electronically from my bank, and they simply exchanged the dollars for euros to some exchange company that they have a contract with. These exchange companies probably have a multitude of assets for their USD, including exchanging USD they hold for euros held by American exchange firms so they can continue to finance exchanges in their respective countries (there are probably other outlets, including selling them to banks, et cetera). The money probably doesn’t ever physically change hands. It probably all takes place electronically, but the exchanges do they place in some way (even if it’s all just an accounting proccess—which is what it probably is in our current fiat currency system).