Author: John Bouman

Velocity Velocity is defined as the average number of times a unit of the money supply (for example M-1) is used for economic transactions during a specified period of time. If a nation’s money supply is $100 and its citizens spend $600 on final goods and services, then the average number of times the $100 was used to buy final goods and services during that year is 6. Velocity Determinants Velocity is determined by the following factors: The stability of the money. If a nation’s money supply is stable, consumers will spend money according to their needs, and businesses will invest money based on their future expected earnings. There is not much reason to believe that consumers and businesses will spend their money more quickly than the year before. However, if the nation’s money supply is not stable (too much money in circulation), and the value of money decreases (inflation), then people will likely spend it more quickly. If, for example, prices double every week, people will spend their paychecks almost immediately. If they hold on to their money until the end of the week, prices will be twice as high. This quicker turnover of the money supply equates to an increase in velocity and makes it feel like there is even more money in circulation than there already is. This combination of too much money in circulation and...

What’s in This Chapter? A pound of strawberries sells for $4 this week and $3.50 next week. A dollar exchanges for 100 Japanese yen one week and 102 Japanese yen the next week. Strawberries decrease in price when they are in season and the supply is greater. The dollar decreases in value when the demand for dollars relative to the yen decreases. In a free market system, currency values change the same way as conventional products like strawberries. Their prices are determined by supply and demand. If a government keeps the value of its currency constant (fixed) relative to another country’s currency, it is similar to a government keeping the minimum wage fixed for a period of time. Shortages occur when the price is set below the free market price, and surpluses occur when the price is set above the equilibrium. A freely fluctuating exchange rate system is more effective and economically efficient than a government-controlled, fixed-exchange-rate system. In a freely fluctuating exchange rate system, there are no long-run shortages and surpluses, and there is no need for central bank intervention. The first part of Unit 10 elaborates on these concepts. The second part of Unit 10 describes the balance of payments. This is an estimate of the currency flows from and to other countries. The balance of payments consists of the current account, the financial account and the...

Purchasing Foreign Currency Most countries exchange many goods and services with other countries. Usually, before a product can be purchased from a foreign country, the buyer needs to buy the foreign country’s currency. For example, a United States business purchasing German cars must first buy euros before it can pay the German exporter for the cars. The values of most currencies fluctuate on a daily basis. For example, 10 Moroccan dirham may exchange for $1 (US) today, while next month it could exchange for $1.10. For a quick way to find currency exchange values, type “currency converter” in the Google (or any other search engine) search field. In addition to currencies supplied by central governments, there are also virtual currencies accumulated in online games. People who play games online (for example, Mega Man, Street Fighter) may accumulate game money (for example, a Zenny) and exchange this (buy or sell) for conventional currencies. Bitcoins and Other Cryptocurrencies Cryptocurrencies are gaining in popularity, acceptance, and legality. An unknown Japanese entrepreneur created the Bitcoin virtual currency and its supply is entirely non-physical and based on cryptography and sophisticated mathematical formulas. Bitcoins are used for a variety of online transactions and, while gaining acceptance in conventional trade, are especially popular in the underground economy. The value of one bitcoin has ranged from less than $100 (US) to more than $100,000. As with many...

Flexible Exchange Rate Systems Most countries allow their currencies to fluctuate in value relative to foreign currencies. The currency values will fluctuate with changes in demand and supply, similar to demand and supply fluctuations in the market for products. An increase in the demand for housing will increase the value (price) of houses. Similarly, an increase in the demand for the Australian dollar will increase the value (price) of the Australian dollar. Depreciation and Appreciation Depreciation and appreciation are changes in the values of currencies within a flexible exchange rate system. If the supply of dollars increases, or the demand for foreign currencies increases relative to the demand for the dollar, then the value of the dollar falls. We say that the dollar depreciates. If the demand for dollars worldwide increases, then the value of the dollar rises. We say that the dollar appreciates. Example 1 Before U.S. dollar depreciation: $1 = 100 yen After U.S. dollar depreciation: $1 = 95 yen = Fixed Exchange Rate System Some countries prefer to keep their currency values fixed relative to other foreign currencies. For example, if 100 units of a foreign currency exchange for $1, and the two countries decide to keep their currency values fixed for a period of time, we speak of a fixed, or pegged, exchange rate system. Through most of the 1990s China kept its currency fixed...

A Country’s Inflows and Outflows of Funds Countries that engage in international trade experience inflows and outflows of products, services, currency purchases, and investments. The accompanying flows of money used to pay for these transactions are recorded in an accounting system called the balance of payments. The balance of payments consists of two main accounts: the Current Account and the Financial and Capital Account. The Current Account The current account records international transactions that typically represent a transfer of goods and services (exports and imports listed in categories 1 and 2 below), as well as transactions that provide income from persons or investment accounts in the United States to citizens in foreign countries, or vice versa (categories 3 and 4 below). The Current Account consists of the following four categories: 1. The merchandise trade account The merchandise trade account includes imports and exports of tangible products, such as cars, computers, clothes, and televisions. If a country imports more tangible products than it exports, it experiences a trade deficit. If it exports more tangible products than it imports, it experiences a trade surplus. 2. The services account The services account includes flows of international money payments for services such as transportation, insurance, banking, consulting, and tourism. 3. The investment income account The investment income account reflects United States investment earnings from foreign stocks, bonds, and real estate, minus foreigners’ investment...