I. The Foreign Exchange Market

Trading Currencies

• International trade, borrowing, and lending, make it necessary to exchange currencies. Foreign currency is the money of other countries regardless of whether that money is in the form of notes, coins, or bank deposits. The foreign exchange market is the market in which the currency of one country is exchanged for the currency of another. The price at which one currency exchanges for another is called the exchange rate.
• Over time, the U.S. dollar appreciates and depreciates against other currencies such as the Japanese yen or European euro. Currency depreciation is the fall in the value of one currency in terms of another currency. Currency appreciation is the rise in the value of one currency in terms of another currency.

· A rise in the U.S. exchange rate is called an appreciation of the dollar; a fall in the U.S. exchange rate is called a depreciation of the dollar.

The Demand for One Money is the Supply of Another Money

The exchange rate is determined by demand and supply in the (competitive) foreign exchange market. When people holding the money of some other country want to exchange it for U.S. dollars, they supply the other currency and demand dollars. When people holding U.S. dollars want to buy the currency of some other country, they supply U.S. dollars and demand the other currency.

Demand in the Foreign Exchange Market

The main factors that influence the dollars that people plan to buy in the foreign exchange market are the exchange rate, world demand for U.S. exports, interest rates in the United States and other countries, and the expected future exchange rate.

• The law of demand in the foreign exchange market is: Other things remaining the same, the higher the exchange rate, the smaller is the quantity of dollars demanded in the foreign exchange market. There are two reasons for the law of demand:

· Exports Effect: Dollars are used to buy U.S. exports. The lower the exchange rate, with everything else the same, the cheaper are U.S. exports so the greater the quantity of dollars demanded on the foreign exchange market to pay for the exports.

· Expected Profit Effect: The lower the exchange rate, with everything else the same (including the expected future exchange rate), the larger the expected profit from buying dollars so the greater the quantity of dollars demanded on the foreign exchange market.

• The law of demand means that the demand curve for U.S. dollars is downward sloping, as illustrated in the figure below.

Supply in the Foreign Exchange Market

The main factors that influence the dollars that people plan to sell in the foreign exchange market are the exchange rate, U.S. demand for imports, interest rates in the United States and other countries, and the expected future exchange rate.

• The law of supply in the foreign exchange market is: Other things remaining the same, the higher the exchange rate, the greater is the quantity of dollars supplied in the foreign exchange market. There are two reasons for the law of supply:

· Imports Effect: Dollars are used to buy U.S. imports. The higher the exchange rate, with everything else the same, the cheaper are foreign produced imports so the greater the quantity of dollars supplied on the foreign exchange market to buy these imports.

· Expected Profit Effect: The higher the exchange rate, with everything else the same (including the expected future exchange rate), the smaller the expected profit from holding dollars so the larger the quantity of dollars supplied on the foreign exchange market.

• The law of supply means that the supply curve for U.S. dollars is upward sloping, as shown in the figure.

Market Equilibrium

• Demand and supply in the foreign exchange market determine the exchange rate. In the figure, the equilibrium exchange rate is 100 yen per dollar, where the demand and supply curves intersect.

· If the exchange rate is higher than the equilibrium exchange rate, a surplus of dollars drives the exchange rate down.

· If the exchange rate is lower than the equilibrium exchange rate, a shortage of dollars drives the exchange rate up.

· The market is pulled to the equilibrium exchange rate at which there is neither a shortage nor a surplus.

Date: 2015-12-11; view: 816