The Economics of Foreign Exchange: Foreign Exchange Markets

Foreign Exchange Markets Whenever a foreign firm or individual purchases U.S. goods or services, a supply of foreign currency to be exchanged for dollars is created. Similarly, when U.S. firms and citizens wish to purchase foreign goods and services, a demand for foreign currency is created. Because of the many banks and dealers buying and selling bank deposits and other funds denominated in various currencies, the market for foreign exchange of any money is quite competitive. Foreign exchange is the money of one nation held by citizens of another nation either as currency or as deposits in banks. Keep in mind that foreign exchange must be willingly held either as currency in the account of a bank or as assets denominated in foreign monetary units. Foreigners holding dollars must either keep them as idle balances in their U.S. correspondent banks or lend them out to U.S. firms or governments. They make such loans by purchasing the debt instruments of governments, banks, or households. Of course, the foreign holders of dollars can also use them to make direct investments in the United States by purchasing U.S. assets such as real estate or corporate stocks. The demand for U.S. dollars as foreign exchange depends on foreign demand for U.S. goods and services and the willingness of foreigners to hold their dollars as deposits (or cash) for future use or to invest the dollars in U.S. real and financial assets. The supply of dollars to foreigners depends on the willingness of U.S. house-holds, firms, and governments to exchange their dollars for foreign currency. This in turn depends on U.S. demand for foreign goods and services as well as the willingness of U.S. citizens and governments to use dollars to acquire financial and real assets denominated in foreign monetary units. There are really many foreign exchange markets one for each possible pair of currencies. Of course, the market of dollars for marks is the same as the market of marks for dollars, because once the equilibrium exchange rate of dollars for marks is established, so is the equilibrium exchange rate of marks for dollars. For example, suppose the equilibrium dollar price of German marks is 50 cents per mark. The equilibrium exchange rate of marks for dollars must therefore be 2 marks per dollar. If this were not the case, what would happen? If a dollar cost only 1 mark while the mark cost 50 cents, you could make some quick profits as a foreign exchange dealer. You could buy 2 marks for $1. You could then turn around and sell each of those marks for $1, thus making a quick $1 profit on your initial $1 purchase! Profit opportunities like this would exist whenever there were discrepancies in the exchange rate of dollars into one currency and that currency into dollars. Because firms specializing in foreign exchange transactions would be quick to seize opportunities to earn profit when such exchange rate discrepancies do occasionally crop up, the discrepancies are usually quickly eliminated. In the preceding example, the demand for marks would increase, pushing up the price of the mark in terms of dollars, and the supply of dollars offered in exchange for marks would increase, putting downward pressure on the price of the dollar in terms of marks. The exchange rates of the mark and of the dollar would adjust until it was no longer possible to make profits by buying marks and then quickly selling them for dollars. Equilibrium Exchange Rates Just like any good or service, the price (exchange rate) of a nation's currency in terms of any foreign currency depends on the market demand for and supply of the nation's currency. The graph in Box 3 shows the demand and supply curves for dollars based on the exchange rate of marks for dollars, which represents the price of a dollar in terms of marks. The demand for dollars by those who hold marks depends on the desires of those people and businesses to use dollars to purchase U.S. goods and services and to invest in U.S. financial and physical assets. Other things being equal, the lower the price of a dollar in terms of marks, the lower the cost of purchasing U.S. items for those who hold marks. To see this, suppose the current price of a personal computer manufactured in the United States is $2,000. If the current exchange rate is 2 marks per dollar, that computer will cost a German citizen 4,000 marks. However, if the exchange rate were only 1 mark per dollar, the same computer would cost a German only 2,000 marks. Naturally, the lower the price of the dollar in foreign currency, the lower the price of U.S. goods, services, and assets (denomi-nated in dollars) in terms of the foreign money and the greater the demand for these items by foreigners. The increase in demand increases the quantity of dollars demanded by holders of the foreign currency. The demand curve for dollars is therefore downward sloping. The supply of dollars offered in exchange for foreign currency, such as the German mark, depends on the willingness of holders of dollars to purchase marks. The supply of dollars for marks depends on the desires of U.S. citizens to purchase German goods and services and to invest in German assets. Other things being equal, an increase in the exchange rate of dollars in terms of marks is likely to increase the quantity of dollars supplied in exchange for marks. To see why this is so, suppose the price of a new BMW available as a U.S. import is 50,000 marks. If the exchange rate is 2 marks per dollar, the dollar equivalent of the marks necessary to purchase the car is $25,000. Now suppose the exchange rate increases to 2.5 marks per dollar. How much will the car now cost someone paying in dollars? To find out, simply multiply the 50,000 marks by the 1/2.5 dollars necessary to buy each mark. The price in dollars is now only $20,000. Naturally, the BMW, as well as other German goods, is now more attractive to holders of dollars because its price in terms of dollars is lower. A higher exchange rate increases the quantity of dollars supplied to foreign exchange markets because it increases U.S. demand for imports. The supply curve of dollars for a foreign currency therefore slopes upward. In Box 3 the equilibrium price of the dollar is 2 marks per dollar. At that price the number of dollars demanded per day by holders of marks exactly equals the number of dollars supplied per day by holders of dollars in exchange for marks. If instead the equilibrium price were 3 marks per dollar, the quantity of dollars supplied for marks would exceed the quantity demanded. The resulting surplus of dollars offered for marks would put downward pressure on the exchange rate of marks for dollars. If the price of dollars were 1.5 marks, the quantity of dollars demanded by holders of marks would exceed the quantity of dollars supplied for marks by holders of dollars. The resulting shortage of dollars would put upward pressure on the exchange rate of marks per dollar. Actual equilibrium exchange rates change in response to shifts in the demand for and supply of dollars for foreign currencies. In fact, foreign exchange rates are quite volatile. They move up and down almost daily. The fluctuations of foreign exchange rates make international transactions a bit risky.