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3 Tutorials that teach Foreign exchange
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Foreign exchange

Foreign exchange

Author: Kate Eskra
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This lesson covers the Foreign exchange
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Tutorial

FOREIGN EXCHANGE

Video Transcription

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Hi. Welcome to macroeconomics. This is Kate. This tutorial is on foreign exchange. As always, my key terms are in red and examples are in green.

So in this tutorial, we'll talk about how the government finances expansionary fiscal policy. And finally, you'll understand that large budget deficits can end up both weakening our currency and raising interest rates when those deficits are financed by borrowing from foreigners.

So let's remind ourselves what fiscal policy is all about. It's typically policy set by a central government authority where spending by the government is adjusted to stabilize economic activity. There are basically two tools that the government can use-- spending and taxation. And so we're looking at the policies in these two areas.

What the government does is they use these two tools to make sure that we stabilize our economies movement through business cycles, to make sure that recessions aren't too severe, and to make sure that expansions aren't actually way too rapid. So we have short and long term goals when we're looking at fiscal policy. In the short term, we have the goals of achieving full employment and price stability.

So this is where the government uses taxation and spending to stabilize the economy, when we're either experiencing really high unemployment rates or high inflation rates. But in the long term, our goal is economic growth over time. We want to make sure that our economy is growing.

And that is the measure of change in real GDP over periods of time. It's usually expressed as a percentage change in the value of all goods and services produced in a country over a specific time period.

So the big idea here is that our short term fiscal policy decisions can actually impact our long term ability to achieve economic growth because of its impact on our national debt. And so that's what I want to talk about right now. So to increase demanded and stimulate the economy in the short term, whenever we need to enact expansionary policy, what the government basically has to do is spend more money than they're taking in in tax revenues.

Whenever expenditures are greater than tax revenue, that's known as a deficit. So deficits are just shortages that result from spending in excess of revenue.

To take on debt, our government has to sell treasury securities. And we're noticing that we have an increasing reliance on foreigners to buy our debt, to buy these treasury securities. It used to be that Americans used to buy all the bonds necessary to finance projects or to finance programs. But now, we're relying more and more and more on other nations to finance our debt.

So generally, running a budget deficit doesn't necessarily have an immediate negative impact on our economy. And sometimes, it's quite necessary to get us out of a recession and make sure that things don't become a Great Depression. That would not be a good idea. So definitely necessary here and there.

But what we need to keep in mind is that when a government run deficits year after year after year, and they don't rein in those programs and that spending, if we continue to add to overall debt, there are some serious consequences. The first consequence can be weakening of the currency and the second one can be raising interest rates. We'll talk about both of these. But what I want to focus on right now for a little bit is the impact it has on our currency or foreign exchange.

So let's, again, go back and remind ourselves what an exchange rate is all about to fully understand how it's impacted. An exchange rate's when we express the value of one nation's currency relative to another nation's currency. So as an example for you, let's say the exchange rate between the US dollar and euro is this. One US dollar can purchase 0.75 euros.

So how does that impact me? Well, if I want to purchase a German car, that's going to be in terms of euros. So let's say it costs 40,000 euros. I would have to exchange my US dollars for euros first, because the German car company is only going to accept payment in euros.

So how do I do it? Well, I take the exchange rate. And I take my 40,000 euros, divide by the 0.75-- because that's how many euros I can get for each dollar. And I would need to pay $53,333. So foreign exchange is just the amount of a foreign currency obtained by exchanging a specified amount of domestic currency.

So the price of most things are determined by supply and demand in a market. So is foreign exchange. As the demand for any currency changes, its value will change.

So if the demand for the currency goes up, its value will go up. If the demand falls, its value would fall. So if foreigners would want to purchase American goods, they would be demanding our dollars to buy them. And then our currency would appreciate or get stronger. If they don't want to purchase our things, the opposite would happen.

The supply side, if the supply of anything goes up, doesn't its value tend to fall? So if the supply of the currency increases in the world, its value would tend to decrease. So if we are purchasing a lot of foreign countries' goods, we would be supplying our dollars to the market in order to do this. And that could weaken our currency. So that's how these foreign exchange rates are typically determined.

