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Macroeconomics
Course: Macroeconomics > Unit 6
Lesson 3: The foreign exchange market- Currency exchange introduction
- Supply and demand curves in foreign exchange
- Accumulating foreign currency reserves
- Using reserves to stabilize currency
- Speculative attack on a currency
- Financial crisis in Thailand caused by speculative attack
- Math mechanics of Thai banking crisis
- Lesson summary: the foreign exchange market
- The foreign exchange market
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Using reserves to stabilize currency
How a central bank could use foreign currency reserves to keep its own currency from devaluing. Created by Sal Khan.
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hey sal, i think you should make sure that everyone understands the difference between depreciation and devaluation, the former being the fall of value of the money in a free floating system (fueled by market forces), the latter being a decision by the government/central bank.(8 votes)
That's a good point--he should distinguish between depreciation and devaluation.
However, to be a little more precise, I believe the key difference is that depreciation is used to describe a smooth decrease in the value of a currency (due to market forces, as you indicated) while devaluation specifically refers to a discrete fall in the currency's value (usually a result of a change in government policy). In other words, depreciation is a downward slope, whereas devaluation is a cliff.
I just mention this because this distinction is helpful when you think about foreign exchange issues mathematically...
But again, you make a good point.(6 votes)
- why would you not the value of your currency to increase? Surely it means that you can buy more foreign goods.(3 votes)
If your currency gets more expensive, imports are cheaper but your exports are more expensive, and that hurts employment in your country. Consumption does not have be the prime objective.(6 votes)
what happens when a foreign country has too little of its own currency(2 votes)
I don't think it can actually happen as every country can print its own bank notes, that's the entire reason why it's called "it's own currency". If the country chooses to use some other country's bank notes, the former becomes dependent of the monetary policy of the last one. It's what happen to Ecuador, which gave up its own currency (the Sucre) back in 2.003, and uses US Dollars. The pro is that dollar is very stable so Ecuador has the same rate of inflation as USA, and most investors feel safe investing in Ecuador as they can take their money out of the country whenever they want so Ecuador has plenty of investment after it left ts own currency. Con is that government cannot spend as much as it would like to because depends entirely on the amount of dollars that investors and tourists spend in the country; if something bad happens like the recent earthquake, government cannot print money to spend as much as it would like to reconstruct the country, it depends entirely of dollars from outside(8 votes)
- How does a country's central bank build foreign reserves if the private companies or individuals who earn foreign exchange do not give it to their central bank. E.g. If i am a businessman in Country B and earn lots of A's, but what if i keep all the A's in my bank account and dont give it to my Central Bank (B) because i might need it later. So cases like these, even though some individual in Country B is earning A, but not the reserves with B's Central bank do not increase, am i thinking correctly?(3 votes)
Try to separate individuals from the central bank. Individuals do not interact with the central bank. It exists to implement monetary policy, control the money supply, set the interest rate, regulate the banks, and act as a lender of last resort (to the banks).
To answer your question, the central bank builds foreign reserves by buying it on the foreign market. The fact that you—a businessman from B who earns a lot of currency A—don't want to give up your currency A is inconsequential. The central bank will buy currency A on the market.
Consider also that once you deposit currency A in your bank account, the fractional reserve system allows your bank to do what it likes with a certain percentage of your money (depending on what country you're in—that could be 90%, 95%, or even all of it).(4 votes)
Once all the A currency is over in B's Central Bank, would be it possible for B's Central Bank to buy more A's by selling some other assets (gold, another country's FX reserves) to A's investors (and get A currency in return), and then sell the A currency in the FX market to get the exchange rate fixed again.(2 votes)
It will never be the case that all of the A's are in B's central bank. If it came close, then the A's would become so scarce that the value of A's currency would increase and B would need to sell A's in order to maintain the exchange rate.(4 votes)
- Can someone please explain what's going on in China?(1 vote)
- Before recently, the Chinese economy was growing faster than could be sustained. They had averages of 9% growth per year before this. If you compare this to a "normal" level of growth of 2-3%, you can clearly see the disparity. What we are seeing is a slowdown of growth to a more reasonable level. The only problem is that investors had made investments expecting China's growth to be 7% or more. For instance, Chinese firms and households have taken on large levels of debt. As a result, they are losing a lot of money.
At the same time, the Communist Party's basis for power is in China's history of high growth during its reign. Now that growth is slowing, the Communist Party's power is definitely shaken, but that is more entering the realm of politics. The government has been slashing interest rates trying to stimulate growth, but all that has accomplished is inflation.
