Foreign Exchange

Foreign Exchange

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Foreign Exchange Paper
A country's currency is a gauge of how well that country's economy is doing. "Currently the United States has a 3% real rate of return. The short-term interest rate is 5.25% and the inflation rate is 2.25% based on the core-rate from the GDP numbers" (Kordell, 2008).
If one compares our real rate of return with other countries; Canada +2.50, Britain +2.50, Euro FX +0.25, and Japan +1.15 one can see that money tended to flow towards the U.S. over the past several years ever since the monetary policy was changed and interest rates in the U.S. started to rise. (Kordell, 2008)
The American dollar has been the world's principal currency since the end of World War II (Wong & Khan, 2006). "Following the breakdown of the Bretton Woods system in 1970, the US dollar has been the benchmark for other national currencies. No other currencies, the deutsche mark, yen or the pound sterling, have come to being a close contender for the dollar's international role" (Wong & Khan, 2006).
"An international currency can be defined as a currency that is used by residents outside the country of issue. It performs the same functions as that of any other national currency- as a medium of exchange, store of value, and unit of account" (Wong &Khan, 2006). Hartmann and Issing (2002) cite the following factors as key to determining the choice of international currency: (1) the size and strength of the domestic economy (2) the depth, breadth, liquidity and degree of openness of the domestic financial markets (3) the convertibility of the currency (4) historical bias. The euro has made considerable developments as an global financing currency. "Recent years have seen an increase in the net issuance of euro-denominated bonds over that of the dollar" (Wong & Khan, 2006).

Table 1 compares the relative economic size and strength of the US, Euroland, and Japanese economy.

United States Euro Japan
Population (million) 270 291 126
Employment (million) 131 114 65
GDP ($bn) 8510 6471 3780
Financial Assets 33828 16648 12414
% of GDP 11.9 16.1 10.5
Share of world exports (%) 16.5 19.0 8.5

Macroeconomic performance
CPI Inflation (%) 2.2 1.1 -0.3
GDP Growth (%) 4.0 2.0 0.5
Unemployment Rate (%) 4.1 10.0 4.6
TABLE 1: THE EURO AREA COMPARED WITH US AND JAPAN

It can be clearly seen that the euro compares positively to the US in most aspects. Population size, employment levels and the value of GDP are fairly close for the Euro area and US and the euro area outperforms the US in terms of the percent of GDP.

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(Wong & Jhan, 2006). This was the case in 2006, but has now shown changes that still show decrease values of the US dollar.

