In this lesson summary review and remind yourself of the key terms and graphs related to the market for foreign exchange (FOREX).
Lesson summary
The foreign exchange market is like any other market insofar as something is being bought and sold. However, the foreign exchange market is unique in two ways:
- A currency is being bought and sold, rather than a good or service
- The currency being bought and sold is being bought with a different currency.
Key Terms
| Key term | Definition |
|---|
| exchange rate | the price of one currency in terms of another currency; for example, if the exchange rate for the Euro (€) is 132 Yen (), that means that each Euro that is purchased will cost 132 yen. |
| foreign exchange market | a market in which one currency is exchanged for another currency; for example, in the market for Euros, the Euro is being bought and sold, and is being paid for using another currency, such as the yen. |
| demand for currency | a description of the willingness to buy a currency based on its exchange rate; for example, as the exchange rate for Euros increases, the quantity demanded of Euros decreases. |
| appreciate | when the value of a currency increases relative to another currency; a currency appreciates when you need more of another currency to buy a single unit of a currency. |
| depreciate | when the value of a currency decreases relative to another currency; a currency depreciates when you need less of another currency to buy a single unit of a currency. |
| floating exchange rates | when the exchange rate of currencies are determined in free markets by the interaction of supply and demand |
Key takeaways
Why the demand for a currency is downward sloping
When the exchange rate of a currency increases, other countries will want less of that currency. When a currency appreciates (in other words, the exchange rate increases), then the price of goods in the country whose currency has appreciated are now relatively more expensive than those in other countries. Since those goods are more expensive, less is imported from those countries, and therefore less of that currency is needed.
For example, suppose the price of a cell phone in the U.S. is , and the current exchange rate in Japan is 90 ¥ per dollar. That means that it takes: to buy the same cell phone in Japan. If two cell phones are imported into Japan, then a total of 800 US dollars will be needed to buy these phones.
However, if the dollar appreciates so that it now takes to buy a dollar, the same cell phone now costs . Because cell phones are more expensive, only one is imported into Japan from the United States, so the quantity of US dollars that Japan wants will fall from to .
The equilibrium exchange rate is the interaction of the supply of a currency and the demand for a currency
As in any market, the foreign exchange market will be in equilibrium when the quantity supplied of a currency is equal to the quantity demanded of a currency. If the market has a surplus or a shortage, the exchange rate will adjust until an equilibrium is achieved.
For example, suppose Westeros is a trading partner of Hamsterville, and the currency of Westeros is the Westeros Gold Dragon (). Currently, the exchange rate is per Hamsterville snark (). At this exchange rate, Hamsterville wants to sell , but Westeros only wants to buy . Therefore, there is a surplus of .
Like any surplus, this will place downward pressure on the price. If the exchange rate is flexible, then the exchange rate will decrease until the quantity supplied is equal to the quantity demanded.
Key Graphical Models
Suppose the United States and Japan are trading partners. Japan’s currency is the Yen () and United States’ currency is the U.S. dollar (). We can represent the market for the U.S. Dollar in the foreign exchange market, as shown here:
You bet! The nation of Nickelstan uses nickels as their currency. The nation of Cookiestan uses the Cookiestan Cookie () as their currency. Of course, the CC is not an actual cookie, but a round piece of paper with the impression of a cookie.
Nickelstan is a popular vacation destination for the citizens of Cookiestan, and people traveling to Nickelstan need the local currency, the Nickel, to buy things. They go to the foreign exchange market for the Nickel to buy Nickels.
Well, how are they going to pay for these Nickels? Not with Nickels! The are going to trade in their own currency. So the demand for the Nickelstan Nickel is based on countries like Cookiestan wanting to buy Nickels.
The higher the exchange rate (that is, the more it takes to buy a Nickel), the less currency will be demanded. For example, suppose a lime smoothie costs Nickels in Nickelstan, and the current exchange rate is per nickel. To the citizens of Cookiestan, a lime smoothie costs once you account for the exchange rate. If suddenly the exchange rate is per nickel, that lime smoothie’s price shot up to . Suddenly those smoothies don’t seem as appealing, so as people buy less of them, they need fewer Nickels to do so.
Ok, so where does the supply of these Nickels come from? Well, Nickelstanians are also fond of travel and need other countries currencies to buy things abroad. So, Nickelstan will supply their own currency in hopes of trading them in for other currencies.
The interaction of the supply of Nickels and the demand for Nickels will yield an equilibrium exchange rate. The graph illustrates the foreign exchange market for Nickels in equilibrium. Note that cookies are the label for the price of Nickels, because that is how the Nickels are being paid for. Also, note that a nickel is on the quantity label because that is what is being bought.
Common misperceptions
We are used to thinking about buying things with a currency, so many new learners are confused about what the price should be in the market for a currency. Buthe price of an orange is never given in oranges; it’s given in some other currency. Just like an orange, a dollar can’t be bought with itself, but instead it needs to be bought with some other currency.
