By Dr Frank Shostak
The price of the Euro in terms of the US$ closed at 1.135 in November against 1.156 in October and 1.193 in November last year. The yearly growth rate of the price of the Euro in US$ terms fell to minus 4.8% in November from minus 0.7% in October. Some commentators are of the view that the US$ is likely to weaken against the Euro i.e. the price of the Euro in the US$ terms is likely to increase. The reason for this is the massive US trade balance deficit.
In September 2021 the US trade balance stood at a deficit of $80.9 billion against a deficit of $62.6 billion in September last year (see chart). Again, some commentators regard a widening in the trade deficit as an ominous sign for the exchange rate of the US$ against major currencies in the times ahead.
For most economic commentators a key factor in determining the currency rate of exchange is the trade account balance. On this way of thinking, a trade deficit weakens the price of the domestic money in terms of foreign money whilst the trade surplus works towards the strengthening of the price.
On this logic if a country exports more than it imports, there is a strengthening in the relative demand for its goods, and thus, for its currency so the price of the local money in terms of foreign money is likely to increase. Conversely, when there is more imports than exports there is relatively less demand for its currency so the price of domestic money in terms of foreign money’s should decline.
Similarly following this way of thinking, all other things being equal, if for some reason there is a sudden increase in the foreigners demand for a country’s currency this is going to strengthen the currency rate of exchange versus other currencies. If, however there is a sudden decline in the foreigner’s demand for a country’s currency, this is going to weaken the currency rate of exchange against other currencies. Notwithstanding we suggest that this way of thinking is questionable. Here is why.
The purchasing power of money and the supply and demand for money
The subject matter of the currency rate of exchange is the price of one money in terms of another money. The rate of exchange of a given money with respect to something is the amount of money paid per unit of something. Alternatively, we can say that the price of something is the amount of money paid for it. The amount of money paid for something is the money’s purchasing power with respect to something. Note that something could be a particular good.
If the supply of money increases for a given stock of goods, the purchasing power of money with respect to the given stock of goods is going to weaken since now there are more money per goods.
Conversely, for a given stock of money, an increase in the production of goods implies that there are now more goods per money. This means that within all other things being equal the purchasing power of money with respect to goods is going to strengthen.
For example, let us say we observe that a given basket of goods is exchanged in the U.S. for one dollar and the same basket of goods is exchanged for two euros in Europe. This means that the purchasing power of one dollar is the given basket of goods in the US. It also means that the purchasing power of two euro’s is this basket of goods in Europe.
We can infer from this that all other things being equal the rate of exchange between the U.S. dollar and the Euro is going to be one dollar for two Euros. Any deviation of the exchange rate from the level dictated by the purchasing power of currencies will set corrective forces in motion.
Suppose that because of a trade surplus and the consequent relative increase in the demand for US dollars the rate of exchange was set in the market at one dollar for three euros. In this case, the dollar is now overvalued in relation to its purchasing power versus the purchasing power of the euro.
Because of the strengthening of the dollar due to the trade balance surplus it will pay to sell the basket of goods for dollars then exchange dollars for euros and then buy the basket of goods with euros—thus making a clear arbitrage gain.
For example, individuals are going to sell the basket of goods for one dollar, exchange the one dollar for three euros, and then exchange three euros for 1.5 basket of goods, gaining an extra 0.5 of a basket of goods.
The fact that the holders of dollars are going to increase their demand for euros in order to profit from the arbitrage is going to make euros more expensive in terms of dollars and this in turn is going to push the exchange rate in the direction of one dollar to two euros.
Why trade balance is not the fundamental cause of exchange rate determination
In order to establish that the trade balance determines the currency rate of exchange, we need to show that the trade balance determines the purchasing power of money.
With respect to the supply of money, only central bank monetary policies and fractional reserve banking can determine it.
Similarly, the balance of trade does not determine the amount of goods produced, which determines the demand for money. The balance of trade only records the value of given goods bought and sold by an individual or a group of individuals. Since the trade balance has nothing to do as such with either the supply of money or the demand for money, we can conclude that trade balances do not determine the purchasing power of money of respective countries.
We do not say that a relative changes in exports or imports as mirrored by the trade balance do not influence the currency rate of exchange. We are suggesting that these changes are not the fundamental causes of the exchange rate determination. Consequently, the influences of these changes are likely to vanish over time as the currency rate of exchange converges towards its fundamental value as dictated by the relative purchasing power of money.
Changes in the relative money supply growth and currency exchange rate
Again, what matters for the currency exchange rate determination is its relative purchasing power with respect to a basket of goods. Within all other things being equal, we can suggest that a major factor behind the change in the purchasing power of money is changes in the supply of money.
Thus, an increase in the supply of dollars for a given basket of goods implies a greater amount of dollars for the basket of goods. This means a decline in the purchasing power of dollars with respect to the basket of goods. Likewise, a decline in the supply of Euros for the same basket of goods implies a smaller amount of Euro’s for the basket of goods. This means an increase in the purchasing power of Euro with respect to the basket of goods.
Hence, we can suggest that overtime if the growth rate in the money supply in the US exceeds the growth rate of the money supply in the Eurozone, within all other things being equal, the US dollar is going to depreciate against the Euro. Using the lagged money growth differential between the US money supply and the Eurozone money supply we can suggest that the momentum of the price of the Euro in terms of the US$ is likely to strengthen sharply during 2022 (see chart). This could mean that the US$ is likely to visibly weaken against the Euro.
Fundamental versus non-fundamental causes
Often various non-fundamental factors are perceived to be important in determining a currency rate of exchange because “it feels ok”. A sharp widening in the trade deficit is regarded as a sign of a likely deterioration in economic fundamentals ahead. This provides the rationale for the selling of the currency of concern.
Alternatively, let us say that an analyst forms a view that the growing US government debt at some stage will likely cause foreigners to stop buying US Treasuries. Consequently, within all other things being equal, this is going to lower the demand for dollars and result in the dollar’s collapse. It would appear that various factors such as the government debt, the interest rate differential, the state of the economy and the balance of trade could be employed to illustrate a scenario of a collapsing dollar. We suggest that all this amounts to a curve fitting.
What matters for the currency exchange rate determination is the relative changes in the purchasing power of respective currencies. Within all other things being equal, one could infer that a major driving factor in the exchange rate determination is the relative change in respective money supplies. Again, various non-fundamental factors are likely to influence the currency rate of exchange. However, the arbitrage will push the exchange rate towards its fundamental value as dictated by the relative growth rate in money supplies.
Irrespective of the popular view that the trade balance determines the currency rate of exchange, this view contradicts the relative purchasing power of the money framework – the essence of the currency rate of exchange determination. Hence, we suggest that an analysis that ignores the essence of the subject of investigation is likely to be highly questionable. Note, our analysis also raises the likelihood that on account of the lagged money growth differential the US$ will come under pressure against the Euro during 2022.