So how strong or weak our currency, why does it matter? Well, it matters because it impacts how much we would want to purchase foreign goods or import. And it matters because it impacts how much foreigners want to purchase our goods or exports.

So without increasing taxes, we know that the government has to borrow money by selling treasury securities to finance the increased government spending and they have to take on debt to do this. So when the government borrows money, then in the future, they obviously have to repay it somehow. And they either have to repay it with tax revenue or with new debt.

Let's talk about this new debt, because that's typically how it's done, it's rolled over. So that's what we're talking about here. And whenever we roll over our debt, at the very least we have to pay interest in order to service the debt.

So because of our increased reliance on foreigners to finance our debt, that is what can impact the strength of our currency. If foreigners begin worrying that our government might not be able to repay, they might not want to lend money to our government. If you're worried that you're not going to get your money back, that could be a problem.

You might not want to take out that loan, or I'm sorry, lend that government money. So this could lower the demand for our currency, weakening it as we already talked about. As demand for something decreases, it tends to lower the price of it.

So our currency could be impacted by depreciating. So again, going back to this, that's how this debt can weaken our currency. But let's now take a look at the impact it can have on interest rates.

So if the government wants to-- we have to go back and look at how our debt is issued to fully understand this process. If the government wants to fund, let's say, just $1 billion program without raising taxes to pay for it, what we do is we sell treasury securities. So we sell basically IOUs. And it's in the form of bonds, bills, and notes. And what they would have to do is sell $1 billion worth of these IOUs.

So let's say they sell a one year Treasury bill to somebody with a face value of $1,000. That's not necessarily how much this person is paying for it. In one year, that $1,000 tells us that the government will owe the bondholder the face value of it, the $1,000.

If the buyer only paid $950, then the government is basically paying $50 to borrow the $1,000. So this has a 5% interest rate on it because the yield is-- that's what this means. It's the yield. So it's the $50 they had to pay in order to borrow the 1,000, or 5%.

Again, going back to buyers' willingness to loan a government money, if the price buyers are willing to pay falls because maybe they're worried about the investment, then the interest rate or that yield is going to rise. So when we look at interests, there are a lot of definitions here of interest, the most basic one being the cost or price of money. There's a difference between nominal and real.

But right here, we're really focusing on this idea, the return on investment, where the return is varying based on the risk profile. As foreigners see a government as being more risky, the interest that they're going to earn on that investment is going to have to rise because it's riskier. So when the bond holders or the loaners are foreigners, then the interest rates can be impacted, like I said, if they worry about a government's ability to repay. As the confidence in government declines, that market price of the Treasury bond falls, and that jacks up or raises the interest rate. So it gives a higher bond yield.

Then the country has to pay higher and higher interest rates to borrow money to roll over its debt. Investors tend to lose more confidence once they see that the rates are going up, and it can just spiral out of control from there. That's exactly what happened in recent times in Greece. Their debt reached extremely high levels.

Investors began worrying that they wouldn't be able to repay. This then forced Greece to pay higher yields to keep rolling over their higher and higher debt, which then led investors to worry even more. And you can see how this can just completely spiral out of control from there and raise interest rates.

So many politicians see no problem with short term debt to finance expansionary policy. But what we went through in this tutorial is that we have to be cautioned that when deficits get too high for too many years in a row, it can really weaken the currency s and raise interest rates. So in this tutorial, we looked at all of these ideas and how, in order to expand the economy in the short run, it can weaken the currency and raise rates. Thanks so much for listening. Have a great day.

Notes on "Foreign Exchange"

Terms to Know

Fiscal Policy

Typically policy set by a central government authority, whereby spending by the government is adjusted to stabilize economic activity.

Deficits

Shortages that result from spending in excess of revenue.

Economic Growth

Measure of the change in real GDP over periods of time; percent change in value of the sum of goods and services produced in a country’s natural borders over a specified time interval. 

Interest

The cost of money; Nominal interest is the prevailing rate; real interest reflects the prevailing rate adjusted for inflation (real = nominal rate minus the inflation rate); Return on investment where return varies based on the risk profile of the investment, time horizon, opportunity cost of a comparable risk-free investment and inflation expectations.

Foreign Exchange

The amount of a foreign currency obtained by exchanging a specified amount of domestic currency.