The reality of exchange rate determination (sources to learn more)

This post contains a very brief overview of, and many sources to learn the reality of exchange-rate determination – alternatively called foreign exchange, or the international, foreign, or external sector.

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This post was last updated February 4, 2022.

Disclaimer: I have studied MMT since February of 2018. I’m not an economist or academic and I don’t speak for the MMT project. The information in this post is my best understanding but I don’t assert it to be perfectly accurate. In order to ensure accuracy, you should rely on the expert sources linked throughout. If you have feedback to improve this post, please get in touch.

Below are many sources to learn the reality of exchange-rate determination – alternatively called foreign exchange, or the international, foreign, or external sector. First, a very brief overview.

The term “foreign trade” is a misnomer. Trade is defined as the exchange of services and physical goods. In reality, this kind of exchange actually comprises only between 1.5% to 8% of all international transactions. The rest is the exchange of financial assets. In other words, the vast majority of international transactions is the exchange of money for money. Here’s from page 8 in John Harvey’s 2021 paper, Modern Monetary Theory, the United Kingdom, and Pound Sterling:

In 2019, there was an estimated $1,650 trillion in foreign exchange market activity (Bank for International Settlements 2019, p.3). In that same year, world trade in goods and services was $24.96 trillion (World Trade Organization 2020, p.17). This is 1.5% of total currency market activity. Even allowing for multiple covering transactions by various parties and multiplying this by a factor of five, it still yields a total of only $124.8 trillion, or 7.5% of total foreign exchange volume.

Despite this, neoclassical theory only recognizes the existence of trade, leading it to conclusions that are nearly always wrong. Here’s my take on the deeper reasoning behind these ostensible flaws.

As I understand it, the definitive work describing the reality of exchange rate determination is John Harvey’s textbook Currencies, Capital Flows, and Crises (CCC). John is a Post Keynesian economist who’s extremely friendly to MMT. The book was a challenge for me, but enlightening and worth the effort. The show notes to part one of my interview with John describes my journey in preparing to read it. I chose to go above and beyond (especially by attempting to read chapter two!), and so made it a bit more difficult than it could have been.

Before attempting to read John’s book, I’d recommend consuming the below resources, starting with the following two:

  1. First, read Jonathan Wilson’s 2021 article, The Cool Stuff Hypothesis Versus the Petrodollar. The post describes why people want to hold the money of another country in the first place. Here’s my two-part interview with Jonathan on this post: parts one and two
  2. Second, read Thomas Oberlechner 2004 book The Psychology of the Foreign Exchange Market. It’s a very complementary read to John’s text (both books cite each other) and is an easy read that requires no economic background.

Sources to learn the reality of exchange-rate determination

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