A common misperception is to confuse 1) the things that cause shifts in the supply or demand of a currency with 2) changes in quantity supplied or quantity demanded. To keep this straight, ask yourself “why is this change happening?” If a change is happening in response to a change in the exchange rate, then you are moving along a curve. If a change is happening in response to something else, the entire curve shifts.
It might seem like a time saver to take short-cuts on labeling graphs, but this is never a good idea. Take your time labeling the foreign exchange market carefully using the elements of a market:
Demand - the demand for the currency that is being exchanged
- Supply - the supply of the currency that is being exchanged
- Quantity - the quantity of the currency that is being exchanged
- Price - some other currency that is being used to buy the currency that is being exchanged
FAQs
The foreign exchange market is an over-the-counter global market where the buying and selling of global currencies occur, determining their exchange rates.
What shifts demand in the foreign exchange market? ›
Some factors that influence the demand for a country's exports include price levels (lower price levels, higher demand), foreign national income (more foreign income, more demand), and foreign consumers' tastes and preferences. The second determinant of demand is interest rates.
How does the exchange rate graph work? ›
The vertical axis shows the exchange rate for U.S. dollars, which in this case is measured in pesos. The horizontal axis shows the quantity of U.S. dollars being traded in the foreign exchange market each day.
What is foreign exchange in macroeconomics? ›
The foreign exchange market is the market in which foreign currency—such as the yen or euro or pound—is traded for domestic currency—for example, the U.S. dollar.
What is the conclusion of the foreign exchange market? ›
In conclusion, the foreign exchange market is a dynamic and essential component of the global financial system. It serves as a platform for the exchange of currencies between countries, facilitating international trade and investment.
What is the foreign exchange market simplified? ›
a market in which one currency is exchanged for another currency; for example, in the market for Euros, the Euro is being bought and sold, and is being paid for using another currency, such as the yen.
Who would demand U.S. dollars in the foreign exchange market? ›
Europeans who want to buy U.S. goods, services, and assets will need to use dollars in order to pay. These individuals will need to exchange euro for dollars, which means that they will buy USD and sell EUR. Since they are buyers of dollars, they will be on the demand side in the dollars market.
What are the three sources of demand for foreign exchange? ›
Foreign exchange is demanded for the purpose of: i Payments of international loans. ii Gifts and grants to rest of the world. iii Investment in rest of the world.
What are the functions of the foreign exchange market? ›
The main functions of the market are to (1) facilitate currency conversion, (2) provide instruments to manage foreign exchange risk (such as forward exchange), and (3) allow investors to speculate in the market for profit.
Why do people demand foreign exchange? ›
Purchase of assets abroad: There is a demand for foreign exchange to make payments for the purchase of assets like land, shares, bonds, etc., abroad. Speculation: When people earn money from the appreciation of currency it is called speculation. For this purpose, they need foreign exchange.
Income levels can affect the foreign exchange rate by influencing expectations of higher interest rates, increased imports, and more financial inflows, which can strengthen the local currency and decrease the exchange rate against foreign currency.
What is the basic of foreign exchange market? ›
The foreign exchange (forex or FX) market is a global marketplace for exchanging national currencies. Because of the worldwide reach of trade, commerce, and finance, forex markets combine to be the world's largest and most liquid asset markets. Currencies trade against each other as exchange rate pairs.
How does foreign exchange affect the economy? ›
The exchange rate affects the real economy most directly through changes in the demand for exports and imports. A real depreciation of the domestic currency makes exports more competitive abroad and imports less competitive domestically, thereby increasing demand for domestically produced goods.
Why is the foreign exchange market important? ›
The importance of the Forex market can be understood by studying its role in a country's economy. The foreign exchange market primarily exists for catering the currency needs of exporters, importers, and travelers. Unlike equity markets, the currency market is not an investor oriented market.
What happens when the exchange rate increases? ›
An increase in exchange rates reduces the balance of trade in a country by reducing exports and increasing imports. If a country's imports are valued higher than their exports, the country is said to have a trade deficit and a lower demand for their currency.
What is the point of the foreign exchange market? ›
The main functions of the market are to (1) facilitate currency conversion, (2) provide instruments to manage foreign exchange risk (such as forward exchange), and (3) allow investors to speculate in the market for profit.
What is the foreign market in simple terms? ›
Foreign markets are any markets outside of a company's own country. Selling in foreign markets involves dealing with different languages, cultures, laws, rules, regulations and requirements. Companies looking to enter a new market need to carefully research the potential opportunity and create a market entry strategy.
What is the foreign exchange market in layman terms? ›
The forex market is where banks, funds, and individuals can buy or sell currencies for hedging and speculation.
What is the primary purpose of the foreign exchange market? ›
In simpler terms, it's the place where one country's currency is exchanged for another's. This market operates 24 hours a day, five days a week, allowing for continuous trading across different time zones. The primary purpose of the foreign exchange market is to facilitate international trade and investment.
