The examples of gains from trade in Chapter 1 focus on the trade between only two people. But, in fact, and as explored in depth in Chapter 29 (Chapter 17 in the Micro and Macro splits), thousands or even billions of people engage in trade. Such trade is called multilateral trade, rather than bilateral trade, because more than two parties participate.

Multilateral Trade and the Need for a Medium of Exchange

Multilateral trade between people requires a medium of exchange to facilitate such trades. A medium of exchange is a generally acceptable item that people can buy and sell goods for. Money—paper currency or coin—is such a medium of exchange.

Money facilitates trade by permitting people to exchange any good or service for money. The money can then be used to buy any other good or service—not only ballet or opera tickets—from anyone—not only Adam or Maria. Hence, money circulates among the buyers and sellers, facilitating the exchange of goods. Money is very handy when trade is multilateral.

Different Money in Different Countries

Different countries use different forms of money: dollars in the United States, yen in Japan, marks in Germany, pesos in Mexico, and so on. The use of different monies is a custom or tradition much like the use of different languages. But just as different languages create a need for translators so that people can communicate, different monies create a need for exchanging one currency for another so that people can trade. In other words, trade between countries requires that people exchange the currency of one country for that of another.

Exchange Rates

When Emily in the United States buys printing services from Johann in Germany, he will want to be paid in marks, but she will have dollars to pay. Thus, Emily will need to exchange her dollars for marks. The exchange rate tells us how many marks Emily can get for her dollars. The exchange rate is the price of one money in terms of another.

For example, if the dollar/mark exchange rate is 2 marks per dollar, then Emily could obtain 2 marks for each of her dollars when buying printing services from Johann. If the dollar/mark exchange rate fell to 1 mark per dollar, then Emily could obtain only 1 mark per dollar. If the exchange rate rose to 3 marks, she could get 3 marks per dollar.

Emily could exchange dollars for marks in many places: Most international airports offer travelers the opportunity to exchange dollars for several different currencies. There are also cash machines that change one currency into another. As long as there is a place where such exchanges can be carried out, people can trade goods and services in different countries, much as they can in the same country. However, the exchange rate can fluctuate from year to year or even day to day. Like most other prices, the exchange rate is determined by the forces of supply and demand (see also Chapter 16 (Chapter 15 in the Macro split) for a discussion of the foreign exchange market).