Series 7: 9.3.2. Foreign Exchange Rates

9.3.2. Foreign Exchange Rates

You might wonder why a U.S. trade deficit often brings capital into the U.S. One answer is that all those dollars being accumulated in foreign countries from their export sales to the U.S. have to be spent somewhere. China and Saudi Arabia have a long history of investing their surplus dollars in U.S. markets.

Another reason is that trade deficits dampen the value of the dollar. A cheaper dollar makes it more expensive for U.S. citizens to vacation in Europe, but it also makes foreign investments in the U.S. more attractive.

When a currency other than the local currency is used to settle international transactions, it is referred to as foreign exchange. The rate at which two currencies trade for each other is called the exchange rate. This is also known as forex or FX.

Suppose $1 today exchanges for the euro at €1.00. If the dollar weakens relative to the euro, $1 will be able to buy fewer euros, say €0.75. If Americans can buy fewer euros, they can buy fewer European goods. Europeans, in turn, will see their euro strengthen in terms of the dollar, making U.S. exports more attractive.

In international trade, foreign goods are generally priced in the currency of their origin. An import from France will be priced in euros. An export from Kansas will be priced in dollars. When imports exceed exports, the demand in the U.S. for foreign currencies goes up, and the demand overseas for U.S. dollars goes down. An excess supply of dollars lowers its price, which makes both imports and domestic investments look cheaper.

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