I had someone make this statement to me, that basically the currency conversion is a good indication of economic strength and that therefore the US economy falls short against many other economies, especially economies using the euro.
arguments against this thought process?
Offer to trade them one of our Big Macs for one of theirs.
Japan must be one of the poorest countries.
Zimbabwe redenominated its currency many times since 1980 by chopping off zeros after hyper-inflationary bouts. So many times that today’s Zimbabwe dollar is worth 10 septillion (10^25) 1980 Zimbabwe dollars. Somehow I doubt their economy imprived 10^25 times.
I’ll be honest even though I have UG in finance I’m still not that great when it comes to this type of stuff. Hoping this process will help me in areas like this.
He further went on to argue that since $1 equals around .80 euros that it therefore takes more money and effort on our part to buy something there, and therefore we are worth less in their minds.
What are the income differences? Does that explain this rationale? While maybe it costs (making up numbers here) 3 euros or $3.75 to buy something there that in the US that is 2, yes it takes more of the but we will earn the $ faster than they will earn the euro? So maybe it only costs the 3 euros but that’s significant in terms of % of income?
Anyone who grasps this concept well and can explain it please chime in.
The real test is “how much of your labor is require to purchace an equivalent amount of ‘stuff’ in each economy.”
There’s an aspect of exchange rates that says, if I have $100 in the US, am I better by spending it here, or by converting it into something else like GBP and buying the same stuff over there. To some extent, it depends on what stuff you are talking about, but if you create a diversified “basket” of stuff that you would need to live, that’s the standard of comparison.
You can go a long way to understanding this relationship just by understanding that first part. That’s called Purchasing Power Parity, and it’s demonstrated by The Economist’s “Big Mac Index,” which compares the price of a Big Mac in various countries.
The other aspect of the economy is how much labor does it take to earn $100 worth of stuff. Food is cheap in many emerging markets, but it also takes the average laborer far longer to earn enough to buy it (which is one reason why it’s cheap, demand is lower at higher prices).
From a purely economic perspective, where you would rather live would be a function of both how easy/difficult it is to earn the money to buy the stuff you need. It might be more expensive here in the states than it is in the Philippines, but if you are earning a higher wage here, it can still take you less time to earn a nice meal here than it would over there. Ideally it would be best to earn here and eat there, but that’s not always a realistic decision.
Wages tend to be determined by productivity, but also by the supply and demand of skilled labor. Which is to say that the ability of firms to pay wages is determined by productivity, but the ability of labor to demand wage ingcreases in line with productivity gains depends on their bargaining power, which depends on things like the supply of labor with the relevant skills, regulations, and whether labor can organize collectively or not. Things like labor unions can constrain the adaptiveness of businesses, but it is also true that when labor is completely unable to organize and make collective bargaining arrangements, ordinary laborers get placed in inhumane conditions, and profits flow increasingly to the owners of capital.
Another thing to consider is the expected inflation rate. If the US has low inflation, while the UK has high inflation, it may be that 1 GPB is $1.60 today, but next year it’s going to be worth $1.40. If that’s true, then the pound is going to be purchasing less and less over time, and that’s really what’s important from an investment point of view. Even though a $1MM GBP account is worth $1.6MM USD right now, you don’t want to hold it if the real purchasing power (the amount of “stuff” you can buy) is shrinking faster than the USD’s.
Thanks for the response. Definitely helpful.
I can’t decide if you’re a troll or not.
Say the Federal reserve started a new Currency “New Dollar” worth 2 USD. Would that mean the US is now > UK?
not trolling on this one…i didnt really know how to think about or articulate an explanation as to why if i take my $100 overseas and only get .8 of their currency unless earning power plays a factor…yeah my $1 only gets me .8, but it takes me 3 minutes labor to earn my $1 versus 8 minutes labor for you to earn your .8, etc.
Let’s put it this way, if the US decided that the Cent was going to be the new currency. Suddenly the US currency would be worth 99% less. Would that mean that you’ve lost purchasing power? No. Currency values are nominal. Just like a stock of a company trading at USD 500 isn’t “expensive” and one that is trading at 50 isn’t “cheap”.
Does cfa material cover international finance like this at all? Haven’t seen it so far…
It’s mostly a Level 2 topic, though it comes up in Level 3 a bit.