Wednesday, January 30, 2008

A Problem of Exchange Rates

Exchange rates, while usually arriving late in the semester of study, offer a number of interesting problems for economics students. And the topic has reverberations for the personal finance course, as well. And while the more traditional economics class may spend more time and get into more depth, a fundamental understanding is appropriate for both classes.

In my experience, one of the biggest stumbling blocks to student understanding is the idea of buying and selling money. I think it is because students usually think of money characteristically first, and functionally second. Yet, I find the idea behind foreign exchange is easier to explain if you rely on the functions of money. The functions of money (medium of exchange, store of value, and measure of value) reveal that money is first and foremost a tool. From there one advances to the idea that if one wants to work in a specific environment, one needs the proper tools. And from there you move to the idea that nations are specific national/economic environments. Therefore, buying money is no more than buying the proper tool for an environment.

The next step is the idea of fixed vs. floating rates of exchange. Again, if the student accepts the idea of money as a tool, the idea that the price of tools may change due to supply and demand (or even risk) becomes simpler to grasp. And as value of a given currency or unit of money changes, the price of goods and services produced with the tool (imports or exports) also changes. And that has an impact on supply, demand, opportunity cost and even the family budget.

Now, it's taken me a while to get to the point of today's blog. The Federal Reserve Bank of St. Louis has a number of excellent, easily digestible publications that can provide up-to-date discussion points and data for teachers. One of these is International Economic Trends, and the most recent issue features a brief cover essay on how the falling value of the dollar is having an inflationary impact in the oil-rich Gulf states of the Middle East. Now some of you may wonder how the value of our currency could affect the value of the currency of another nation's money so significantly. The answer lies in the fact that many of the Gulf currencies are pegged to the dollar. Essentially their exchange rate for the dollar is fixed, while it may float against other major currencies such as the euro or yen. That means their currency value mirrors ours, and that has implications for their monetary policy. And as we have been loosening policy to preempt an economic slowdown, those nations have also had to match the value of our dollar, perhaps loosening when it is not warranted given their economic situation.

I urge you to look at the essay. And consider looking at past issues. I think you'll find International Economic Trends a handy resource. I look forward to your thoughts.


Anonymous said...

I understand that the US only imports 10% of our oil from the Middle East. How does this impact inflation in these countries? If the US increased its Middle East imports would inflation increase in the Middle East or do all the Middle East Countries already receive payment in US dollars regardless of who is buying the oil?

Tim said...

Oil is one of the commodities that is generally priced in dollars regardless of the buyer.

This is a practical matter, but is also a reason many of those countries link their currency to the dollar.

But overall, it has less to do with oil payments and more to do with the fact that as the U.S. dollar loses value in forex markets, linked currencies lose just as much.

This means that oil producing countries, who have to import much of what they consume, end up paying higher prices for a wide variety of products, contributing to overall inflation.