World Wealth and Poverty

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World Wealth and Poverty

• Lecture 3

Money Money Money
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World Wealth and Poverty. Lecture 3 Money Money
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• International Money

Most countries have their own money their own
currency. People in that country conduct most of
their business in that currency.
But currencies are exchanged, one currency sold
in order to buy another currency
The price at which one currency is bought and
sold is measured by the amount of another
currency that can be bought with it Its EXCHANGE
RATE
On 26 Feb 07 the / exchange rate was 1.96 per
and the / rate was 1.49 per ie to
buy 1 you must pay 1.96 or 1.49
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• Why do people buy other countries currencies

For international travel Buying
imports Investing in foreign countries Specula
ting in stocks and shares in other countries To
speculate on the changing value of currencies
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• Trade in goods and services

A woman in US wants to buy a Sony DVD player from
Japan that has a price of 5000 yen. She must buy
5000 yen from her dollar income. If the exchange
rate is 100 yen per dollar it will cost her 50.
Someone in Japan, perhaps a Japanese citizen or
perhaps the Japanese central bank, will sell her
the yen.
She then uses the yen to buy the DVD player.
Looked at as trade, she has created an import to
the US worth 50 dollars AND an export from Japan
worth 50
More importantly she has DEMANDED 50 worth of
yen and SUPPLIED 50 dollars on the
international currency market
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• Currency Market

This international currency market foreign
exchange market forex - is a market like any
other
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• Changes in exchange rates

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World Wealth and Poverty. Lecture 3 Money Money
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• International trade balance and exchange rates

If the only reason for buying and selling a
particular currency is trade then -
Disequilibrium on currency market current
deficit or surplus in balance international trade
But a falling exchange rate makes imports more
expensive (and exports cheaper)
So people buy fewer imports (and in foreign
countries they buy more exports) so supply of
currency falls (and demand for currency rise)
This continues until the countrys exchange rate
stops falling. ie equilibrium is reached in
currency market
But this means that international trade for the
country involved is now balanced (usually at
least Marshall-Lerner condition)
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• Balancing trade through exchange rate changes.
  Another theory

Purchasing Power Parity (PPP)
An exchange rate is at its PPP if all goods in a
country exchange at the equivalent price in all
other countries.
If a Big Mac and Fries costs 3.80 in the US and
2 in UK, they cost the equivalent in each
country if the exchange rate is 1.90 per . (For
2 you could buy a Big Mac in the UK or sell the
2 for 3.80 just enough for your Big Mac in
the US). If this were true of all goods in the UK
and US, 1.90 would be the PPP exchange rate.
A non PPP exchange rate would encourage buying
from the cheaper country and selling to the more
expensive
In a world of free trade this would boost demand
for the cheaper countrys currency, and reduce it
for the more expensive country. A new higher
exchange rate for the cheaper country would result
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Are all exchange rates PPP?

• Not all exchange rates are PPP because
• free trade can offer a range of prices
• trade is not always free and unhindered (discuss
  in classes)
• governments can strongly influence exchange rates

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How governments can influence exchange rates
By buying their own currency from their gold and
foreign currency reserves thus increasing demand
and/or borrowing from other countries or the
International Monetary Fund to buy their own
currency
But what happens when government resources are
finished?
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Governments alter policy to adjust their exchange
rate.
A Government can slow down an economy, reduce its
growth rate, using aggregate demand methods
So people and firms spend less on, amongst other
things, imports. The country absorbs fewer
imports, so there is a smaller supply of its
currency and exchange rates increase.
Although the rate is higher, people suffer
because the economy is not working at full
capacity - there is unemployment. This happened
in the UK in the mid 1970s.
So the method works but its effects on economic
and human development can be bad.
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Capital movements and exchange rates
In the modern world only a tiny fraction of
currency exchange transactions are to finance
trade (less than 3)

• Huge sums of money are exchanged so that their
  owners can INVEST in other countries
• Perhaps directly in a factory or firm Foreign
  Direct Investment (FDI)
• Perhaps to gamble on a foreign stock exchange
  Portfolio Investment

The latter is the bigger component of currency
exchange.
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What effect does portfolio investment have on
exchange rates?
If people think speculative profits can be made a
in country they will buy that countrys currency,
thus increasing its demand
So the exchange rate increases
But if international speculators think no profits
are to be made they will withdraw their funds and
the opposite effect will occur.
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Financial institutions and exchange rates
Note that a country with strong financial centres
will tend to attract speculative funds thus
increasing the demand for its currency.
Such a country can sustain an artificially high
exchange rate as long as the funds maintain the
demand for its currency
The high, financially sustained, exchange rate
means that the country can maintain a trade
deficit , ie can buy a higher value of goods than
it sells. The terms of trade are skewed in the
countrys favour
Most big countries in this position are basically
in the OECD or the G8
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Do financial markets bring wealth or poverty?
Can non OECD countries bring in portfolio
investment to boost their terms of trade?
Many countries have tried to encourage the
emergence of speculative financial markets e.g.
stock exchanges

• Success has often led to short term gains but
  long term nightmares
• Speculative funds (hot money) move out as
  quickly as they move in
• Countries whose policy are disapproved of by
  speculators find that capital has flown elsewhere
  and their exchange rates ruined.
• This has happened to Brazil, Mexico, Argentina,
  Russia and South Korea over the last 15 years.

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Speculation in currencies
Since a large portion of currency exchanges are
to obtain currency for speculation in stocks and
shares, and such speculation can occur anywhere
in the world, currency dealings for this purpose
will fluctuate wildly between different
currencies.
So exchange rates will fluctuate wildly. But this
means there are profits to be made by speculating
in currency exchange rates. Consequently many
deals will be made purely to gamble on exchange
rates.
The potential for instability in the currency
markets is therefore enormous.
Nearly every country in the World has suffered to
some extent in this way, even the biggest
financial players have lost e.g. the UK in 1976
and 1991
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International money dealing who wins and who
loses
Speculators have enormous power If they think
that their colleagues will disapprove of the
political or social policy of a country they will
put their funds elsewhere.
This is not a conspiratorial view if policies
dont accord with the views of speculators they
will naturally believe the host country will do
badly and so their colleagues will remove funds.
So the exchange rate will fall and speculators
who have not removed their funds will make big
losses. This is a relentless and dangerous
mechanism!
What it means is that views and ideologies of the
richest in world society will have undue weight
with Governments across the globe often to the
direct disadvantage of their own citizens.
Many people have seen this and are campaigning
against it but more of this next week.
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Bibliography Hahnel, R. (2002) The ABC of
Political Economy. Ch 8. London Pluto
Press Parkin M, Powell M, Matthews K. (2005).
Economics (6 ed). Ch 33, 34. Harlow
Pearson Sloman J. (2003). Economics. (5th ed.).
Ch 23, 24 25, 26. Harlow Prentice Hall