Exchange rates… How does that work?

In this first section I will explain how the system should work - but doesn’t. The second section will explain what needs to be included to make the model work.

The brokers...

In any exchange you have brokers. These are people who match up buyers and sellers, taking a small percentage from both. They may also have a small float of the commodities being traded. These people continuously monitor the enthusiasm for trade in each direction and adjust the prices up or down to keep the two sides in balance. If the broker failed to do this then not all buyers could be matched with sellers and the broker would miss out on opportunities to earn commission.

The situation can be summed up in the picture below, with the enthusiasm for exchange in balance.
Now let us consider how changes in the balance between buyers and sellers can occur. Assuming that they are currently in balance at 100 yen per dollar. Then over the coming months Japan has a spurt of good economic development. New highly automated factories come on line, producing new products more efficiently than ever before. Meanwhile in America, there are many strikes and factory output makes no progress. In the shops the Japanese goods have their prices lowered and more of them are purchased relative to the American goods.

In order for Americans to buy the, now higher, proportion of Japanese goods, they will have to convert additional dollars into yen. Quite the opposite will be going on in Japan. The proportion of American goods that appear good value relative to Japanese goods will diminish. There will correspondingly be a reduction of Japanese in the queue to convert their yen into dollars in order to buy American goods. The only way the foreign exchange brokers can equalise the size of the two queues is to offer less yen per dollar.
If the exchange rate mechanism worked as described so far then we would not end up with American shops full of cheap Japanese goods that trounced American goods on value. Instead the mechanism should ensure that the dollar yen exchange rate was constantly adjusted so that the Japanese goods appeared roughly constant in value compared to the American ones. The container ships travelling back and forth between the two countries would contain equal amounts of goods in both directions. If the Japanese were now far more efficient and productive than the Americans then the ships would be equally full of goods, but imbalanced in terms of the man-hours required to make the contents. It may be that the boat full of Japanese goods sailing to America contained 1million Japanese man-hours of produce, whereas the equally full boat travelling in the opposite direction would contain 2million American man-hours of goods.

You may notice that in the real world the theoretical events just described do not appear to have transpired. The container ships sailing between Japan and America are not equally full of goods. There must be something missing from the model…

Savings...

In this section we will consider the effect of savings on the exchange rate. Consider what would happen if there was a greater enthusiasm for saving in Japan than in the US. One possible mechanism for the Japanese to save is to purchase US government bonds. In order to do this the Japanese must exchange some yen into dollars. The result is that there are now two kinds of Japanese people in the queue wishing to exchange yen for dollars, one set wishing to get dollars to buy American goods the other wishing to get dollars to buy American bonds. If there was a steady growth in the total quantity of US bonds purchased by the Japanese then the exchange rate could be maintained at a lop-sided value throughout.

As you can see, from the point of view of the broker, he has perfectly balanced the supply and demand between dollars and yen even though the flow of goods will be unequal.

Can this lop-sided state of affairs continue indefinitely?

Nobody saves forever for no reason. The whole point of savings is that they can be dipped into in hard times. The hard times could be due do myriad random reasons, but one almost guaranteed one is simply demographics. Many countries around the world having ageing populations with diminishing numbers of active workers. At a certain point in this process, a tipping point is reached the number of people retiring and cashing in their savings becomes greater then the number of people attempting to save for the future. The result would be that the Japanese on aggregate have no desire to buy additional American bonds, indeed they will want to cash in their bonds and convert the released dollars into yen. I.e. they will join the queue on the left hand side of the above picture. At this point the only way the brokers can get the queues back into balance is to insist on more dollars per yen. The value of the dollar will then plummet and the Japanese will be very disappointed in their investments.

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