However, the biggest problem of all is the lack of good data from China. China's authoritarian political system engages in major censorship, which suggests that data that makes it look bad would not come to light. You can infer broad trends from foreign data, but for a more fine-grained answer, accurate data simply doesn't exist.(5 votes)
- Why would a country not want their currency to appreciate relative to other currencies?(3 votes)
- Countries whose GDPs are dominated by exports or something like tourism. If your currency is "strong" or has appreciated relative to other currencies, foreign nationals will be less likely to purchase your exports or visit and purchase your g/s.(1 vote)
- wouldn't the central bank be appreciating its money even more when it prints more money because it is buying the a's for less then it is to create the b's so essentially its making the country richer?(2 votes)
- No. Money is not wealth. Creating B's does not make country B richer.(2 votes)
- at4:14, even if the central bank of b runs out of a's currency, wouldn't a's central bank be already hard at work printing money to keep their currency from appreciating?
in fact, if a's bank had some of b's currency, then in the first situation where b is printing money, would they have been selling their reserves of b's currency?(1 vote)- Not every country tries to manipulate the exchange rate like B does. For instance, many countries support free-floating exchange rates rather than keeping them pegged. Also, it might be that B is a lot smaller country than A, and so B needs to worry about the exchange rate with A, but A does not need to worry about the exchange rate with B. An example of this would be the United States, which itself does not worry about the exchange rate, but about 13 countries have pegged their currency to the dollar.(3 votes)
- At3:44-48 you mentioned how the selling of these particular reserves will cause the currency to not devalue as much, could you explain why this happens? Thank you(1 vote)
- If you are trying to buy your own currency, that will cause your currency to appreciate, because demand is higher.(2 votes)
4:14Video transcript
Narrator: In the last video we saw how everyone in country A got
excited about investing in country B and so they
wanted to convert their currency into country B's currency. Left to its own devices
with this new demand for currency B, it would
have made currency B more expensive, but
instead of allowing that to happen the central bank of country B said no, no, no, no,
no, I want to keep the exchange rates relatively stable, so I'm going to print
B's and use those to buy up A's. So at the end of that
video the central bank of country B ended up with
foreign currency reserves. It ended up with some of A's currency on its balance sheet. What I want to do in
this video is think about what if demand goes the other way and how could the central
bank use its foreign currency reserves to prevent its currency from devaluing. Let's go to the next stage in our little hypothetical story here. Let's say people in A,
all of this investment happened in country B,
everyone was all excited. Probably a bubble was forming of some kind and then all of the sudden the investors in country A start to
get a little bit scared. They start to hear reports
of the bubble forming, they start to realize that
conditions in country B weren't as good as they thought it might have been initially,
so they start to panic. They start wanting to
unwind their investments. Whatever they had in country
B they want to sell it, they get B's currency
for it and they want to convert that to their home currency. Now you have the reverse situation of what we saw in the last video. Everyone wants to sell their B's, so they had invested in country B maybe they had bought
some real estate there, they're going to sell their real estate, they're going to get B's for it and then they're going to get out of that countries currency. They're going to want
to convert that money back in to A's, but this
is the opposite situation. Now everyone wants to run out of country B and there isn't a lot of
supply of A's in return. No one's really looking
to trade A's for B's now. Everyone is irked, the
market is going completely in the opposite direction. If, once again, foreign exchange markets were allowed to float
freely what would happen? In this situation all
the demand is for the A's and all the supply is on the B's so you would have either more ... Let me write it this
way, you would have fewer A's per B. (writing) Fewer A's per B ... or you could have more B's per A. These are the same statement. (writing) More B's per A. In general, A has now
become more expensive in terms of B or B has
become cheaper in terms of A. Let's say you're the central bank and you say well I don't like this either. Now all of a sudden,
usually this unwinding, this panic happens much faster and in more dramatic
fashion than the initial phase over here. You say, oh my God people in our country they might not be able to ... If this were to happen
foreign imports would become so expensive people
might not be able to even afford food that we have to import from other countries or essential supplies from other countries. So they say, no, we're going to intervene. We were able to accumulate some of these foreign currency reserves
so we can use those now to try to stabilize our currency. In this situation what
the central bank would do is say okay I've got some reserves of A what I'm going to do is I'm going to go into the open market. I'm going to go into the open market and also sell my reserves ... and sell my reserves of
A and try to equalize the supply and the demand. So, once again, if
they're able to sell these reserves, now all of the
sudden their currency will not devalue or maybe
not devalue as much. The one kink in the system
here is that they only have a finite of reserves. This right over here is finite. In the previous video
when we saw that they were printing their own
currency to build reserves, they could do this all day, all night because they have the
right to print as much of their own currency as they want. But now they are using
reserves of someone elses currency to keep their own currency from being devalued, but
they can't print someone else's currency. They're hoping that what they have on hand is enough to fight this
... what they're probably perceiving is a short term imbalance, but it could be scary. What happens if all of
this currency runs out? Then they blow all of
their currency reserves and if this kind of panic keeps occurring then you're going to go
back to the free market forces and their currency
will have to devalue. That's how central banks attempt to keep their currencies relatively stable. In future videos we'll go through real cases of when this happened and what exactly happened when the foreign currency reserves ran
out and how speculators could use that knowledge
to essentially make an easy speculative buck.