Monday 8 August 2011

Reserve currency explained for idiots like me

The more I learn about the economy the more I don't understand so I asked someone who understands these things to explain it in the most basic of basic terms and here is their reply.

- -
In very basic terms being the holder of the reserve currency allows you to buy things cheaper than anyone else as they have they added cost of changing their money into your currency first.

For example, if a 42 gallon barrel of oil costs $6, America gets it for $6. For that same barrel, the UK has to pay $6 and $1 to change the pound into dollars first.
So America can sell that barrel of oil to the Americans for $14.28 per gallon. The UK has to sell it at the equivalent of $16.66.

So cheaper petrol costs means it is cheaper to deliver something 10 miles in America ($142) than in the UK ($166) so the item being delivered, once delivery costs are factored in, is always going to be cheaper in the US. (Taxes, inflation etc must also be considered but ignore those for this purpose)

Now imagine the pound became the reserve currency and it got its 42 gallons for £6 while America had to pay £6 plus £1 to convert its dollar into pounds first. Petrol prices should fall in the UK while prices would definitely rise in America and the cost of delivering the items by ship, plane, car van etc would rise due to the added cost of the fuel.

So basically, the reserve currency allows you to be cheaper than anyone else in the World so prices are kept down. Take that away and prices go up, budgets get squeezed, jobs are lost, unemployment rises and Government raises less revenue and basically it all unravels.
- -

It's easy when someone explains it to you without all the blinding economic talk.

7 comments:

Nog said...

"So basically, the reserve currency allows you to be cheaper than anyone else in the World so prices are kept down. Take that away and prices go up, budgets get squeezed, jobs are lost, unemployment rises and Government raises less revenue and basically it all unravels."


The second part of this doesn't entirely follow. You might be mixing buying and selling here.
Whoever explained it to you didn't adequately explain how having the reserve currency is a double-edged sword.


-Dollars are worth more Yuans, so Americans can buy more Chinese goods for each dollar they spend (good for American importers)
-Yuans are worth less dollars, so Chinese folks can't buy as many American goods (bad for American exporters)

Having the reserve currency runs off all of the manufacturing, industry, and farming. We keep trying to drive down the dollar and the PRC keeps proping it back up. It's hardly all fun and games.



-Nog

Cody Bones said...

"For example, if a 42 gallon barrel of oil costs $6, America gets it for $6. For that same barrel, the UK has to pay $6 and $1 to change the pound into dollars first.
So America can sell that barrel of oil to the Americans for $14.28 per gallon. The UK has to sell it at the equivalent of $16.66."

Whoever explained this to you was smoking something, I'm just not sure what. Two points, the first is that the dollar and the pound fluctuate against each other. If the two currencies were trading at par (1-1) than 6 dollars would buy 6 pounds and vice versa. When the dollar is depressed as it is right now (at .61 pounds) than your 6 pounds actually buys almost 10 dollars worth of oil. The second issue I have is with your friends explanation is that it does NOT cost an extra 16% to convert currency, that's about the most ridiculous thing I have ever heard. The conversion charge on many RETAIL credit cards are about 1%. Institutions pay only a fraction of that as well. It's just a few basis points for the conversion. Your price of gasoline is lowered whenever the pound rises against the dollar. It's the taxes my friend

Nog said...

Cheezy has an excellent point. If things are marked down just because you can buy them in dollars, someone will sell other currencies and buy things like oil until there is a price equilibrium. There are, in fact, folks who do this sort of thing for a living.

If a dollar is worth 1 pound, and a dollar can buy 1 barrel of oil and a pound can only buy .5 barrels, there'll be a killing to be had. Someone will make billions having a computer program do the following.
-Take 1 dollar and buy 1 barrel of oil
-Take 1 barrel of oil and buy 2 pounds
-Take 2 pounds and buy 2 dollars
-Take 2 dollars and buy 2 barrels of oil
-Take 2 barrels of oil and buy 4 pounds
-etc.....

The MIT mathematical economists and their computer programs working at trading firms will start ticking and an equilibrium price will be reached in nanoseconds. In real life, the differences don't have to be this drastic. They can be just a small fraction of one percent. Every time the smallest currency-price disparity arises, some computer program flags it and starts trading like hell until the disparity is gone.


-Nog

Falling on a bruise said...

I asked him for a jist of it and not a finanically accurate example because that is where people fall asleep. Just the very basic idiots guide for simpletons with whole numbers to keep it simple. That my financially astute friends is what this is.

Cody Bones said...

"That my financially astute friends is what this is."

no it isn't, its just dead wrong.

Falling on a bruise said...

I bet you £10 it isn't, just as soon as i change it into dollars which means it will cost me $11 and you only $10. Not very fair is it. Hey, isn't that how the reserve currency works? I will ask my friend, he knows about these things.

Cody Bones said...

Umm 10 pounds will cost me $16.21, and the exchange cost will be 2cents