This has been solely copied from Naked Economics by charles wheelan.

What is Currency ?

  1. Currencies are no different than any other good; the exchange rate, or the “price” of one currency relative to another, is determined by supply relative to demand.

  2. The American dollar is just a piece of paper. It is not backed by gold, or rice, or tennis balls, or anything else with intrinsic value. The Japanese yen is exactly the same. So are the euro, the peso, the rupee, and every other modern currency.

  3. if the value of the ruble is losing 10 percent of its purchasing power within Russia every year while the U.S. dollar is holding its value, we would expect the ruble to lose value relative to the U.S. dollar (or depreciate) at the same rate.

  4. This isn’t advanced math; if one currency buys less stuff than it used to, then anyone trading for that currency is going to demand more of it to compensate for the diminished purchasing power.

Is Currency backed by gold ?

  1. It was.
  2. At present. No.
  3. Gandhiji’s promise of giving the dharak the amount on note is a popular myth.

Why it was removed ?

  1. Us faced problem of people and countries asing for gold when the value of currency dwindled. So to protect it’s gold reserves, it had to raise interest rate.
  2. Raising an interest rate makes investors keep their money. So the gold reserves were protected.
  3. But it also increases rate of debt, which isn’t recommended during economic crisis.
  4. So they removed this gold thing. Now it’s just fiat currency.

What are tradable and non tradable goods ?

  1. Tradable Goods are which can be traded such as Computer, Television etc. Even IT services will be considered as tradable goods.

  2. Haircuts, Babysitting, Rental Services(not like oyo, plain simple house renting) etc.

  3. In a modern economy, more than three-quarters of goods and services are nontradable.

What is Purchasing Power Parity ?

  1. If someone earns 10,000 Jordanian dinars a year, how many dollars would a person need in the United States to achieve a comparable standard of living.

  2. Here is the strange thing: Official exchange rates—the rate at which you can actually trade one currency for another—deviate widely and for long stretches from what PPP would predict. If purchasing power parity makes economic sense, why is it often a poor predictor of exchange rates in practice? The answer lies in the crucial distinction between goods and services that are tradable, meaning that they can be traded internationally.

  3. The Economist created a tongue-in-cheek tool called the Big Mac Index for evaluating official exchange rates relative to what PPP would predict. The McDonald’s Big Mac is sold around the world. It contains some tradable components (beef and the condiments) and lots of nontradables (local labor, rent, taxes, etc.). The Economist explains, “In the long run, countries’ exchange rates should move towards rates that would equalize the prices of an identical basket of goods and services.

Why it Works ?

  1. In the long run, basic economic logic suggests that exchange rates should roughly align with purchasing power parity. If $ 100 can be exchanged for enough pesos to buy significantly more stuff in Mexico, who would want the $ 100? Many of us would trade our dollars for pesos so that we could buy extra goods and services in Mexico and live better. (Or, more likely, clever entrepreneurs would take advantage of the exchange rate to buy cheap goods in Mexico and import them to the United States at a profit.) In either case, the demand for pesos would increase relative to dollars and so would their “price”—which is the exchange rate. (The prices of Mexican goods might rise, too.) In theory, rational people would continue to sell dollars for pesos until there was no longer any economic advantage in doing so; at that point, $ 100 in the United States would buy roughly the same goods and services as $ 100 worth of pesos in Mexico—which is also the point at which the exchange rate would reach purchasing power parity.

  2. This is how gold gained it’s value. No one really cared until someone did. (Ref. Sapiens)

Is Weak currency bad?

  1. A weak currency-
    1. Export Cheaper, Good for exporter
    2. Import Costly, Bad for importer.
  2. When the Japanese yen appreciates against the dollar by a single yen, a seemingly tiny amount given that the current exchange rate is one dollar to 90 yen, Toyota’s annual operating earnings fall by $450 million.

  3. This is how world economy remain in balance, if someone exports a lot and has lot of forex reserves, then that economy will demand more investment, if the economy will demand more investment more people will buy there currency, hence the price will rise, and when the price of currency will rise the government will not be able to export more and someday, the economy will achieve equilibrium. And that’s why growth rate of developed countries are so low as compared to developing countries.

Can a government can manipulate value of it’s currency ?

  1. The government could use its reserves of other foreign currencies to buy pounds—directly boosting demand for the currency.A currency intervention can feel like trying to warm up a cold bathtub with one spoonful of hot water at a time, particularly while speculators are doing the opposite.

  2. The government could use monetary policy to raise real interest rates, which, all else equal, makes bonds (and the pounds necessary to buy them) more lucrative to global investors and attracts capital (or keeps it from leaving).

  3. China’s export-oriented development strategy depends on keeping the renminbi relatively cheap. To accomplish that, the Chinese government recycles accumulated dollars primarily into U.S. treasury bonds, which are loans to the U.S. federal government. Both parties get what they want (or need), at least in the short run. The Chinese government has used exports to generate jobs and growth. America has funded its dissavings with enormous loans from China. The situation really isn’t much different than Farmer China and Farmer America: The United States gets loans from China to buy its exports.

Does strong currency imply strong currency ?

  1. The U.S. economy was ground zero for the global recession that began in 2007. With the U.S. economy in such a poor state, one would have expected the dollar to depreciate relative to other major global currencies. In fact, U.S. treasury bonds are a safe place to park capital during economic turmoil. So as the financial crisis unfolded, investors from around the world “fled to safety” in U.S. treasuries, causing the U.S. dollar to appreciate despite the floundering American economy.

