Countries buy and sell goods off each other all the time. When they receive money for goods they produce (i.e. when they sell their exports), these are known as credits. When they spend money on goods they want (i.e. when they import), these are known as debits. A country's balance of payments will show them where they've spent and received.

Now, imagine the USA wants to buy British trucks. They put in an order for $5000. Seems easy enough. Except, what on earth will the British company want dollars for? Surely, being British, they want Pounds Sterling as this is the currency of their country.

So, before the deal can be made, the USA must go and buy Pounds in the foreign exchange market. This has a direct impact on the demand and supply of both Pounds and Dollars. In this case, dollars are being supplied, and Euros are being demanded. Supply of dollars increases (thus causing its value to go down - or depreciate - as it is less scarce), whilst demand for Pounds increases (thus causing its value to go up - or appreciate - as people want it). This is shown below.

So what we can say is:

• debits = supply of home currency (we want something, we have to get rid of our currency to buy the other)
• credits = demand for home currency (other countries want your stuff, they need to buy your currency first)

 

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Countries have different ways of arranging their currency value. Click on the tabs below to find out more.

 

The easiest way to remember this is 'how much bang do you get for your buck?'

The idea is simple. When we see an exchange rate - say $1:Y100, we assume that what $1 buys you in the United States, Y100 will buy the same amount in China. If the exchange rate changed to $1: Y200, this should tell us that there is inflation in China. As a result, China's currency will depreciate.

This is too simplistic though. As economists we know that there are many reasons for exchange rate fluctuations. We need a better measure to compare exchange rates - these are known as Purchasing Power Parity Exchange Rates. They are calculated by international organisations to account for the differences in spending power.

As a result, using a PPP Exchange Rate, we know that what $1 buys in the USA, Y100 buys in China. Without a PPP Exchange Rate we don't know how far our money could go. Theoretically we shouldn't need PPP Exchange Rates, but realistically, we do.

We need them because the following things cause the exchange rate to change as well as inflation....

 

Arguments for and against the single currency usually centre around the Euro. Firstly it is important to define what a single currency is. We must differentiate between:

a) A global single currency
b) A localized single currency - e.g. the Euro.

As a hotly debated topic, what could cause countries to want to give up their own historic currencies and take on a new, foreign one? Have a look at our notes below, and then see if you can get more reasons for the video.