The Foreign Exchange Market

The Foreign Exchange Market

The foreign exchange market is the monetary nexus between countries that makes it probable for global trade to be accomplished more efficiently than barter. Because each nation uses its own monetary unit, people in one nation who want to acquire goods in another nation must replace their own currency for the other to accommodate the business deal. The foreign exchange market is where one countries’ currency is exchanged for another.

On any given day in the region of $1.5 trillion in foreign exchange is traded! By any shape or form, that's a lot. The stature dwarfs the worth of day-by-day international stock exchange. “It is almost 20% of the United States GDP and nearly the size of the U.S. federal budget for an entire fiscal year (www.worldgameofeconomics.com).” Contrary to what several people may believe, the majority of foreign exchange trading is not in currencies, as such. Rather, it is in the form of bank deposit balances. “ Also, a surprisingly small number of banks account for the bulk of the volume, and nearly 90% of all trades involve U.S. dollars (www.worldgameofeconomics.com).”

Even though a small number of countries officially fix the trade value of their currency to a key currency or basket of currencies, the market forces of supply and demand chiefly determine the exchange rate betwixt nearly all currencies. When people in Europe provide euros to demand dollars with the purpose of purchasing U.S. products, the exchange value of the euro depreciates and the dollar appreciates, and everything else is constant. If the supply of a currency surpasses the demand for it, its worth will decrease in the foreign exchange market. On the other hand, if the demand for a currency is greater than its supply, then its value will increase. A rise in the supply of one currency is simultaneously a boost in demand for the other. The figure below illustrates how this works in the context of international trade.

Figure 1-1 (A) French citizens supply euros to their banks and demand dollars to import goods and services from the United States. The worth of the euro falls from $1.00 to $0.98. (B) At the same time, the value of the dollar appreciates from 1.00 to 1.02 euros. (C) U.S. citizens supply dollars to their banks to demand euros to import goods and services from France. The worth of the dollar falls from 1.02 euros to 1.00 euro. (D) Simultaneously, the euro goes back to equal $1.00. If supply and demand for the two currencies is at equilibrium, then the exchange rate betwixt the two currencies will stay constant. Exchange rates fluctuate when the relative supply and demand schedules do not balance.

To really comprehend how the market decides whether the euro has a value of $0.98, $1.00, or $1.02, one needs to look at the contributors and the underlying market forces motivating their decisions. The key players or participants in the foreign exchange market are companies and persons who engage in worldwide commerce and their banks, foreign investors, currency speculators, and central banks. “Somewhat surprisingly, less than 20% of all foreign exchange transactions are directly linked to the needs of importers and exporters of internationally traded merchandise and services. Over 80% of the transactions involve short-term speculation and the purchase of foreign financial investments (www.worldgameofeconomics.com).” Very seldom, do central banks interfere in the foreign exchange market to intentionally influence the exchange value of their nation's currency.

The relative supply and demand schedules for any two currencies on the part of these contributors are a function of population, consumer tastes, disposable incomes, the relative price levels in the two countries, peoples' expectations concerning future prices and exchange rates, the relative rates of real return on financial investments, and the purposes of central banks. “We can formulate the following generalizations for each of these variables (assuming the others are held constant):

1. A country with a vast population will demand more currency from a country with a small population than vice versa.

2. People will demand more currency from another country when they find its products to be more attractive.

3. Countries with high and growing incomes will demand more foreign currency than countries with low incomes or those that are in recession.

4. Relatively high domestic inflation in a nation will curtail the demand for its currency.

5. If importers anticipate prices in the exporting country to increase in the future, they will demand more of that currency in the present to beat the price increases.