I will write a little about money and commerce with foreign countries. How does exchange occur when there are different currencies involved? From my introductory economics text, the process is confusing. If exactly the same dollar amount bought by the United States from one country is sold to that country things are simple. Then, the exchange can be handled by changing the balances in the accounts of the buyers in the United States and changing the balances in the accounts of the sellers in the other country. Nothing but the goods or services get exchanged between the two countries. Obviously the inflow and outflows never match exactly over a time period. However, foreign accounting is set up so that the accounts always balance.
Balance of payment accounts are set up into current accounts and capital and financial accounts (using the International Monetary Fund practice – which the United States accounts follow). Current accounts measure what is bought and sold and capital and financial accounts measure the exchange of capital. Adding the current account balance to the capital and financial account balances should give zero. In other words, when money is spent on foreign goods, the foreign money which is paid to the seller must come from somewhere. Likewise, when money comes from sales to foreigners, the dollars which are received must come from somewhere. In practice, usually the accounts do not balance. The negative of the sum of the current account and the capital and financial accounts is called the statistical discrepancy.
In the United States, the current account is the net of the dollar amounts of all of the goods and services exported and imported, plus net transfers of dollars for which nothing is received in return – such as foreign aid, plus net investment income. Exported goods and service increase the current account – we import dollars, and imported goods and services decrease the current account – we export dollars. Transfers into the country increase the current account – we import dollars, and transfers out of the country decrease the current account – we export dollars. Income from foreign investments increases the current account – the foreign company buys dollars to give to the investor and sells their foreign currency, and income from the United States to foreigners for investment in the United States decreases the current account – the domestic company buys foreign currency and sells dollars to pay the foreign investor.
The capital and financial accounts measure flows of ownership of capital. According to what I have read, most of the world works with a capital account, but the International Monetary Fund splits the capital account into a capital account and a financial account. The capital account is then mainly forgiveness of foreign debt. The financial account – which contains most of the exchanges – is measuring net investments of various kinds and the buying and selling of currencies by national governments. Some of the types of investments measured are the buying of a manufacturing plant in a foreign country, a foreigner buying stocks on the New York Stock Exchange, or a loan by a foreign bank to a domestic borrower. Returns such as interest and dividends on investments are put in the current account. If a foreign manufacturing plant is bought by a domestic buyer, the capital account decreases – dollars are sold and the foreign currency is bought. If a foreigner buys stocks on the New York Stock Exchange, the capital account increases – dollars are bought and the foreign currency is sold. If a loan is made by a foreign bank to a domestic borrower, the capital account increases – dollars are bought and the foreign currency is sold.
The government is one of the buyers and sellers of foreign currency. The usually reported balance of payments deficit (surplus) is the difference between the current and the capital and financial accounts without the net foreign assets and foreign liabilities of the federal government.
The buying and selling of currency also fall in the financial account. Let’s say that businesses in the United States have bought a lot of goods from China. The businesses need to have Chinese money to pay the Chinese company for the goods. Foreign currency is bought and sold in the foreign exchange market at the exchange rate between two countries. There is quite a history of how foreign exchange works. However, over the last forty years, exchange rates have pretty much been free to float, and a foreign exchange market has developed which is currently the biggest of the financial markets. While, in some cases, actual currency is transferred – for example, a tourist to Canada exchanges US dollars for Canadian dollars, I think that most foreign currency transactions occur “on the books” – that is an account in one currency is credited and an account in another currency is debited.
With exchange rates free to float, sometimes a government will want to raise or lower the rate at which the country’s currency trades. The government’s central bank would then buy the country’s currency on the foreign exchange market to raise the exchange rate or sell the country’s currency to lower the exchange rate. Sometimes a country will peg the country’s currency to another country’s currency. For example, I have read that China pegs the Chinese currency to the US dollar. Then, I think, the Chinese government will buy and sell the Chinese currency at the pegged exchange rate without regard to the foreign exchange market. While the foreign exchange market facilitates foreign transactions, the market has developed into a market where most of the trading is for speculation.
At the national level, the International Monetary Fund was created out of the Bretten Woods conference after World War II to help manage the fixed exchange rates that came out of Bretten Woods. By 1969, the fixed exchange rates were breaking down and the International Monetary Fund created something called special drawing rights, which were not denominated in any currency and through which governments could exchange currency. All of the members of the International Monetary Fund received some. Special drawing rights are still part of financial accounts, but the International Monetary Fund exists now mainly to facilitate loans to countries in financial trouble.
The United States has been running a trade deficit for at least forty years now. The claims on dollars by foreigners that have not been balanced by foreigners buying our goods and services (the current account balance) are mostly balanced by foreign investment in the United States of those dollars (the capital account balance). For example, the Chinese government has been “returning” United States dollars to the United States by investing in government securities.
Here is a link to the international accounts of the United States for 2011 and part of 2012, http://www.bea.gov/iTable/iTableHtml.cfm?reqid=6&step=3&isuri=1&600=1. For the second quarter of 2012, the current account showed $735,670 million in exported good and services, -$821,039 million in imported goods and services, and a net of -$32,743 million unilateral current transfers, giving a current account balance of -$118,162 million. The capital account has a balance of -$291 million. For the financial account, the change in US-owned assets abroad, excluding financial derivatives, was $248,186 million (a positive number indicates a decrease), foreign owned assets in the United States, excluding financial derivatives, was -$143,607 million (a negative number indicates an decrease) and net financial derivatives, were $464 million, giving a capital and financial account balance of $104,752 million. The statistical discrepancy is then $13,360 million. So, in the second quarter of 2012, the United States was decreasing investments abroad, foreigners were decreasing investments in the United States, though the investors in the United States were decreasing investments faster. From the current account, the United States was buying more goods and services from abroad than were being bought by foreigners from the United States.
While foreign exchange rates used to be fixed by governments and all currency was ultimately redeemable for gold, now money is “fiat” money, not backed by anything, and markets determine the cross values of national currencies. Currency markets work like the usual market. If the demand for a currency goes up, so does the price if the supply is held constant. If the supply of a currency goes up, the price of the currency falls if the demand stays constant. The main buyers and sellers of currency these days are large banks. I suspect that the markets now balance imbalances in supply and demand for currencies, whereas before governments did.