Every time a U.S. resident buys something---be it a commodity
a service, or an asset---from a Japanese resident, one or other
of them has to convert U.S. dollars into Japanese yen. The
U.S. importer must pay in yen or persuade the Japanese exporter
to accept dollars. In the latter case, the Japanese exporter
has to convert the dollars to yen before the funds can be used
to cover her domestic costs. Similarly, every time a Japanese
resident wants to buy something in the United States either she
or the U.S. exporter must convert yen into dollars.
Sometimes exporters in smaller countries prefer to accept
U.S. dollars in payment even when they are not trading with a
U.S. resident and importers are willing to pay in U.S. dollars
even though they are not U.S. residents. In this case the
dollar is serving as a vehicle currency or as
international money in the same way that the yen serves
as money within Japan. The transactors on both sides, of course,
have to convert between their local currency and U.S. dollars.
When a country's residents make payments to foreigners, a supply
of the domestic currency and demand for the foreign currency is
created. Similarly, payments to domestic residents from abroad
create a supply of the foreign currency and a demand for the
domestic currency. The foreign exchange market is where
these buyers and sellers of national currencies come together---it
operates through a world-wide electronic network. The price
of foreign currency in terms of domestic currency is the foreign
exchange rate, which could equally well be defined alternatively
as the foreign currency price of domestic currency.
Since an exchange rate exists between each country's
currency and the currency of every other country, there are
many more foreign exchange rates than there are currencies.
These rates of exchange must all be consistent with each other.
For example, one should not be able make a profit by converting
pounds into yen at the market exchange rate of yen for pounds,
then the yen into dollars at the market rate of dollars for
yen, and then the dollars back into pounds at the market rate
of exchange of pounds for dollars. Any such profits---called
arbitrage profits---are immediately eliminated by arbitrage.
To understand the nature of arbitrage, suppose that the
exchange rates between the pound, the yen and the dollar at a
particular point in time are as follows:
one pound = 370 yen one yen = 0.005 dollars
one dollar = 0.54795 pounds.
A British foreign exchange trader (the term foreign exchange
is used to refer to any foreign currency purchased with or sold
for a domestic currency) can sell 100 million pounds for 37000
million yen, then sell these yen for 185 million dollars which
can be then be converted back into 101.37 million pounds
for a realized net profit of 1.37 million pounds. Moreover,
this arbitrage profit is virtually a sure thing. The only way
the trader could lose is for the exchange rates to change in
the minute or two it takes to make the three transactions. This
is different from a speculative profit. Speculation is an attempt
to profit from expected future changes in exchange rates while
arbitrage is an attempt to profit from simultaneous transactions
at existing rates. Speculative profits occur when foreign exchange
rates move as the speculator expects they will move. Arbitrage
profits occur as long as the exchange rate does not move significantly
while the arbitrage transactions are being made.
When an arbitrage opportunity presents itself, traders all
over the market will attempt to take advantage of it. In the
situation outlined above, everyone will try to buy yen with
pounds, dollars with yen, and pounds with dollars. The price
of the yen in terms of the pound will rise, with the result that
less yen will exchange for a pound, and the price of dollars in
terms of yen will rise, so that less dollars will
be obtained for a yen. These exchange rate adjustments will
continue until all three exchange rates are consistent with each
other.
Suppose, to continue the example, that the yen price of
the pound falls from 370 to 368, and the dollar price of the yen
falls from .005 to .0049592. The three rates will then be as
follows:
one pound = 368 yen one yen = 0.0049592 dollars
one dollar = 0.54795 pounds.
An arbitrager could no longer make a profit. An initial
investment of 100 million pounds would yield only
(36800)(.0049592)(.54795) = 100.002 million pounds, which we will assume
to be an insufficient gain to cover transaction costs.
As a result of the actions of arbitragers, any inconsistencies across
exchange rates will be eliminated so quickly that only traders sitting
right at their computer terminals would have any chance of profiting from
them.
It is time for a test. Be sure to think up your own answers before looking
at the ones provided.
From a macroeconomic point of view, the main thing
that distinguishes countries from regions within countries is
the fact that countries almost always have separate monetary
units---the pound in England, the yen in Japan, the deutschmark
in Germany, the French franc, the U.S. dollar, the New Zealand
dollar, and so forth. International exchange of goods, services
and securities requires that national currencies be exchanged in
the process. Japanese yen received for a sale of Canadian lumber
to Japan, for example, are of no use to a Canadian exporter who
must pay his employees in Canadian dollars.