Unit 5.2 Foreign Exchange Markets

Another financial market that influences macroeconomic variables is the foreign exchange market, a market in which currencies of different countries are traded for one another. Since changes in exports and imports affect aggregate demand and thus real GDP and the price level, the market in which currencies are traded has tremendous importance in the economy.

Foreigners who want to purchase goods and services or assets in the United States must typically pay for them with dollars. United States purchasers of foreign goods must generally make the purchase in a foreign currency. An Egyptian family, for example, exchanges Egyptian pounds for dollars in order to pay for admission to Disney World. A German financial investor purchases dollars to buy U.S. government bonds. A family from the United States visiting India, on the other hand, needs to obtain Indian rupees in order to make purchases there. A U.S. bank wanting to purchase assets in Mexico City first purchases pesos. These transactions are accomplished in the foreign exchange market.

The foreign exchange market is not a single location in which currencies are traded. The term refers instead to the entire array of institutions through which people buy and sell currencies. It includes a hotel desk clerk who provides currency exchange as a service to hotel guests, brokers who arrange currency exchanges worth billions of dollars, and governments and central banks that exchange currencies. Major currency dealers are linked by computers so that they can track currency exchanges all over the world.

The Exchange Rate

A country’s exchange rate is the price of its currency in terms of another currency or currencies. On March 26, 2019, for example, the dollar traded for 64.40 rubles, and the euro for 72.51 rubles. There are as many exchange rates for the dollar as there are countries whose currencies exchange for the dollar – roughly 200 of them.

Determining Exchange Rates

The rates at which most currencies exchange for one another are determined by demand and supply. How does the model of demand and supply operate in the foreign exchange market?

The demand curve for dollars relates the number of dollars buyers want to buy in any period to the exchange rate. An increase in the exchange rate means it takes more foreign currency to buy a dollar. A higher exchange rate, in turn, makes U.S. goods and services more expensive for foreign buyers and reduces the quantity they will demand. That is likely to reduce the quantity of dollars they demand. Foreigners thus will demand fewer dollars as the price of the dollar – the exchange rate – rises. Consequently, the demand curve for dollars is downward sloping, as in Figure Determining an Exchange Rate.

Figure Determining an Exchange Rate

The equilibrium exchange rate is the rate at which the quantity of dollars demanded equals the quantity supplied. Here, equilibrium occurs at exchange rate E, at which Q dollars are exchanged per period.

The supply curve for dollars emerges from a similar process. When people and firms in the United States purchase goods, services, or assets in foreign countries, they must purchase the currency of those countries first. They supply dollars in exchange for foreign currency. The supply of dollars on the foreign exchange market thus reflects the degree to which people in the United States are buying foreign money at various exchange rates. A higher exchange rate means that a dollar trades for more foreign currency. In effect, the higher rate makes foreign goods and services cheaper to U.S. buyers, so U.S. consumers will purchase more foreign goods and services. People will thus supply more dollars at a higher exchange rate; we expect the supply curve for dollars to be upward sloping, as suggested in Figure Determining an Exchange Rate.

In addition to private individuals and firms that participate in the foreign exchange market, most governments participate as well. A government might seek to lower its exchange rate by selling its currency; it might seek to raise the rate by buying its currency. Although governments often participate in foreign exchange markets, they generally represent a very small share of these markets. The most important traders are private buyers and sellers of currencies.