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Accumulating foreign currency reserves

How and why a central bank would build foreign currency reserves. Created by Sal Khan.

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  • leaf green style avatar for user Sebastian Ag
    But why do they have to print more money to begin with? Isn't it a good thing for country B that the A's currently are worth less than B's?
    (8 votes)
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    • leaf green style avatar for user duncan2012
      That is good for importers, because it means than people can buy goods from country A, priced in A's, for fewer B's. On the other hand, exporters from Country B will suffer because goods from country B, priced in B's are more expensive for people in Country A to buy with A's currency.

      Another way to think about it is to imagine you are going to Europe on vacation. You have calculated that you need 500 euros cash for the trip. The exchange rate is normally 1 Euro/dollar, so you would need 500 dollars to purchase the Euros you needed. If the Federal Reserve buys US treasuries to put more money in circulation and the and the exchange rate is now 1.5 dollars/Euro, you now would need 750 dollars to get the money you needed. But if you were a European citizen looking to come to the US, then instead of needing 500 euros to buy 500 dollars, you would only need 333 euros.
      (14 votes)
  • leaf green style avatar for user Dylan Silva
    Why is this situation bad for B? Shouldn't it give holders of B (the citizens of B) more buying power?
    (5 votes)
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  • leaf yellow style avatar for user Juraj Kovalcik
    What will happen, when investors stop buying properties or investing their money in B?
    What action will take the B's central bank?
    (7 votes)
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  • starky ultimate style avatar for user Alwin Look
    Since most financial trade is electronic now, and foreign exchange can be conducted faster, in greater quantities, does the central bank of B actually physically "print" the money and physically ship it over to the country A upon completion of transaction? Or does it somehow just "declare" an increase in B currency in its database and merely edit its data files to add a few million more B currency, which it then trades electronically to receive also just a digital receipt of A currency?
    (2 votes)
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    • mr pink red style avatar for user Wes Brown
      From my knowledge, the US Federal Reserve issues "electronic funds" to its banking partners which are then lent out to the institution's customers. The only time physical currency is transacted in our modern world is when customers (you or I) withdraw money from the bank for cash transactions. My assumption is the Fed has a database of how much currency it distributes to its partner banks when it issues new currency. Of course, the Fed will eventually have to restock currency supplies in banks as it fluctuates or they phase out older denominations, etc.

      Unfortunately, this is problematic when the national currency is scrutinized a bit more, especially in light of it being "fiat" and backed by no physical commodity that has market-defined value. All that's theoretically needed to expose this issue is a bank run on several of the partner banks. If too many people ask for their cash at the same time, actual amounts of cash would be incapable of sustaining that demand. Hence exposing the lack of supply (and true value) of that currency. This is what's referred to as fractional reserve banking; ie, the reserve of currency (or even the commodity its backed by) is less than total real demand.
      (2 votes)
  • blobby green style avatar for user zaclim1
    So is maintaining foreign currency reserves a market distortion?
    (3 votes)
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  • leafers ultimate style avatar for user Raul Pereira
    How does the central bank of country A purchases currency of country B (foreign currency)? By direct purchase on the forex, by buying debt issued by the central bank of country B, i.e. by lending money to country B, or both ways? Cheers
    (2 votes)
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  • blobby green style avatar for user Afeef Mirza
    Sal says that country B buys extra As with the new money printed ... but my question is, even if country B hadn't printed the money, it would still have had the same amount of As, because they would have paid the higher exchange price to get the Bs anyway...

    example: if there are 100 As and 100 Bs on the forex market, 1 for 1 and then the situation becomes 200 As want those 100 Bs... B does not have to print extra money to get those 200 As ... as A would have bought those 100 Bs for double the price anyway.... correct?
    (2 votes)
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    • ohnoes default style avatar for user Tejas
      You misunderstand the point. The reason that the central bank of B wants to engage in this transaction at all is because B does not want the exchange rate to be 2:1. B wants the exchange rate to remain at 1:1. B doesn't actually care about having foreign currency reserves. The exchange rate is what is important to B.
      (2 votes)
  • aqualine ultimate style avatar for user Ben McCuskey
    In Sal's example of Country B printing more dollars to prevent it's dollars from becoming more valuable relative to Country A, could Country B be accused of being a "currency manipulator"?

    Also, by now holding a lot of Country A's dollars, does Country B have a vested interest in the economic health of Country A? If Country B is holding a lot of Country A's dollars, then Country B wants the value of Country A's dollars to not decline too much because then their holdings of Country A's dollars will decline. Is that accurate? Thanks.
    (2 votes)
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  • piceratops ultimate style avatar for user Yuli Dias
    Why are there countries that hold high fc reserves, and receive a large number of international investment (ike Brasil or China), and yet their money is not relatively expensive when compared to Euro or Dollar?
    (2 votes)
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  • male robot johnny style avatar for user tannsomphors
    What are the positive and negative effect of reserving the currency value?
    (1 vote)
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Video transcript

Let's say we've got two countries: country A and country B And at the start of our little hypothetical thought experiment they have a very stable exchange rate, maybe it's one for one. Every A, if you were to go into a foreing currency markets, you could get a B for it. So there's this kind of this stable supplying demand between this two currencies. Now let's say for whatever reason folks in A start to believe that country B is the hot place to invest. They want to buy country B's real state, they want to invest in country B's stock market. and so if they wanna buy stuff in B they essentially have to hold more B's currency and so more and more people in A want to exchange their "A's" for country B's currency. So you have this huge supply of A comming out to the foreign exchange markets but you still have the same amount of B that wanna go the other way, maybe, you know, these are maybe there to either invest in country A or maybe buy some of country's A exports, or whatever it might be. But if we just let this happen on it's own when all of a sudden there's a much larger demand for converting A into B than converting B into A, you'll have a situation where the B will just get more expensive. There's more demand for B than there are for A. It'll get more expensive in terms of A. So if you look at it from country A's point of view, you're now having to pay more A per B At a completely equivalent statement from country B's perspective you now have to pay fewer B's per A. Now, let's say for whatever reason you are the central bank (right over here) of country B and you don't like your currency becoming stronger, maybe you just don't like the volatility in the exchange market, you don't like the idea that the exchange rates go up and down so dramatically, maybe you just don't want your exports to get expensive or that imports from another country to get cheap. For whatever reason you do not like this movement happening and so what you're going to do is, because you have the right to do it, because you are the central bank of your country, you can print more of your currency (right here the currency pies) so you're gonna print more of these, you could print more of them just like that and then you could use that extra bit that you've just printed to buy more A's and so now you've kind of renormalized the supply and the demand for B. But what's going to be the end product of that? Well, you did succesfully keep your currency from appreciating relative to the A's which, based on how this was all set up, that was your goal, but the other thing that you ended up with is such a printed B's that you're able to buy A at the open market, you now, on your balance sheet, you have a bunch of A. And so when people talk about foreign currency reserves and pretty much every bank, every central bank has foreign currency reserves, this is what they're talking about. That central bank printed their own currency and went out to currency for and exchange markets and bought other countries' currencies. And there's multiple reasons for them doing it. This might be one of them, or it might be to protect them in the case that this whole dinamic reverses in the other direction, specially if it reverses in a very dramatic way.