  2. What you can miss from the above statement is, basically investor saw the ripples across all other economy, so because they didn’t find any other better alternative they invested in US Treasury bond.

Fixed and Floating exchange rates.

  1. Fixed exchange rates (or currency bands). Fixed or “pegged” exchange rates are a lot like the gold standard, except that there is no gold.

  2. Most developed economies have floating exchange rates; currencies are traded on foreign exchange markets, just like a stock exchange

  3. The primary drawback of this system is that currency fluctuations create an added layer of uncertainty for firms doing international business. Ford may make huge profits in Europe only to lose money in the foreign exchange markets when it tries to bring the euros back home. So far, exchange rate volatility has proven to be a drawback of floating rates, though not a fatal flaw. International companies can use the financial markets to “hedge their currency risk”.

Curious Case of Argentinian Peso

  1. At the end of 1990, inflation in Argentina was more than 1,000 percent a year, to no one’s great surprise given the country’s history of hyperinflation.

  2. Is that a currency you want to own? Argentina had long been the world’s inflation bad boy—the monetary equivalent of someone who stands you up for three straight dates and then tries to tell you that the fourth time will be different.

  3. It won’t be, and everyone knows it.

  4. Argentina declared that it was relinquishing control over its own monetary policy. No more printing money. Instead, the government created a currency board with strict rules to ensure that henceforth every Argentine peso would be worth one U.S. dollar. To make that possible (and credible to the world), the currency board would guarantee that every peso in circulation would be backed by one U.S. dollar held in reserve. Thus, the currency board would be allowed to issue new pesos only if it had new dollars in its vaults to back them up. Moreover, every Argentine peso would be convertible on demand for a U.S. dollar. In effect, Argentina created a gold standard with the U.S. dollar substituting for the gold.

  5. The proponents argued that it was an important source of macroeconomic stability; the skeptics said that it would cause more harm than good. In 1995, Maurice Obstfeld and Kenneth Rogoff, economists at UC Berkeley and Princeton, respectively, had published a paper warning that most attempts to maintain a fixed exchange rate, such as the Argentine currency board, were likely to end in failure.

  6. It failed. … Bad.

3 Basic Observation of an Impending Economic Crisis

  1. A country attracts significant foreign capital.

  2. Something bad happens: a government borrows too heavily and stands at risk of default; a property bubble bursts; a country with a pegged exchange rate faces devaluation; a banking system is exposed as rife with bad loans—or some combination of all of these things.

  3. Foreign investors try to move their capital somewhere else—preferably before everyone else does.

Can’t we just pass a law to make it harder to flee ?

  1. If foreign investors can’t leave a country with their capital, they are less likely to show up in the first place.

  2. The Economist summarized the study’s findings: “An occasional crisis may be a price worth paying for faster growth.”

Current Account Deficit (CAD, not Computer Aided Design)

  1. The current account measures income earned abroad from trade in goods and services, plus some other sources of foreign income, such as dividends and interest on overseas investments as well as remittances sent home by Americans working abroad.
  2. A country running a current account deficit is earning less income from the rest of the world than it is paying out.

  3. The United States has been running large and persistent current account deficits with the rest of the world, meaning that year after year we are getting more goods and services from the rest of the world than we sell to them.

  4. The Japanese are not sending us an extra $50 million in merchandise because we’re friendly and good looking; they expect us to make up the difference. To do that, we have only a couple of options. One option is to sell our Japanese trading partners assets instead—stocks, bonds, real estate, and so on.

  5. The United States is running chronic current account deficits because year after year we are consuming more than we produce. In other words, we are doing the opposite of saving (in which you produce more than you consume and set the extra aside). As a nation, we are literally doing what economists call “dissaving.”

China and US, Like Sisters, Like Peace and Chaos

  1. US had 1 trillion dollar of trade deficit when the book was written. Currently it is around 120 billion dollar. But still you should read the below argument. Because it’s quite interesting.

  2. In the long run, the situation poses serious risks for both parties. The United States has become a large debtor nation. Debtors are always vulnerable to the whims and demands of their creditors. America has a borrowing habit; China feeds it. James Fallows has noted, “Without China’s billion dollars a day, the United States could not keep its economy stable or spare the dollar from collapse.”13 Worse, China could threaten to dump its huge hoard of dollar-denominated assets. That would be a ruinous thing to do. As Fallows points out, “Their years of national savings are held in the same dollars that would be ruined; in a panic, they’d get only a small share out before the value fell.” Still, that’s an awfully powerful weapon to give a nation with which we often disagree.

  3. The Chinese have it worse. Suppose America’s debt burden grows beyond what U.S. taxpayers can (or are willing) to pay back. The U.S. government could default—simply refuse to honor its debts. That is highly unlikely, mostly because there is another irresponsible option that is more subtle: America can “inflate away” much of its debt to China (and other creditors) by printing money. If we recklessly print dollars, the currency will lose value—and so will our dollar-denominated debts. If inflation climbs to 20 percent, then the real value of what we have to pay back will fall by 20 percent. If inflation is 50 percent, then half of our debt to China effectively goes away. Is this a likely outcome? No. But if someone owed me a trillion dollars and also had the authority to print those dollars, I would spend a lot of time worrying about inflation.

World Bank and IMF, Like Sisters, Like Peace and Chaos

If the World Bank is the world’s welfare agency, then its sister organization, the International Monetary Fund (IMF), is the fire department responsible for dousing international financial crises.