The Economics of Foreign Exchange: International Trade Transactions

International Trade Transactions If you've ever taken a trip to a foreign country, you know you must purchase foreign currency to pay your expenses while in the country. All your bills, even those you pay by credit card, will be in terms of that country's currency: French francs, Italian lire, Japanese yen. Credit card bills you receive when you return home will be converted to dollars based on the prevailing exchange rate at the time. You'll pay in dollars, but the credit card company will have its bank pay the bills in the foreign currency. The price of one nation's monetary unit in terms of the monetary unit of another nation is called its foreign exchange rate. The foreign exchange rate of the French franc in dollars is the number of dollars necessary to buy each French franc. For example, suppose the foreign exchange rate of French francs in dollars is 10 cents per franc. This means that if you exchange $100 you'll receive 1,000 French francs in return. You can then use your francs to purchase French goods and services while visiting the country. Similarly, French tourists visiting the United States will have to purchase dollars to meet their expenses while in this country. To do so, they'll go to an American bank or foreign exchange dealer where they'll sell their francs for dollars. The foreign exchange rate of the dollar for francs is the price of the dollar in francs. If it takes 10 cents to buy each franc, it follows that the foreign exchange rate for dollars is 10 francs per dollar. The foreign exchange rate of the dollar is the inverse of the foreign exchange rate of the franc: Exchange rate of the dollar = 1/Exchange rate of the franc 10 francs per dollar = 1 franc/($0.10 per franc) An American tourist can figure out the equivalent number of dollars necessary to buy an item priced in francs by multiplying the price of the item in francs by the exchange rate: Dollar price = (Price in French francs)(Exchange rate of francs) If a hotel room costs 1,500 French francs per night and the dollar exchange rate is 10 cents per franc, the price of the room in dollars is (1,500 French francs)($0.10 per Franch franc) = $150 However, if the dollar exchange rate of the French franc were 18 cents, as was the case in midJanuary 1988, the cost of the room would be 1,500($0.18) = $270! When the dollar exchange rate of the French franc goes up, so do the dollar prices of items priced in francs. Similarly, a French tourist would use the exchange rate of dollars expressed in francs to figure out the price of a hotel room in the United States in francs: Price in French francs = (Dollar price) (Exchange rate of the dollar) If the room costs $200 and the exchange rate is 10 French francs per dollar, the price of the room in francs will be ($200) (10 francs per dollar) = 2,000 French francs If instead the exchange rate of the dollar were only 5 francs per dollar, then the price of the hotel room would be only 1,000 French francs. Thus a decrease in the exchange rate of the dollar makes goods priced in dollars cheaper to people with French francs. International Transfers of Bank Deposits Resulting from International Transactions As is true for most transactions within the United States, most international transactions involve transfers of deposits among banks. However, in the case of international transactions the bank deposits are denominated in a variety of monetary units, such as dollars, francs, marks, and pesos. The foreign exchange market is a market in which buyers and sellers of bank deposits denominated in the monetary units of many nations exchange their monies. Only a small fraction of daily transactions in foreign exchange markets actually involve trading of currency. When you buy francs in the form of paper currency or coins while visiting France, you engage in a retail transaction with a foreign exchange dealer, usually a bank. The retail price you pay for the francs in terms of dollars is naturally higher than the wholesale price representing the rate the bank must pay to exchange francs for dollars or dollars for francs. When banks and dealers trade currencies, each of the transactions is in the millions of dollars. The foreign exchange market is highly competitive. Hundreds of banks and other dealers maintain contact by telephone and electronics to exchange bank deposits denominated in one currency for those denominated in another currency.