These charts from the Barchart (2008) site show a steady increase of the Yuan vs. the U.S. Dollar; considerable Euro strength vs. the British Pound; and a generally strengthening Yen vs. U.S. Dollar. Indeed, the U.S. Dollar has looked weak vs. the Euro and the Yen, reflecting diversification of currency reserves overseas.
Among the variables in the worldwide monetary system is the relationship between exchange rates and inflation. Economists realize that when the US dollar declines in value, in relation to the yen, for example, that products made in Japan will become more expensive to US consumers (Emerging Textiles, 2008). This should be considered for the other currencies as well.
As shown above the US dollar index (dollar measured against a basket of currencies) came off by 9%, following an 8% decline in 2006. The abrupt 2 year move away from the US currency can primarily be explained by a declining in interest rate differentials between the US and the other major economies. The dollar decreased against its Canadian counterpart last year (13.45%), followed closely by steep declines against the euro (11.45%) and Australian dollars (11.49%). Declines against the Swiss franc, yen and sterling were slightly slower, ranging between 4% and 8%. In 2007 the US economy went into trouble with growth prospects for 2008 which decreased with each new data release. (Today FX, 2008)
Factors that have caused the Trend
The recent trend in the value of the American dollar can be attributed to a few factors. Those factors include; financial markets becoming more integrated internationally, the U.S. dollar is still the world's principle international currency regardless of evolving exchange rate, and the official and unofficial dollarization has continued in several emerging market economies. It seems that the monetary policy has been affected by an increase in international variables. The changes in the U.S. monetary policy can impact emerging market economies in a number of ways. Some of those include, dominate capital flows in emerging markets, associated with financial crisis, impacted interest rates and financial markets under differing exchange rates.
The most recent trend and important trend would be the increasing international financial integration and growing capital mobility. There is a growing trend toward globalization and or international integration of financial markets and increased capital mobility.
Advantages and Disadvantages
Advantages and Disadvantages of Supporting Foreign Currencies
The advantages of our government supporting foreign currencies are that by doing this we promote democracy in other parts of the world and increase trade with those countries. Promoting foreign currency is like investing in a foreign country because the U.S. Dollar is stronger than most other foreign currencies and exchange rates in trade would favor the United States.
Since the United States has a negative international trade balance and there are more imports than exports, it favors the United States to support a foreign currency because this affects the trade deficit in that the foreign currency is now worth more and so the products that the foreign country builds cost more to import, thereby making U.S. goods more valuable. Promoting a contractional fiscal policy by supporting foreign currencies allows the United States to decrease the deficit. "Contractionary policy works in the opposite direction. It decreases income. When income falls, imports fall (while exports are unaffected), so the trade balance shifts in the direction of surplus. Thus expansionary monetary policy increases the trade deficit; contractionary monetary policy decreases the trade deficit." (Colander, 2006) Since the United States has lost some of it's competitiveness in producing goods, we must promote foreign currencies in an effort to keep the domestic economy stable or increasing and try to reduce the deficit without implementing a contractionary monetary and fiscal policy.
One disadvantage of the government being involved is that private investors spend more time speculating as to what the government thinks and less time on the fundamentals, thus destabilizing the short-term exchange rates. Another disadvantage, according to the Treasury department of Bombardier, is that if the government is investing in foreign currency, the value of that currency can go up and the U.S. dollar value can decrease. The government can also lose money in the investment of foreign currency because the rate of return is not as high. Government involvement allows for a tremendous amount of imports from other countries. This, in the long-term, can have a negative effect on our own economy in the area of industry and employment. If too much is imported from one particular country, there is a possibility that the value of their currency could raise causing inflation on their side.
In conclusion one can assume with certainty that the exchange rates are a very complex part of the economy. They are determined by a combination of several evident and hidden factors. In this paper we tried to explain the basic and most important ones. We live in a dynamic environment and the changes are rapid and sometimes unpredictable, we cannot be sure about the future. We can only predict based on the current information we possess.

References
Keleher, R. E. (1999, February). International demensions to U.S. monetary policy. Retrieved February 15, 2008, from http://www.house.gov/jec/fed/intern.htm
Kordell P, (2008). Currency Trends – How to spot them. Slipka Financial. Retrieved February 13, 2008, from http://www.slipkafinancial.com/currencytrends.html

Wong, W.K., & Khan, H. (2006). Can American Dollar Survive the Onslaught of Euro? An Empirical Investigation. U21Global, (), . Retrieved February 13, 2008, from http://www.u21global.com/PartnerAdmin/ViewContent?module=DOCUMENTLIBRARY&oid=14093. database.

Hartmann, P., & Issing, O. (2002). The international role of the euro. Journal of Policy Modeling, 24 (), 315-345 . Retrieved February 13, 2008, from http://ideas.repec.org/a/eee/jpolmo/v24y2002i4p315-345.html database.

Emerging Textiles. (2008). Currency Trends in January 2008 (Monthly Report) . Retrieved February 13, 2008, from www.EmergingTextiles.com

Barchart. (2008). Currency Trends 2008, Retrieved February 13, 2008, from, http://www.barchart.com/

Today FX. (2008) Currency Trends Outlook of 2008. Retriieved February 13, 2008, from, http://www.todayfx.com/Outlook08.html
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